What is Factoring?
Factoring is a financial service for unlocking working capital. Opted by a seller, it denotes an ongoing relationship between a financial institution (called the factor) and a business concern (called the client) where the seller sells his trade receivables to a factor to address immediate cash flow concerns.
Factoring is used predominantly for international trade and sometimes involves an import factor from the importer’s country. The client (or the seller) sells goods and/or services to his customer (the buyer). The factor purchases the client’s accounts receivable or book debts and provides an advance, generally up to 80%-90% of the amount due to the exporter upfront.
At maturity, the factor pays the remaining amount after adjusting for costs. The costs include the cost of discounts and service charges. In short, factoring is a financial instrument to monetize credit sales immediately.
To know more about what factoring is and how it works, we recommend you visit this page.
Factoring as a service has been steadily growing compared to other traditional trade finance mechanisms including documentary credits like a letter of credit (LC) or a letter of undertaking. This is due to the unique advantages a factoring solution offers.
Advantages of Factoring
Immediate cash flow/liquidity:
Under the factoring arrangement, the factor pays up to 80% (in some cases even 90%) of receivables within one-two working day of presentation of the invoice. This substantially reduces the average receivable days, leading to improved liquidity and efficient working capital management.
No Need for Collateral:
Many banks require collateral from small businesses. However, most factoring companies don’t need collateral as the receivables, and the buyers are duly audited and the financial institution assumes the risk.
Focus on Core Activities:
Factoring saves time and the cost of collecting customers’ receivables. This makes it a good solution for small businesses. The factor provides all services related to sales ledger management, collection of account receivables, credit control and protection, etc., enabling the company to concentrate on its core competencies more efficiently.
A sale, not a loan:
Factoring isn’t a loan and doesn’t create any liability on the balance sheet. This is in stark contrast to a bill discounting service where the discounted bills are simply used as collateral against the loans.
Factors need to recover dues from buyers in several other countries that their exporters regularly ship. So, they are generally aware of the potential risks of dealing with a buyer or a specific region.
In several cases, a factor offers various advisory services to its clients, including credit assessment for overseas buyers. This helps the exporter to learn more about the customer and to negotiate better terms and conditions for the business. In cases where the factor rejects the application due to a poor record or risky importer, the factor will keep the exporter informed about the dangerous trade.
This helps the exporter avoid such transactions and engage only with verified and legitimate buyers. Some factors also have experts on their team who advise exporters on the finer technical aspects of a client’s business.
Protection from Bad Debts:
If a client chooses non-recourse factoring, the factor assumes the risk of bad debts. So, the exporter can focus on growing the business with the unlocked capital instead of worrying about getting paid. However, in non-recourse factoring, the cost competitiveness aspect of the financing mechanism is slightly compromised.
Since factoring is a very competitive industry, costs are usually reasonable, making it a cost-effective way of managing the sales ledger functions. This is especially the case with recourse-based factoring.
As mentioned earlier, Non-recourse financing options can be slightly more expensive. However, for the exporter, the risk associated with the transaction is also commensurate with the cost.
Easy and Fast:
It is widely considered one of the most significant merits of factoring. Exporters with scalable, growing, and profitable business ventures generally need working capital quickly and not necessarily at a lower cost.
Business exigencies require a growing export company to be quick and agile. This is possible only with fast financing as traditional bank loans have painfully long procurement channels. Moreover, the application required to establish a factoring relationship is much simpler than other types of financing, like bank loans.
Higher Credit Limits:
Almost all factoring companies, including Drip Capital, put a cap on the outstanding limit that an export company can avail. But this number is generally pegged at a fairly high value that most small businesses don’t exceed. In the case of Drip Capital, the limit is $ 2.5 Million.
Before moving onto the disadvantages, it's worth noting that Drip Capital is a company that specializes in financing factoring services.
Over the course of half a decade, we've fine-tuned our offerring to maximize all the advantages that factoring has to offer and minimize the disadvantages.
Disadvantages of Factoring
Non-recourse Factoring can be Expensive:
Although recourse and collateral-based factoring are relatively competitive, non-recourse and non-collateral-based factoring can be costly. The mitigation of risk and the agility of the product comes at a cost.
Non-recourse factors usually charge an interest rate that starts from 0.7% per month, but this pricing is depends on the risk profile. For recurring arrangements with a decent credit-profile, factoring may turn-out to be a quite affordable, especially for businesses looking for quick cash.
Sometimes, factoring companies may also levy nominal service charges on a case-to-case basis. This article on typical factoring costs and interest rates covers the topic in much more detail.
Exhausting Collateral Security:
A business uses its receivables to get financing. These receivables don’t appear on the balance sheet of the client. The client no longer has any control over the book debts. Hence, they cannot be used as collateral security in other financial services.
Continuity of Service:
Factoring depends upon the factor’s perceived creditworthiness of the customer. It is also a continuous process that can be used for multiple shipments spanning several buyers on a rolling basis.
However, factoring companies, like Drip Capital, regularly undertake risk assessments even for funded clients. A factor can arbitrarily reject invoices from a particular customer if the factor deems the buyer’s credit profile unworthy. This may not necessarily be in line with the assessment of the exporter and can cause issues with the factoring arrangement.
Lack of a Personal Touch in Buyer/Seller Relationships:
There may be a certain degree of discomfort for the importer while a factoring company appraises his credit profile and regularly checks all the shipments. Some buyers might want to deal directly with the seller instead of involving a third party.
Bank Loan V/s Factoring
To effectively understand the advantages of factoring, it is essential to compare it with one of the most traditional forms of financing- bank loans.
Advantages of International Export Factoring
Some advantages are unique to export factoring that exporting companies in India can easily benefit from;
Understanding of global markets: Due to the very nature of their business, factoring businesses need to have an understanding of top importing countries within specific industries, local laws, legislations and rules. A company that specialises in export factoring facilities will know how to navigate these complexities which adds onto the "advisory services" that we covered above
Currency Denominations: Although this is not necessarily true for all export factoring firms, availing advances or loans in a currency of your choice helps hedge against currency risks and factoring companies like Drip Capital can make these payments in multiple currency denominations and help exports scale their business
Steps in International trade service:-
1.The exporter and the importer enter into a contract. The exporter receives a purchase order.
2.The exporter sends all the information about the importer to the export factor.
You can get an in-depth understanding of International factoring in this post.