Factoring is a financial transaction between two parties, client and a factor, in which the client sells its accounts receivable (Money owed to client by a buyer) to the factor to receive money immediately in exchange.
Factoring is an agreement in which receivables arising out of a sale of goods/services are sold by a firm (client) to the factor (financial intermediary) as a result of which the title of goods/services represented by the receivables passes on to the factor.
It is an arrangement between a factor and his client which includes any two of the following services provided by the factor to the client –
Maintenance of account
Collection of debts
Protection against credit risk
Through factoring an organization (client) relieves itself from the procedures and expenses of collecting receivables arising out of a sale and receives immediate cash to finance its business operations.
A factoring agreement involves three parties:
The Factor, The Client (sells receivables to factor), Customer (pays to factor)
Functions of a Factor:
Maintaining Accounts – Preparing and updating sales ledger and providing periodic reports with useful information
Providing advisory services – Advices the client regarding credit worthiness of a buyer, potential customers, market trends etc.
Providing Short-term Finance – Provide money in advance up to 80% of the receivables
Providing Credit Protection – Protects the client against bad-debts/non-payment
Providing Collection Facilities – Collect money on behalf of the client and remits the money back after deducting his charges
Mechanism of Factoring
A Factoring contact for sale of receivables –
• It starts with a credit sale and agreement between the client and the buyer/customer.
• The client (seller)
Sells goods on credit to buyer/customer
Prepares invoice, delivery challan, factoring agreement and other documents
Hands over the documents to factor (Financial institution/Banking Institution)
Receives payment in advance up to 80% of cost of good by the factor
• The factor
Makes an advance payment to factor on receiving all the documents (invoice, challan, agreement etc.)
Prepares and sends periodical account statements to customer
Receives payment from customer/buyer on due date
Remits the balance (20%) from the money collected to the client/seller after deducting its commission, fees, service charges etc.
Advantages of Factoring:
To Client/Seller –
The client gets immediate cash on sale which can be invested somewhere else.
It protects the client against credit risk i.e. risk of non-payment by buyer.
It allows the client to offer lucrative credit schemes to customers and increase his sales and profit.
It reduces the financial burden of the client and relieves him maintaining accounts and collection of receivables
It acts as an additional source of finance for the client and allows him to explore new markets.
To Customers/Buyers –
It allows customers to save bank charges and expenses.
It allows customers to purchase expensive products through flexible credit schemes.
The factoring procedure is simple and easy than applying for a bank loan, it saves time, money and effort.
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