Factoring is a monetary transaction in which a firm sells its unpaid invoices or accounts receivable to a third party, a factor, at a discount in exchange for immediate cash.
The factor pays the business an amount that is less than the value of the invoices and then takes on the responsibility of collecting payment from the customers whose invoices were purchased.
Example of Factoring A small business called "Raj Corporation" sells goods to a customer and issues an invoice for ₹1,00,000, due in 30 days.
Raj Corporation needs cash to pay its employees and suppliers, but does not have the funds to wait 30 days for the customer to pay the invoice. Raj Corporation decides to factor in the invoice.
It contacts a factoring company and agrees to sell the invoice for ₹95,000. The factor immediately pays Raj Corporation ₹90,000 in cash and takes over the responsibility of collecting the ₹1,00,000 from the customer.
When the customer pays the invoice, the factor takes its fee of ₹5000 and returns the remaining ₹5000 to Raj Corporation.
The factoring process allows Raj Corporation to get the cash it needs right away, while the factor takes on the risk of collecting payment from the customer.
Types of Factoring
There are various types of factoring, and they are mentioned below:
1. Recourse Factoring In recourse factoring, the business that sells the invoice (called the "client") is responsible for repaying the factor if the customer does not pay the invoice.
In other words, the client has "recourse" to the factor if the invoice is not paid. Recourse factoring is typically less expensive than non-recourse factoring, but it carries more risk for the client.
2. Non-recourse Factoring The factor assumes the risk of non-payment, and the client does not have to repay the factor if the customer does not pay the invoice.
Non-recourse factoring is more expensive than recourse factoring but provides more protection for the client.
3. Full-Service Factoring Full-service factoring is a type of factoring that includes additional services beyond the purchase of accounts receivable.
In full-service factoring, the factor not only provides financing by purchasing the client's invoices but also takes on other responsibilities, such as credit checks on customers, collections, and record keeping.
Full-service factoring is often more expensive than traditional factoring, but it can be a good option for businesses that do not have the time or resources to handle these tasks themselves.
4. Maturity Factoring Maturity factoring is a type of factoring in which the factor purchases the invoices and assumes responsibility for collecting payment from the customers but does not advance any cash to the client until the invoices are paid.
This means that the client does not receive any money until the customers pay the invoices, which can be 30, 60, or 90 days after the invoices are issued or on a pre-fixed date.
Maturity factoring is generally less expensive than other types of factoring because the factor does not have to advance any cash to the client.
5. Advance Factoring It is a type of factoring in which the factor immediately advances a portion of the invoice amount to the client and then collects the total amount from the customer when the invoice is due.
Advance factoring can be a useful source of short-term financing for businesses that need cash quickly.
Benefits of Factoring
There are various benefits of factoring unpaid invoices of small businesses.
- It provides quick access to cash
- It helps to improve the cash flow
- Businesses don’t incur debt as factoring is not a loan
- It is easier to qualify for factoring than traditional loans
- Factors handle credit checks, saving companies from dealing with risky customers
- Collections of unpaid invoices is done by the factor, saving businesses time
Challenges of Factoring
Despite the benefits, factoring poses certain challenges for small businesses.
- It is expensive, especially for companies having several invoices
- The fee levied by factors deducts the amount from the total amount businesses need to receive from their customers
- Businesses run a risk of non-payment from their customers, which can be a financial burden in recourse factoring
- Businesses lose control over their invoices
- Factors may limit the type of accounts receivable they purchase from the businesses
Meaning of Bill Discounting
Bill discounting is a financial transaction in which a business sells a bill of exchange (such as a promissory note) to a bank at a discount in exchange for immediate cash.
Example of Bill Discounting Suppose a business called Akash Corporation has a bill of exchange for ₹5,00,000 due in 60 days. It might sell the bill to a bank for ₹4,95,000 in exchange for cash. The bank will then collect the full ₹5,00,000 from the drawee when the bill is due.
Types of Bill Discounting
There are different types of bill discounting.
1. Bill Discounting Backed by LC Bill discounting backed with a letter of credit is a type of bill discounting in which the drawee's payment is guaranteed by a letter of credit issued by a bank.
It is a relatively low-risk form of financing since the payment is guaranteed by the bank's letter of credit.
2. Clean Bill Discounting In a clean bill, a business sells its bill of exchange or promissory note to a bank in return for immediate payment upfront.
3. Invoice Bill Discounting In invoice bill discounting, or IBD, a business sells its unpaid invoices to get access to cash.
Benefits of Bill Discounting
There are a few benefits of bill discounting, such as:
- Improving the cash flow of a business by selling bills of exchange, promissory notes, or unpaid invoices
- Providing flexibility to businesses for funding different parts of the business
- Improving the creditworthiness of a business if it meets its financial obligations on time and has a healthy cash flow
- Risks of Bill Discounting
- Like any financial transaction, bill discounting comes with its own set of risks.
- It affects the profit margin as the bank discounts the total amount, which can be costly.
- As it is unsecured, the bank will ask for a personal guarantee, which can lead to legal consequences if defaulted on
- It can pose a risk of bad debt if the buyer declares insolvency
Difference Between Factoring and Bill Discounting
Factoring and bill discounting are both financial arrangements in which a company sells its unpaid or outstanding invoices to a third party in exchange for immediate payment.
However, there are some differences between the two.
1. Scope of Services Factoring is a more comprehensive financial arrangement that typically includes not only the purchase of the company's invoices but also credit checking of the company's customers, collection of outstanding invoices, and other financial services.
Bill discounting services, offer a more limited arrangement that only involves the purchase of the invoices.
2. Cost Factoring is typically more expensive than bill discounting, as the scope of services is broader.
3. Credit Risk In a factoring arrangement, the factor (i.e., the company that purchases the invoices) typically assumes the credit risk of the company's customers.
In a bill discounting arrangement, the company typically retains the credit risk of its customers.
Factoring and bill discounting both provide businesses access to immediate cash, which can help to improve their cash flow.
However, before dealing with either financial transaction, a business should be aware of the pros and cons of both to make an informed decision.
FAQs 1. Is GST Applicable on Bill Discounting? GST is not applicable on invoice or cheque discounting as it is not related to loans or credit facilities.
2. Is Bill Discounting the same as Bill Purchase? Yes, bill discounting and bill purchase are essentially the same thing. In both cases, a company sells its outstanding invoices to a third party in exchange for immediate payment at a discounted rate.
The third party that purchases the invoices is typically a financial institution, such as a bank or a specialized discounting company.
3. Why Would a Firm Choose Factoring Instead of a Loan? There are several reasons why a company might choose factoring instead of a loan:
Quick access to cash: Factoring allows a company to quickly access cash by selling its outstanding invoices to a third party. This can be a more attractive option than taking out a loan, which may involve a longer application and approval process.
No collateral required: In many cases, factoring does not require collateral, as the company's invoices serve as the security for the arrangement. This can be an attractive option for companies that do not have assets they can use as collateral for a loan.
Improved cash flow: Factoring can help a company to improve its cash flow by providing it with immediate access to cash. This can be especially useful for companies with many outstanding invoices but need to meet short-term financial obligations.
-Credit risk management: In a factoring arrangement, the factor (i.e., the company that purchases the invoices) typically assumes the credit risk of the company's customers. This can be an attractive option for companies concerned about their customers' creditworthiness.
