Factoring: Definition, Procedure and Merits of Factoring



Factoring is yet another type of financial service provided by the specialist organizations to small-scale enterprises. When small-scale enterprises sell on credit basis, collection of receivable becomes a serious problem for them and, thus, affects their working capital position.

In such case, factoring organizations come to rescue of small enterprises to make collection from debtors. It is due to such role played by factoring in solving clients' collection problem from debtors; it has been becoming popular among the small-scale enterprises.

What is factoring after all? Factoring involves sale of receivables to specialized firm, called factors. Factors collect receivables and also advance cash against receivables to solve the client firm's liquidity problem. For providing their services, they charge interest on advance and commission for other services.

In other words, factoring is an arrangement under which a financial institution (called factor) undertakes the task of collecting the book debts of its client in return for a service charge in the form of discount or rebate.

The factoring institution eliminates the client's risk of bad debts by taking over the responsibility of book debts due to the client. The factoring institution advances a proportion of the value of book debts of the client immediately and the balance on maturity of book debts.

Factoring Procedure:

Factoring involves a procedure which is likely to vary depending upon the type of agreement between the supplier/firm and the factor. Nonetheless, the general procedure involved in factoring includes sending order by the client to the factor for evaluating the customer's creditworthiness and approval.

Having being fully satisfied with the customer's credit worthiness and agreeing to buy receivables, the firm sends goods/products to the customer. The customer will also be informed that his account has been sold to the factor, and he is instructed to make the payment of credit amount directly to the factor.

To perform his functions of credit evaluation and collection for a large number of clients, a factor may maintain a credit department with specialized staff. After having purchased a firm's receivables and if he agrees to own them, he will have to provide protection against any bad-debt losses to the firm.

Merits of Factoring:

Factoring is characterized by the following merits:

1. The availability of factoring services enables the enterprise / firm to concentrate more on manufacturing and selling of goods.

2. The risk of bad debts, i.e. an expected loss to the firm is minimized if not fully eliminated.

3. The factoring institution also provides advice to enterprise on ongoing and likely business trends and other matters relating to the particular business. In India, subsidiaries of four Indian banks, namely. State Bank of India; Canada Bank; Punjab National Bank; and Allahabad Bank are providing factoring services to business enterprises.