The Hindu Business Line : Factoring of receivables and payables

Working capital management is a difficult job and one has to be very careful about cash management to maximise profits. One such tool available to the businesses is factoring. Receivables and payables are factored by institutions.

Factoring is a fund-based financial product. It involves three parties: the seller of goods; the buyer of goods; and the factoring agent.

Consequent to a credit sale, the seller holds the debt till maturity. The amount due from the buyer is carried to the financial statements as receivables. Working capital is locked up in this.

The buyer enjoys his credit period and is under no legal obligation to pay until the due date. The factoring agent takes over the debtors and advances funds to the trader. By so doing, he steps into the shoes of the seller.

In plain language, the factoring agent buys up the receivable from the seller. The factoring agent provides immediate finance to the seller in consideration of assigning the receivable to him. This unshackles the amount locked up as receivables.

A significant point in factoring is that the risk of the debt going bad is passed on to the factor. On the due date, if the debt turns sticky or bad, the factor has no recourse to the seller. He has to bear the loss arising out of bad debts. Since he bears the risk of bad debts, he charges a little extra premium in addition to the interest charges.

Factored funds are, therefore, costlier to the entity than the working capital borrowings. The tag line is that these funds are totally unsecured. The factor has no recourse to the seller in case of bad debts. The risk of bad debts is passed on to the factoring agent.

The trader can bargain with the factor for 100 per cent of the debt to be paid up front, though it is the usual practice that 80-85 per cent is paid immediately and the balance on realising the debt.

For example, A sells to B on a credit period of 60 days. For the period of 60 days, the funds are locked up with B. C is a factoring agent, who advances money to A on assigning the debtor to C. On the due date, C approaches B for payment. If honoured by B, it is fine. But if B fails to meet his commitment, C cannot go back to A and ask for payment. C has to bear the risk of the debt going bad or to take measures of recovery, legal proceedings or otherwise.

IMPACT ON FINANCIAL STATEMENTS

Once factored, the debtor slips out of the balance sheet. This has an impact on the current ratio of the entity. But, this is offset since the cash received from the factor appears either as cash and bank balances or by way of stocks, etc, depending upon the utilisation of cash.

One significant impact is on the debtors' turnover ratio, with the sundry debtors appearing at meagre levels.

Such factoring is carried out by entities as an extended arm of lending. It is a non-banking financial activity, though quite a number of bankers are in this line of activity.

The factor has to satisfy himself about the quality of the debt before factoring it. A receivables audit is carried out to ensure the genuineness of the deal, that the payments are coming in time, that there are not too many sales returns, that there is no two-way trade between the parties, etc.

As a precautionary measure, the factor accepts factoring of only those debts which he is confident of recovering in the normal course. Knocking the doors of justice is the last recourse and is normally avoided because of the time and cost involved.

REVERSE FACTORING

Factoring can be done for payables too. This is called reverse factoring. The buyer of goods on credit enjoys certain credit period. But he may be entitled to certain benefits, such as discounts against immediate payment. The factoring agent helps in this area also. He factors the payable by charging interest and looks to the buyer for payment on the due date.

This again is an unsecured fund as the factor does not seek any charge on stocks. This benefits the buyer by way of enjoying discounts from the seller and at the same time, enjoying his credit period. He can have the cake and eat it too.

By making payment, the stocks become "paid stocks" in banking terminology and, therefore, can figure for calculation of drawing power. The trader enjoys higher CC limits against the higher levels of stocks offered as primary security.

The current ratio does not get affected as the factoring agent appears as a current liability in place of the supplier of goods. Factoring of receivables and payables is a useful tool to the business community, especially small and medium enterprises. The trader has to consider the cost of funds for factoring vis-à-vis working capital borrowings and can take a decision on availing such advantages. Of course, the same receivable cannot be offered to the banker for getting working capital limits.

A good combination could be that the trader seeks fund-based limits from his banker against debtors up to 30 days. Debts outstanding for more than 30 days can be factored for the remaining period. The banker cannot object to such factoring of debts more than 30 days old since anyway the banker is not funding these debts. Fresh debtors arising out of sales during the month can be substituted to the bankers and, thereby, continue to enjoy the limits. Older debtors can be factored.

Normally, the banker insists on higher margins on debtors to offset the profit element. The banker does not fund the profits of the entity. The trader has to work out the cost and other points, such as the track record, comfort levels with bankers, and the factoring agent, probability of the debt turning bad, etc., before taking the plunge.

More Stories on : Financial Services | Insight

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Factoring of receivables and payables

Reining in carbon emissions

Time to switch over to alternatives?

`Economic nexus'-based taxation

Is online trading a form of employment?

Money changing

Choosing good over smart

Part-time or Distance MBA?

Inflation and interest rates

Just Do IT

Importance of competing on quality, not price

Persevere and be patient