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Purpose and goals of Factoring in business

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Date added: 17-06-26


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Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables (essentially a financial asset), not the firm's credit worthiness. Secondly, factoring is not a loan - it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three. 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 use of Factoring to obtain the Cash needed to accommodate the firm's immediate Cash needs will allow the firm to maintain a smaller ongoing Cash Balance. By reducing the size of its Cash Balances, more money is made available for investment in the firm's growth. A company sells its invoices at a discount to their face value when it calculates that it will be better off using the proceeds to bolster its own growth than it would be by effectively functioning as its "customer's bank." Accordingly, Factoring occurs when the rate of return on the proceeds invested in production exceed the costs associated with Factoring the Receivables. Therefore, the trade off between the return the firm earns on investment in production and the cost of utilizing a Factor is crucial in determining both the extent Factoring is used and the quantity of Cash the firm holds on hand. The various steps involved in a Factoring is summarized in the below drawn diagram:

The benefits of factoring

The factoring services consist of four main functions: Finance for the supplier; the factoring pays the client the amount necessary for his working, in exchange for his invoices. Maintenance of the receivables account; the factoring company manages the trade debts of the client, keeping the sales accounts ledgers and sending out the invoices. Collection of receivables; the factoring company collects the payments due from the debtors of the client. Protection against the default in payment by debtors; the factoring company carries the risk of any bad debt (if the debtor fails to pay).

Factoring in India

Factoring service in India is of recent origin. It owes its genesis to the recommendations of the Kalyanasundaram Study Group appointed by the RBI in 1989. Pursuant to the acceptance of these recommendations, the RBI issued guidelines for factoring services in 1990. An amendment was made in the Banking Regulation Act in 1983, whereby banks were permitted to provide these services either through their own departments or divisions or through their subsidiaries. Direct and indirect lending services were provided by setting up merchant banking and mutual funds subsidiaries. Factoring and forfaiting services were of recent origin following the recommendation of the Kalyansundram Committee, set up by the RBI in 1988. The Committee was constituted to examine the feasibility of factoring services in India, their constitution, organizational setup and scope of activities. The group recommended setting up of specified agencies or subsidiaries for providing the factoring services in India. While attempting to assess the potential demand for factoring services in India, the study group under the leadership of Mr. C. S. Kalyansundram estimated the value of outstanding open account credit sales available for financing during 1989-90 at Rs. 12,000 crore in respect of SSI and Rs. 4500 crore for medium and large scale sector. Assuming only 50% of the above business will be available for factoring; the aggregate potential demand for factoring was expected to be around Rs. 4000 crore per annum mainly emerging from the SSI and large and medium companies. The first factoring company was started by the SBI in 1991 namely Factors and Commercial Ltd. (SBI FACS) followed by Canara Bank and PNB, setting the subsidiaries for the purpose. While the SBI would provide such services in the Western region, the RBI has permitted the Canara Bank and PNB to concentrate on the Southern and Northern regions of the country, for providing such services for the customers. The major players since 1991 are Canbank Factors, SBI Factors and later Foremost Factors. The new entrants in the market include ICICI, HSBC and Global Trade Finance. Canbank Factors leads in the domestic market with about .65%-70%of the share. Growth of factoring in India has been far from slow. According to a World Bank report, India's factoring activity grew by over 800% between 1998 and 2003. According to the latest report from Factors Chain International (FCI), the Indian factoring market has grown from Euro 1290 million to Euro 3560 million (a growth of 176%) between 2002 and 2006. The Vaghul Committee Report on Money Market Reforms has stressed on the need for factoring services to be developed in India as part of the money market instruments. Many new instruments had already been introduced like Commercial Paper (CP), Participation Certificates (PC), Certificates of Deposits etc. but the factoring service has not developed to any significant extent in India. According to Factors Chain International, a global umbrella organization of factoring companies, India with just eight companies clocked a total turnover of Rs 19,860.5 crore in 2006 way below Japan's Rs 4,15,789.1 crore Taiwan's Rs 2,23,152. 6 crore and China's Rs 7,97,77.1 crore in Asia. The Indian factoring market has grown by 176 per cent from Rs 7,196.7 crore to Rs 19,860.5 crore between 2002 and 2006. Global leaders are the UK, France and Italy. Mr. Arvind Sonmale, MD & CEO, Global Trade Finance Ltd, said: "India accounts for 0.3 per cent of the world turnover. Even among Asian countries, India's share works out to an insignificant 2.37 per cent. It is estimated further that the factoring market would grow to reach a volume of Rs 45,944 crore by end-2007. Given the vast size of the Indian SME sector, factoring, which is getting qualitatively revamped from time to time by newly updated product lines, is expected to grow in the long run."

Roadblocks for Growth in India

The overall worldwide growth in factoring is estimated at 12%. Europe has the largest market representing 64% of the world volumes with a growth of 18% during the year. America's growth was 10%, whereas Australia recorded impressive growth of 40%. Asia saw a fall in volume. The growth trends mentioned above support the fact that there is enormous scope for expansion worldwide and India is no exception to this. The potential in India is estimated at an annual turnover of Rs. 15000 to Rs. 20000 cr, but large portion is untapped because of the following reasons:  1) Though Factoring is similar to Bill Discounting, What people fail to understand is that similarity is only in one aspect, i.e., both provide short term finance against receivables. Factoring also provides a package of other services which many people are not aware of.   2) Recourse   factoring only provides financing but not credit covers, whereas in case of non-recourse factoring, in the event of   default of a customer, the factor will bear the risk of bad debt.   However, the facility, which will attract more clients, is   almost missing, in India.    3) Factors have not been successful in creating awareness about   the concept of factoring. The difference between factoring   and bills discounting is still not clearly understood. The   customers are still not aware of the extra benefits and services   they can enjoy through factoring; they are not demanding these   services from factoring service providers.    4)Bankers do not permit their Customer to Shift their Business   to Factors: Every businessman invariably has dealings   with a bank. Hence, his banker does not permit him to shift his   account receivables business to a factor, but promises to   meet his requirements. A World Bank study says weak contract enforcement institutions and tax, legal, and regulatory impediments will hamper factoring services. "Factoring generally requires good historical credit information on all buyers; if unavailable, the factor takes on a large credit risk." It also points out that fraud represents another big problem in this industry (e.g. bogus receivables and non-existent customers). Mr. Laxman N. Sankade, Managing Director, Canbank Factors Ltd, said: "For factoring to develop, it is imperative that an enabling legal environment be created and the Factoring Bill be passed in Parliament. It is also seen that a lot of weak companies would actually be able to tide over their liquidity problems if the receivables are acceptable to the factoring companies and which could be factored." According to Mr. Basab Majumdar, Head- Factoring and Receivables Finance, India, HSBC, "Assignment of debt is still a cumbersome process and involves stamp duty which again is a State level subject and there is no uniformity in the rates of stamp duty across States. Moreover, every time a debt has to be assigned to the factor and stamp duty paid on the transaction, which has the potential of making the proposition expensive for the client. Most of the developed countries have implemented clear laws related to assignment/transfer of debt, bankruptcy, debt recovery, etc. Additionally in India, access to information on companies, their repayment performance with the banking system, etc is thinly available, which results in lack of information to decide on credit." According to Mr. Sankade, factoring in its true sense is factoring without recourse to the client. This may not be possible in India unless credit insurance is introduced in the country. In most of the Western countries, factoring is done without recourse, as they have the facility of credit insurance from insurance companies." Some of the factoring companies are also not happy with their status as non-banking finance company (NBFC). Mr. Sonmale said: "We can't initiate summary proceedings. There is no protection under either Debt Recovery Tribunal (DRT) or the Securitisation Act." Mr. Sankade said they have been pitching for a good sub-classification under the NBFC as a factoring company which would be better to attract business. He said banks should see factoring as a product that is complementary and improves the risk profile of the receivables.
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