What is Factoring in Finance and How Does It Work ?

Factoring in finance is a secure way for businesses to access necessary funds for growth, diversification, meeting supply demands, etc.

The concept of factoring is recently gaining popularity as a financing option for many companies looking to fix their working capital gaps. In fact, RBI's regulated Trade Receivables Discounting System (TReDS), the invoice-discounting system for MSMEs in India, saw more than three-fold growth from Rs. 11,165 crore in FY20 to Rs. 34,362 crore in FY22.

In this article, we break down the basics of factoring, the typical costs that are associated with factoring, the types of factoring arrangements and Drip Capital's factoring solutions for Indian businesses.

What is Factoring in Finance?

Factoring refers to a type of financing where a financier purchases a debt or payable invoice from a business or seller. The financier, called a factor, buys the accounts receivable at a discounted rate. The buyer then pays the invoice amount directly to the financier responsible for collecting the invoice value.

Factoring allows small businesses access to funds for regular use, growth, and diversification. It is a simple way for exporters to free up funds stuck in the supply chain and accelerate cash flow. Moreover, since businesses sell the accounts receivable to the financier, they also transfer the debt, guaranteeing payment.

// Also Read :- What is Small Invoice Factoring, and How Does it work?

How Does Invoice Factoring Work?

A typical procedure of factoring an invoice looks somewhat like this:-

1. The seller or the supplier is in urgent need of cash and cannot wait for the said number of days to receive payment so the company approaches the factor.
2. The factor ask for some basic details. In India, all factoring companies ask for basic KYC details to check background and company history.
3. The factor checks the companies financials, number of shipments undertaken, the buyer's purchasing history and either approves the onboarding or disapproves the application.
4. Post approval, the borrowing company may be onboarded onto the factoring platform, where the company can add the details of the buyer and factor the invoices as per his/her convenience.
5. The factor will make payment an upfront payment (which is generally 80%-90% of the invoice value to the seller)
6. The remaining amount will be sent to the seller after deducting the necessary charges after the financial institution receives the payment

Example of a Factoring Transaction

Here's an example to elucidate the concept of factoring even further:-

1. Let's take a hypothetical example where Lucky Automotive Parts Ltd is exporting automobile anciliaries worth $100,000 to Autobahn Motors AG in Germany
2. Both parties enter into an factoring agreement that Autobahn Motors will make a payment of $30,000 upfront and the rest of the payment upon receipt of the order, or X days (generally 30, 60 or 90) upon receipt of the order (This is the general norm in export transactions)
3. Lucky Automoative begins production of the parts using the advance disbursed by Autobahn motors.
4. After loading the goods onto the ship, Lucky motors has now completed the order but will need to wait at least 15-30 days before receiving payment.
5. This working capital shortage can be a serious problem for growing businesses who have other orders to fulfill but lack the capital to cater to them
6. In this case, Lucky motors has another order from Imperial Motors in Australia. However, the company does not have the funds to source the raw materials needed for production. Taking another bank loan is ruled out as Lucky motors has already exhausted their credit limit.
7. It is precisely in a caselike this where Lucky motors can sell the trade receivables to a financial institution like Drip Capital, receive the payment within 48 hours and begin production for Imperial Motors.
8. Drip Capital can finance upto 90% of the pending invoice. In this case that will sum upto, $81,000
9. When the payment date from Autobahn Motors is due, Drip Capital will collect the amount directly from the buyer and after deducting the applicable fees, forward the remaining amount to Lucky motors directly.

Types of Factoring in Finance

Factoring is a popular mode of financing for businesses. There are different types of factoring depending on a business’s specific needs. These include:

Recourse factoring

In recourse factoring, sellers remain liable to factors on the debt until buyers clear all outstanding dues. Factors remain free of bad-debts-related risks.

Non-recourse factoring

In a non-recourse arrangement, the Factor assumes the credit risk and liability of non-payment on a factored invoice.

// Also Read Factoring Vs Non Recourse Factoring Explained

Advance factoring

Here, the factor pays the seller as per the pre-agreed interest rate against the yet-to-be-collected receivables.

Disclosed factoring

In disclosed factoring, the buyers also have thorough knowledge and understanding of the factoring arrangement.

Undisclosed factoring

In the case of undisclosed factoring, buyers are unaware of the factoring arrangement.

Maturity factoring

Maturity factoring or collection factoring is a process where the factor pays the seller on or after the invoice maturity date.

Invoice factoring

Simple factoring refers to the standard process of factoring where a business sells their accounts receivable to factors.

Domestic factoring

Quite simply, factoring transactions where both the buyer and the sellers are in the same country is called domestic factoring.

Export factoring

An export factoring transaction can also involve a third factor in the importing country (although not always necessary). A company specializing in export factoring needs to have a global expertise in several industries, a strong understanding of international trade processes and the ability to make disbursements in different currencies.

Reverse factoring

Reverse factoring is a financing arrangement that the buyer initiates to offer early payment to sellers or suppliers.

We've covered more about each of these types of factoring techniques in detail here.

Other than these, Importers and Exporters engage in cross-border trade and sell their accounts receivables to a factoring company (factor) called International Factoring.

What are the Typical Costs in Factoring?

Interest Cost: Factors advance payments to companies at a set interest rate which depends on the tenure of repayment, principal amount, and credit history. The interest costs of factoring, range between 0.7% per month (for a healthy credit profile) to 1.5% per month (for average credit profiles)

Processing fee/underwriting fee: Underwriting fee refers to the payment that the seller makes to the factor as compensation for providing secured credit against an invoice. Processing fees are the charges payable to the factor for collating and processing the factoring request. Companies generally charge a flat fee for this or a % of the invoice amount for processing fee.

Overdue interest: Overdue interest payments are applied on invoices past their due date at a specific interest rate. The factoring company starts calculating overdue interest payments after the due date.

We have covered, in-detail, the costs associated with a factoring transaction in this article.

What are Pros and Cons of Factoring?

To briefly summarize, these are the pros of financial factoring that really benefit growing businesses.

Pros

1. Quick - Unlike most traditional business loans or bill discounting facilities, factoring does not require lengthy documentation and a longer lead time till the borrower can receive funds into his account.

2. Flexible - Exporting companies can choose when they want to factor their invoices and they need not factor all the invoices from a specific buyer.

3. Credit Limits - Since factoring is technically the sale of an asset, it is not treated as a loan. This also means that companies can avail this facility over and above their credit limits.

Cons

1. Pricing: Although this varies based on the perceived creditworthiness of the customer by the factor. The costs of factoring are generally on the higher side. However, longer-term and recurring arrangements with factoring companies generally means cheaper pricing.

2. Reputation: Any receivables factoring company, like Drip Capital will request for the issuance of a notice of assignment to the buyer. Some sellers or exporters may not be comfortable with this as it lacks a personal touch between the buyer and a seller.

This post has a more exhaustive list of benefits and disadvantages of financial factoring.

How to Treat a Factoring Solution from an Accounting Perspective?

Factoring transactions are generally recorded in a company’s balance sheet for a financial year. Initially, the seller should record the initial sale of receivables and the accounting treatment in their annual balance sheet. They also need to calculate the associated factoring costs and sales discounts.

For example, let us consider company ‘A’ which has an outstanding Rs. 1 crore accounts receivable and wishes to avail funds. The financier approves the company and agrees to factor in its receivables and charge the following:-

• A 3% finance charge
• A 20% of the gross accounts receivable as reserve
• Rs. 1 lakh as collected cash + Rs. 50,000 as other fees.

While the business handles allowances, resolves disputes, and prepares product shipments, the factor identifies sales discounts while charging the costs of acknowledged sales discounts. The business enterprise receives Rs. 70 lakhs in cash and records a loss on sale to the tune of Rs. 25,000 as the 3% financing fee.

The factor now owns the receivable accounts. Thus, the accountant will shift the receivables from the entry for the gross receivable amount sold to the factor. The business enterprise will record ‘Due from factor’ as an asset henceforth and it represents the reserve amount.

Where to Find a Good Factoring Solution?

For the perfect factoring solution, companies should consider some basic pointers.

• Industry expertise: Before venturing out to obtain the best factoring service, companies should choose one with ample industry experience and one that understands your business. Moreover, they should understand the unique characteristics of the industry and your precise requirements.

• Flexibility: The factor should clarify certain points, including:-

a)Whether the business owner should sign a personal guarantee b)Whether they should sell their invoices c)Whether they would require factor invoices for all customers d)Minimum invoice amount and penalties, if any, on not meeting requirements e)Maximum factored amount

• Customer service: A good factoring solution will always cater to their clients and pay attention to their texts and emails. Business owners might have a lot of queries regarding their liabilities and receivables. They should check whether the factoring service provider assigns personal account managers or dedicated customer service to deal with their queries.

• Stability: Business owners should ensure that their financier is secure and maintains a reliable track record. Factoring companies should operate according to RBI’s directives and maintain strict codes of conduct.

• Pricing: Factors make a legal purchase of the business’s invoices at a discounted rate. Depending on the invoice tenure, they can either charge a one-time lump sum fee or a percentage of the invoice. They can also charge discount fees, contractual commitments, average monthly purchase volumes, and other fees. Pricing may also include costs of running credits, legal documentation, and other administrative fees. Therefore, companies must weigh all these options and carefully choose their factoring company.

Factoring is thus a valuable mode of financing for businesses to improve cash flow by releasing funds stuck in the supply chain. Moreover, since this financing is based on accounts receivable sold to financiers, sellers are not liable for the debt.

Taking all these aspects into account, Drip Capital's financial factoring services are ideal for small and medium sized Indian businesses to fix their working capital woes

Frequently Asked Questions on Factoring

How many invoices are eligible for factoring at once?

The number of invoices businesses can sell to factors varies as per different financiers. Some factors need sellers to factor in all monthly invoices, while others allow them to select specific ones as necessary.

How long do businesses have to be in contract with a factor?

Different financiers have different periods of contractual requirements. Some factors ask for a minimum six to 12-month contract period, while others may not.

When do businesses receive the financed money?

After the factor buys an invoice, they usually pay an initial amount (80%-90% of invoice value) right at the outset. Then, they pay the remaining invoice value after deducting their fees once buyers pay the invoice amount.