The mechanism of factoring can be explained:
Mechanics of Factoring shown in figure is explained below:
1. Firstly, the customer places an order with the Client. (It may be noted that the client is the seller and customer is the buyer of goods).
2. Then the client enters into Factoring arrangement with the Factor. The pre-payment limit, service charges, and discount charges and other terms and conditions of the arrangement are agreed upon. The Client has to obtain a “LETTER OF DISCLAIMER “from the bank holding charge on his receivable.
This is required because in many cases the receivables may have been assigned to the bank for credit facility extended by it. After obtaining this letter, the Client executes the Factoring documentation.
3. The client dispatches the goods or services to the customer on credit on open account basis and then sends the corresponding invoice to the customer directly. From then onwards, the client passes all credit sales invoices to the Factor. While the original invoice and document of title to goods like lorry receipt to the Customer, copies of these documents are handed over to Factor for Purchase.
4. The original as well as copies of invoices sent to customer, contain a printed Notice of Assignment addressed to the customer, directing the customer to make all payments to the Factor.
5. On receiving a copy of the invoice, the Factor purchases the invoice subject to the overall limit and the Customer limit. The Factor arrives at a sub-limit for each customer of the client within the overall limit.
The drawing power is calculated taking into account the prescribed margin (usually around 20%). The prepayment limit is generally around 80%-85% of the eligible debt. The Client is now free to draw any amount up to the drawing power.
For the Client to draw money, the Factor issues a cheque favoring the Client’s Bank A/c. Realization are handled by the Factor directly under advice to the client. Outstation cheques are also collected/ discounted by the Factor.
6. Periodical statements and MIS (Management Information System) reports are furnished to the Client and the Customer.
7. If monthly installments are not paid within the due date, follow-up letters are sent.
8. When the payment is cleared by the Customer to Factor, a notice is sent by the Factor to the Client.
9. This is followed by the release of retention margin held by the Factor to the Client.
For rendering the services of collection and maintenance of sales Ledgers, the service charges usually vary between 0.4% to 1% of the invoice value, depending on the volume of operations. This service charge is collected at the time of purchase of invoices by the Factor.
For making an immediate part payment to the Client, the Factor collects discount charges from the Client. The discount charges are comparable to bank interest rates at these charges are collected monthly.
Factoring and Services
Factoring has three key elements; the Client has the option to select a combination of these components to suit his financial needs.