As the accounts receivable amount to the blocking of the firm’s funds, the need for an outlet to impart this liquidity is obvious. Other than the lag between the date of sale and the date of receipt of dues, collection of receivables involves a cost of inconvenience associated with tapping every individual debtor. Thus, if the firm could contract out the collection of accounts receivable it would be saved from many things such as administration of sales ledger, collection of debt, and the management of the associated risk of bad-debts, etc.
Factoring is a type of financial service which involves an outright sale of the receivables of a firm to a financial institution called the factor which specializes in the management of trade credit. Under a typical factoring arrangement, a factor collects the accounts on the due dates, affects payments to the firm on these dates (irrespective of whether the customers have paid or not), and also assumes the credit risks associated with the collection of the accounts. As such factoring is nothing but a substitute for in-house management of receivables. A factor not only enables a firm to get rid of the work involved in handling the credit and collection of receivables, but also in placing its sales in effect on a cash basis.
Definition and functions – Factoring Services
Factoring is a financial service in which the business entity sells its Trade receivables/debtors to a third party at a discount in order to raise funds. The Bank/Financial institution purchasing the receivable is known as factor. Factoring may be with or without recourse. ‘With a recourse’ means that in the event of bad debts factor (Bank) can approach the ‘supplier’.
Though the purchase of book debts is fundamental to the functioning of factoring, there are a number of functions associated with this unique financial services. A proper appreciation of these functions would enable one to distinguish it from the other sources of finance against receivables. They are:
– assumption of credit and collection function;
– credit protection;
– encashing of receivables;
– collateral functions such as:
- loans on inventory,
- loans on fixed assets, other security and on open credit,
- advisory services to clients.
Factoring vs. Accounts Receivable Loans
Accounts receivable loan is simply a loan secured by a firm’s accounts receivable by way of hypothecation or assignment of such receivables with the power to collect the debts under a power of attorney. In case of factoring however, there is an outright sale of receivables. Thus, in case of the former, the bank may debit client’s account for ‘handling charges’ if the debt turns out to be bad as against non-recourse factoring.
Factoring vs. Bill Discounting
Under a bill discounting arrangement, the drawer undertakes the responsibility of collecting the bills and remitting the proceeds to the financing agency, whereas under factoring agreement, the factor collects client’s bills. Moreover, bill discounting is always with recourse whereas factoring can be either with recourse or without recourse. The finance house discounting bills does not offer any non-financial services unlike a factor which finances and manages the receivables of a client.