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Factoring Accounts Receivables into Business Finance

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Date added: 17-06-26


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In short term financing, factoring forms an important part. Factoring is a financial transaction whereby a business sells most of its accounts receivable to a third party who is called a factor at a discount in exchange for immediate money with which to finance continued business. In pledging accounts receivables, the firm retains title to the receivables whereas in factoring of account receivables are transferred titles by selling them.

Factoring differs from a bank loan in 2 main ways. First, the major emphasis is on the value of the receivables which is essentially a financial asset, not the firm's true credit worthiness. Secondly, factoring is in fact, not a loan - it is the selling or the purchase of a financial asset or simply the accounts receivable of the firm. Factoring is also different from forfeiting as forfeiting is a transaction based operation while factoring is a firm-based operation. This means that in factoring, a firm sells all of its receivables while in forfeiting, the firm sells one of its transactions. Thus, forfeiting is not the same as factoring accounts receivables can be. Unlike loans, in the method of factoring, there are 3 parties involved: The Company who is selling the invoices and its receivables; the debtors in the system and the factor who is getting all those account receivables. Sometimes, factoring is used in place of invoice discounting, which involves borrowing where the receivers is to be used as collateral. In factoring, receivables are directly sold. Thus, factoring is different from invoice discounting.

Factoring is a method used by a firm to obtain Cash when the available Cash Balance held by the firm is insufficient to meet current obligations and accommodate its other cash needs, such as new orders or contracts. The factoring technique is mainly used during short term financing so that the firm's immediate cash needs to allow the firm to maintain a smaller ongoing cash balance. Firms may often find it necessary to both maintain a Cash Balance on hand, and to use such methods as Factoring, in order to enable them to cover their Short Term cash needs in those periods in which these needs exceed the Cash Flow.

The factoring involves a process as described: When initially contacted by a prospective invoice seller, the factor i.e., subsidiary of a bank holding company first establishes whether or not a basic condition exists which involves the satisfactory answer to the question: does the potential debtor(s) have a history of paying their bills on time Factoring of accounts receivable process satisfy needs as said:

Factor is often a subsidiary of a bank holding company.

Factor maintains a credit department and performs credit checks on accounts.

Allows firm to eliminate their credit department and the associated costs.

Contracts are usually for 1 year, but are renewable.

Cost of factoring

Factoring can serve as a vehicle for outsourcing credit and collection responsibilities. Factoring of accounts receivable results in various costs as shown: Factor receives a commission on the face value of the receivables which is typically <1% but can run to as much as 3%. Cash payment is usually made on the actual or average due date of the receivables. The third type of cost is that if the factor advances money to the firm, then the firm must pay interest on the advance. Total cost of factoring is composed of a factoring fee plus an interest charge on any cash advance. Thus, this method is used to incur cost on a firm. Although expensive, it provides the firm with substantial flexibility. For a small firm, the savings may be quite substantial.

If the factored recievables total $10,000 and factoring cost is 2% then the factor credits the firm's account with 2% less i.e., $9,800. If the firm wishes to draw before receivables become due, then an interest of 1.5% per month is to be paid. In 1 month if the firm wishes to have 1 cash advances then, the firm is entitled to the interest cost of $9,800 X 0.015 = $147.00 Therefore the actual cash advance will be $9,800 - $147 = $9,653

Factoring exports and flexibility

These days, it is used for aircraft parts, surgical tools and common photo equipment. Factoring foreign receivables has advantage over asking buyer about trade of credit. The main advantage is to ship goods without risk of not getting paid. Increase sales in foreign markets by offering competitive 'open account' terms of sale. But, transaction fee cannot be passed to the buyer and getting paid can sometimes take too much time.

Factoring companies do not finance small shipments. Working is demonstrated as: US exporters sells account receivables to factor company. The factor assumes credit risk and takes responsibility for customer credit checks and billing. If the buyer discovers that the credit of firm is not good then he has the right to deal back. Financing technique has its limitations. Though factors make their money by assessing credit risks, they often donot want to factor exports of the firm.

The typical factoring arrangement is assumed to be continous. As new receivables are incurred, they are sold to the factor and the firm's account is then credited. The principal sources of factoring are banks, subsidiary and bank holding factors including certain old - line factories. Factors relieve the term of credit checking, the cost of processing variables, the collection and bad - debt variables.

Composition of Short term finance

Short term finance contains a number of parts, most of which are

Cost of financing method

Any meaningful analysis of several alternative sources of funds of financial analysis is a comparison of their costs and the problem of timing. The major problem with cost determination is that cost differentials among the various short term financing alternatives are not necessarily constant over time. Indeed, they fluctuate in keeping with changing market conditions.

Fund availability

The availability of funds is also important. If a firm cannot borrow through commercial paper or through a bank loan because of its low credit standing, it must turn to alternative sources. The lower the credit standing of the firm fewer are the sources of short term financing available to it.

Timing

Timing bears heavily on the question of the most appropriate mix of short term financing. With short term loans, the firm can pay off the debt it has surplus funds and thereby reduce its overall interest costs. With factoring of accounts recievables, advances can be taken only when needed, and interest costs incurred only as necessary.

Flexibility

Flexibility with respect to short term financing pertains to the firm's ability to pay off a loan as well as to its ability to renew or even increase it. Flexibility also relates to how easily the firm can increase its borrowing on short notice. With a line of credit or revolving credit at a bank, it is an easy matter to increase borrowings, assuming the maximum limit has not been reached. With other forms of short term financing, the firm is less flexible.

Degree to which assets are encumbered

It mainly involves some legal claims. With secured loans, lenders obtain a lien on the various assets of the firm. This secured position puts constraints on the firm's future financing possibilities. When receivables are actually sold under a factoring arrangement, the principle remains the same. In this case, the firm is selling one of its most liquid assets, thus reducing its creditworthiness, in the minds of many creditors.

The best mix of short-term financing depends on these 5 factors as stated. A proper balance with these factors needs to be checked. All of these factors influence the firm in deciding on the appropriate mix of short term financing. Because cost is perhaps the key factor, differences in other factors should be compared with differences in cost.

Conclusions

In the end, it can be seen that firms often go for Short Term Finance to meet temporary requirements of money. Some merits of short term financing can be:

Low interest cost: Relatively more economical to raise short-term finance as interest rates are lesser.

Flexibility: Loans can be paid back if not required.

No interference in management: The management retains their freedom in decision making which is not altered by the lender.

Long term: Short term financing loans can be renewed regularly and used for long term financing too.

But despite the above said merits, Short term finance suffers from demerit of temporary use due to its huge amount of uncertainty and risk in case of crisis and several legal formalities. Therefore most of the organizations may tend to keep away from short term financing loans.

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