MFS-IV Chapter - Factoring Factoring: The Concept

Factor is a financial intermediary/institution/company which assumes the responsibility of collection of receivables arising out of credit sales of their clients and in return charges commission for its services. So, A Factor Company essentially means A Financial Intermediary/Institute/Company/Bank That buys trade invoices of a manufacturer or a trader, at a discount, and Takes responsibility for collection of payments. Factoring is the Sale of Book Debts by a firm (Client) to a financial institution (Factor) on the understanding that the Factor will pay for the Book Debts as and when they are collected or on a guaranteed payment date. Normally, the Factor makes a part payment (usually upto 80%) immediately after the debts are purchased thereby providing immediate liquidity/finance to the Client.

PROCESS OF FACTORING
Client makes a credit sale to a customer. Client hand over/sells the customers bills to the Factor and notifies the customer about the same. Factor makes partly payment (advance) against account purchased, after adjusting for commission and interest on the advance. Factor maintains the customers account and take follows up for payment. Customer remits the amount due to the Factor.

Factor makes the final payment to the Client when the account is collected or on the guaranteed payment date

Charges for Factoring Services:

Factor charges Commission (as a flat percentage of value of Debts purchased) (0.50% to 1.50%) Commission is charged up-front. For making immediate partly payment, interest charged. Interest is higher than rate of interest charged on Working Capital Finance by Banks. If interest is charged up-front, it is called Discount.

Functions of a Factor:
1. Administration of sales ledger - Maintains the clients sales ledger - Gives periodic reports - Current status of his receivables - Receipts of payments from customers - Customer-wise record of payments - Change in payment pattern 2. Provision of collection facility - Undertakes to collect receivables on behalf of the client - Relieving the clients from problems involved in collection - Enables the clients to reduce cost of collection 3. Financing Trade Debts: Purchase the book debts of his clients and provide up to 80% finance against bills/book debts. This service is provided where debts are factored without recourse. Within fixed credit limit, the factor undertakes to purchase all trade debts of the customer without recourse. Factor assumes the risk of default (Bad Debts). 5. Advisory Services: Specialized knowledge and experience Customers perception/ changing needs and fashion 4. Credit Control And Credit Protection:

MFS SEM-IV (2010-12)

Page 1

Change in marketing strategies Emerging trends about market/ competitiors

Types / Forms of Factoring:

1. Recourse Factoring: Factor does not assume credit risks associated with receivables. Credit Risk is borne by the Client. In India, Factoring is done with recourse. Factor assumes credit risks associated with receivables. OR The loss arising out of non - recovery of receivables is borne by the factor. Charges a higher commission Credit risk is assumed by Factor In USA/UK, Factoring is commonly done without recourse. Factor pays a specified portion (75% to 80%) in advance. Balance being paid upon collection from the customer. The client has to pay interest on advance payment. Factor does not make any advance payment to the Client. Factor Pays on date of collection/agreed future date. Less RISK for Factor and charges nominal commission.

2. Non-Recourse Factoring:

3. Advance Factoring:

4. Maturity Factoring / Collection Factoring:

5. Full Factoring / Old Line Factoring: Features of almost all the factoring services. Entire spectrum of services; collection, credit protection, sales ledger administration, short-term finance etc.. 6. Disclosed Factoring: Name of factor is disclosed in sales invoice. Name of factor is NOT disclosed in sales invoice. Buyer, Seller, Factor domiciled in the same country. 7. Undisclosed Factoring: 8. Domestic Factoring: 9. Export / Cross Border / International Factoring: Usually Four Parties Involved Viz. the Exporter, Importer, Export Factor, Import Factor. Two Agreements. Import Factor Provides Link Between Export Factor and Importer. Import factor underwrites customer trade credit risk, collects receivables and transfers fund to export factor .

Advantages of Factoring:
1. 2. 3. 4. 5. 6. 7. Off-balance Sheet Finance Reduction of Current Liabilities Improvement in Current Ratio (due 2 reduction in CL as Credit Sale is converted into Cash Sale) Higher Credit Standing: cash flow acceleration and timely payment of liabilities More time for Planning and Production Reduction of Cost and Expenses Additional Source of Finance

MFS SEM-IV (2010-12)

Page 2

 WHY FACTORING HAS NOT BECOME POPULAR IN INDIA? OR OPERATIONAL PROBLEMS OF FACTORING IN INDIA
Banks reluctance to provide factoring services Factoring requires assignment of debt which attracts Stamp Duty. Cost of transaction becomes high. Lack of awareness. High cost of credit information Other Issues: NON-MAINTENANCE OF PROPER BOOKS AND RECORDS, POOR ADMINISTRATION OF SALES REGISTER, POOR COLLECTION MECHANISM, PROBLEMS IN RECOVERY.

FORFAITING: THE CONCEPT

Forfeiting refers to financing of receivables pertaining to international trade. The forfeiting owes its origin to a French term forfeit which means to hand over/give up (or surrender) ones rights on something to someone else. Forfaiting is a mechanism by which the right for export receivables of an exporter (Client) is purchased by a Financial Intermediary (Forfaiter) without recourse to him. Converts exporters credit sale into cash sale. Discounting the documents covering the entire risk of non-payment in collection. Credit period can range from 3 to 5 years.

Characteristics of Forfaiting:
Converts Deferred Payment Exports into cash transactions, providing liquidity and cash flow to Exporter. Absolves Exporter from Cross-border Political OR Conversion Risk associated with Export Receivables. Finance available upto 100% (as against 75 - 80% under conventional credit) without recourse. Acts as additional source of funding and hence does not have impact on Exporters borrowing limits. It does not reflect as debt in Exporters Balance Sheet. Provides Fixed Rate Finance and hence risk of interest rate fluctuation does not arise. Exporter is freed from credit administration. Provides long term credit unlike other forms of bank credit. Saves on cost as ECGC Cover is eliminated. Simple Documentation as finance is available against bills. Forfait financer is responsible for each of the Exporters trade transactions. Hence, Export business can be done more efficiently. Forfait transactions are confidential.

KEY Advantages of FORFAITING SERVICE

IMPROVES CASH FLOW: CONVERTS A CREDIT BASED TRANSACTION INTO A CASH TRANSACTION ENABLES TO PROVIDE SUPPLIERS CREDIT POLITICAL, TRANSFER & COMMERCIAL RISK PROTECTS FROM EXCHANGE RATE FLUCTUATIONS EASY DOCUMENTATION COMPETITIVE ADVANTAGE: ELIMINATE RISKS:

PROVIDES TRANSACTION SPEED & SIMPLICITY:

MFS SEM-IV (2010-12)

Page 3

RELIEVES FROM ADMINISTRATIVE & COLLECTION PROBLEMS

FORFAITERS CHARGES The DISCOUNT charged by the Forfaiter depends upon: Cost of Forfaiting/Documentation Charges Margin to cover risk Management charges Fees for delayed payment Period of Forfaiting contract Credit rating of Avalling Bank Country/Currency Risk of the importer Installment of repayment etc

FACTORING vs. FORFAITING

FACTORING Usually 75 80% of the value of the invoice Factor does the credit rating in case of nonrecourse factoring transaction FORFAITING 100% of Invoice value The Forfaiting Bank relies on the creditability of the Availing Bank No services are provided

POINTS OF DIFFERENCE Extent of Finance Credit Worthiness

Services provided

Day-to-day administration of sales and other allied/advisory services

Recourse

With or without recourse

Always without recourse

Size of transaction

Usually no restriction on minimum size of transactions that can be covered by factoring.

Transactions should be of a minimum value of USD 250,000. Usually available for export receivables only denominated in any freely convertible foreign currency.

Scope of service

Service is available for domestic and export receivables.

WHY FORFAITING HAS NOT DEVELOPED Relatively new concept in India. High Rupee Fluctuation High cost of funds High minimum cost of transactions (USD 250,000/-) RBI Guidelines are vague (unclear). Very few institutions offer such services in India. Exim Bank is one of the major player and very few other cos involved. Lack of awareness.

Sr. No. 1 2 3

Bills Discounting Versus Factoring:

Bills Discounting Always With Recourse Only provision of finance B/E can be rediscounted Factoring With or without Recourse Other services also Cannot be rediscounted

MFS SEM-IV (2010-12)

Page 4

- Individual transaction. -- Each bill is separately discounted

Series of transactions

5 6

Not off-balance sheet mode of financing Generally not cross-border

Off-balance sheet mode of financing May be cross-border

INDIAN BANKING SYSTEM

RESERVE BANK OF INDIA
Scheduled Commercial Banks Public Sector Banks Pvt. Sector Banks Foreign Banks
New Generation Banks Old Generation Banks

Regional Rural Banks (RRBS)

Co-operative & special purpose Banks Co-operative Banks Development Financial Institutions

MEANING OF BANK
BANK IS A FINANCIAL INTERMEDIARY WHICH MOBILISE SAVINGS OF INVESTORS AND CHANNELIZE THESE SAVINGS IN TO INVESTMENT BANK IS LINK BETWEEN MONEY SAVERS AND MONEY SEEKERS BANK IS A FINANCIAL INSTITUTION WHICH IS ENGAGED IN THE BUSINESS OF PURCHASING AND SELLING OF MONEY

RESERVE BANK OF INDIA (RBI): THE APEX BANK (CENTRAL BANK)

THE RBI IS THE NERVE-CENTRE OF THE MONEY MARKET AND THE MAIN REGULATOR OF THE BANKING SYSTEM. THE FUNCTIONS/ROLES OF THE RBI COMPRISE: 1. NOTE ISSUING AUTHORITY (ISSUE OF CURRENCY), 2. GOVERNMENT BANKER, 3. BANKERS' BANK, 4. SUPERVISORY AUTHORITY, 5. PROMOTER OF THE FINANCIAL SYSTEM AND 6. REGULATOR OF MONEY AND CREDIT (MONETARY AUTHORITY). 1. NOTE ISSUING AUTHORITY/ISSUER OF CURRENCY

RBI has sole right to issue Currency Notes of all denominations (except the one rupee notes and coins). The currency notes issues by the RBI are legal tender throughout INDIA. Currency management by the RBI involves efforts to achieve self-sufficiency in the production of currency notes/coins, with a judicious denomination mix, improvement in the efficiency of distribution networks, withdrawal and destruction of notes, technology up gradation and enhancement in the security features of currency notes. The currency notes have 100 per cent backing of eligible assets. 2. GOVERNMENT BANKER As the government banker, apart from banking services relating to receipts/payments on behalf of the government, the issue, management and administration of government public debt is a major function of the RBI. As a GOVT. Banker, RBI provides short term loan and advances to various govt. Bodies for meeting their short term cash flow mismatches. For providing various services, the RBI charges commission from GOVT. 3. BANKERS BANK OR CENTRAL BANK As a bankers bank, the RBI controls the volume of reserves of the banks and determines their deposit-credit creation ability. As a central bank, the RBI has a special relationship with banks. It controls the volume of SLR and CRR and determines their creditcreation ability. It is, in effect, the banker of the last resort means provide credit to commercial banks as and when they need. 4. SUPERVISING AUTHORITY/REGULATOR AND SUPERVISOR As a regulator and supervisor, the RBI prescribes the broad parameters within which the banking and financial system functions. It regulates and supervises the banking system, under the provisions of the Banking Regulation Act. The NBFCs are regulated under the provisions of Chapter III- B of the RBI Act.

MFS SEM-IV (2010-12)

Page 5

RBI issue licenses for the establishment of new banks/setting up new branches/prescribe minimum capital and reserve rules/ inspect working of banks/ investigate any complaints and irregularities/ approve or force amalgamation /reconstruction/liquidation of banks. 5. PROMOTER OF THE FINANCIAL SYSTEM Over a time, RBI has setup various DFI/PFI. The RBI promoted institutes like IDBI, IFCI, ICICI, IRBI, EXIM BANK, SIDC, NIDC, SIIC, TFCI,UTI, DICGC, ECGC AND SO ON. 6. REGULATOR OF MONEY AND CREDIT/ MONETARY AUTHORITY As the central bank of the country, the RBI formulates and conducts the monetary policy. Monetary policy refers to the use of the techniques of monetary control to achieve the broad objectives of maintaining price stability and ensuring an adequate flow of credit to productive sectors so as to assist growth. The instruments of monetary control used by the RBI are: OPEN MARKET OPERATIONS (OMOs), BANK RATE (BR), CASH RESERVE RATIO (CRR ), STATUTORY LIQUIDITY RATIO (SLR) AND REPO.

OPEN MARKET OPERATIONS (OMOS): The OMOs involve sale and purchase of Government securities and T-bills. Through the OMOs, the RBI can affect the reserve position of banks, yields on Government securities/T-bills and volume/ cost of credit. They are poised to emerge as a major tool of monetary policy in India. OMOs CAN BE ONE OF THE MEASURES ADOPTED BY RBI TO CONTROL INFLATION IN THE ECONOMY. BANK RATE (B/R): The B/R is the standard rate (i) at which the RBI buys/rediscounts bills of exchange/other eligible commercial papers and (ii) that RBI charges from commercial banks for offering short term advances. The B/R technique regulates the cost/availability of finance to banks/FIs. At present BR is 6%. CASH RESERVE RATIO (CRR): The CRR refers to the cash which banks have to maintain with the RBI as a percentage of their net demand and time liabilities to ensure safety and liquidity of bank deposits. As an instrument of policy, the CRR has been used by the RBI very actively. CRR IS THE PRIMARY RESERVE REQUIREMENT. At present CRR is 6%. STATUTORY LIQUIDITY RATIO (SLR): The SLR enables the RBI to impose a secondary and supplementary reserve requirement. Strictly speaking, SLR is not a technique of monetary control; it only distributes bank resources in favour of the Government/public sector. SLR investment is in the form of G-Sec. At present SLR is 25%. REPOS : A repo/reverse repo/ready forward/ repurchase (buy-back) is a transaction in which two parties agree to sell and repurchase the same security. The seller sells specified securities, with an agreement to repurchase the same at a mutually decided future date and price. Likewise, the buyer purchases the security with an agreement to resell the same to the seller, on an agreed date and at a predetermined price. At present REPO RATE is 6%. The same transaction is 'REPO' from the viewpoint of the seller and 'REVERSE REPO from the angle of the buyer. Repo is also known as ready forward as it is a means of funding by selling a security held on a spot basis and repurchasing the same on a forward basis. The terms of the contract are in terms of a repo rate, representing the money market borrowing/lending rate. It is generally lower than the B/R. Repos have a maturity of 1-14 days. They are very safe transactions. TYPES OF REPOS: Two types of repos are currently in operation in India: INTER-BANK REPOS and RBI REPOS.

DEPOSIT PRODUCTS Deposit products are the major source of bank funds. The two components of deposit products are: (i) Various types of deposits and (ii) Operations of deposit accounts. TYPES OF DEPOSITS/ACCOUNTS Deposits of banks are classified into: (i) DEMAND DEPOSIT,

MFS SEM-IV (2010-12)

Page 6

(ii) (iii) 1. 2. 3. 4. 5. 6. 7.

TERM/FIXED DEPOSIT AND HYBRID/FLEXI DEPOSIT. DEMAND DEPOSITS Demand deposits, repayable to depositors on demand, are of two types: (i) current and (ii) savings. CURRENT DEPOSITS/ACCOUNTS: The primary objective of current deposits is not soliciting savings but convenience of the large customers who are relieved of handling payments. There are no restrictions on withdrawals/deposits in current accounts. Withdrawals are permitted by cheques in favour of self/other parties. They are non-interest bearing. In case of accounts which do not have sufficient balances, the bank may levy service charges. Overdrafts of different durations, short term/regular, are permitted. SAVINGS DEPOSITS: As a product, savings deposits encourage saving habits among the depositors. Such deposits may be either with cheque book facility or with no cheque book facility. Withdrawals are on demand. There are restrictions on the number of withdrawals and the minimum balance to be maintained. The interest rates are regulated by the RBI. No overdraft facility is available on such deposits At present SAVING BANK RATE is 3.5%. TERM/FIXED DEPOSITS: Term/fixed deposits are repayable on pre-fixed maturity. They comprise of (i) FIXED and (ii) RECURRING deposits. FIXED DEPOSITS : Fixed deposits are for a fixed period specified at the time of making the deposits. The repayment on maturity includes principal and the accrued interest. The option to receive interest on quarterly/ monthly basis also is available at the discretion of the depositors. On maturity, the deposits can be renewed for another term at the prevailing rate of interest. Loans against the security of fixed deposits may be availed of. The minimum period of deposit is 7 days. The interest on such deposits is higher vis--vis saving deposits. At present FD RATE is 6 TO 7.5%. RECURRING/CUMULATIVE DEPOSITS: Recurring/ cumulative deposits are a variant of savings deposit. A pre-fixed amount at a pre-fixed frequency (monthly/quarterly) for a pre-specified period (12 to 120 months) can be deposited. The interest is pre-fixed and almost equal to the fixed deposit rate. Loans against the deposit are permitted. Prepayments of deposits at lower rate of interest are also permitted. HYBRID/FLEXI DEPOSITS: THE NEW INNOVATION The hybrid/flexi deposits are a fusion of demand and fixed deposits. Balance in excess of a specified level in a savings deposit is automatically transferred (sweep transfer) to the predetermined term deposit of a pre-determined maturity. In the event of a shortfall in the savings component, funds are automatically transferred back through reverse sweep.

OPERATIONAL ASPECTS OF DEPOSITS The operational aspects of deposits are: (I) Opening/Closing Accounts, (II) Deposit Insurance And (III) Nomination. OPENING/CLOSING ACCOUNTS: While opening new accounts, banks have to comply with the RBI-prescribed KYC procedure in terms of establishing the identity and residential address of the depositor by special documentary evidence. A person who wants to open a deposit account has to (i) fill up and sign the prescribed application form (ii) furnish (a) Introductory reference from an existing depositor of the bank, (b) Acceptable proof of his identity/residential address such as passport, license, ration card, voters ID card, telephone/electricity bills and so on (c) A photograph and (d) A minimum initial deposit. DEPOSIT INSURANCE: Banks deposits to the extent of Rupees ONE Lakh per account are insured by the DICGCI of the RBI. NOMINATION:

MFS SEM-IV (2010-12)

Page 7

Nomination facility is available to the depositors in all types of deposits. The nominees would be paid the outstanding amount in the event of the death of the depositor.

LOAN PRODUCTS AND OTHER INSTRUMENTS The loan products of banks are their assets. There are three aspects of loan/advance products of banks: Credit facilities given to customers, Mode of security/creation of charge on secured loan/advances and Instruments used by customers in banking transactions
LOAN PRODUCTS /CREDIT FACILITIES The credit facilities from banks are divided into: a) Fund-based and b) Non-fund-based. A. FUND BASED The fund-based credit facilities provide funds for (i) working capital and (ii) term/project finance for capital expenditure. A. (a) (b) (c) (d) WORKING CAPITAL FINANCE : The working capital finance is provided by way of Cash Credit Overdraft Demand Loan And Bills Purchased/Discounted.

CASH CREDIT / OVERDRAFT/DEMAND LOAN/BILLS DISC. Cash credit is a unique credit facility. It is a running account for drawing of funds with three elements: credit limit/line of credit, drawing power and actual drawls. Interest is payable on the actual drawls. Overdraft is drawing from a current account in excess of credit balance. A demand loan is a one-time facility subject to periodic/lumpsum principal repayment together with monthly/quarterly interest payments. Bills purchase/ discounting is a specific-asset credit facility. TERM LOANS/PROJECT FINANCE TERM LOANS Term/project loan involves a detailed project appraisal of the borrower. It is secured by mortgage of property. To ensure safety of funds loan agreements contain some positive/negative covenants/ conditions. PRIME LENDING RATE (PLR), LATER ON RENAMED AS BASE RATE (AT PRESENT IT IS 7.5 TO 8%)

B. NON-FUND-BASED:

The non-fund-based credit facilities do not involve outlay of funds. They are contingent liabilities and banks would be liable to honour its commitments. The credit facilities in this category are: Letter of Credit and/or BANK Guarantees.

MODES OF SECURITY ON SECURED ADVANCES BY BANKS

Secured advances of banks have charge against assets in various modes: I. Lien II. Pledge III. Hypothecation and IV. Mortgage. LIEN: Lien means lenders claim on assets offered as security for a loan. Lien refers to the right of bank to retain assets of the borrowers and sell them under the specified circumstances. PLEDGE: Pledge is DELIVERY of Movable Property (say inventory of goods) from borrower to the bank to secure a debt. While the ownership in the goods lies with the borrower, their possession is given to the bank who can sell them in the event of default in repayment. HYPOTHECATION: Hypothecation refers to a charge on movable goods/ commodities in which possession and ownership of the assets charged to banks remains with the borrower. Borrower has the right to sell/use them. On a periodic basis, borrower has to submit stock statement of goods to the bank. MORTGAGE: Mortgage is a charge on Immovable Property offered as security for a loan. Various types of Mortgage*** (Refer pp. 11.16)

I. II. III. IV.

MFS SEM-IV (2010-12)

Page 8

 INSTRUMENTS USED IN BANKING TRANSACTIONS

The instruments issued by banks for use by customers in banking transactions are: Bankers Draft Travelers Cheques And Dividend/ Interest Warrants

RETAIL BANKING PRODUCTS Retail banking refers to banking products/services offered to primarily individual customers of various types. The two elements of retail banking are: 1. Channels of retail banking services delivery and 2. Retail banking products. (i) (ii) (iii) CHANNELS OF RETAIL BANKING SERVICES: ATM Telebanking and Internet banking.

AUTOMATED TELLER MACHINE (ATM): A full-fledged ATM can perform the following functions: A. Cash Dispensing B. Generation Of Statement Of Accounts C. Account Balance Enquiry D. Request For Cheque Book E. Deposit Of Cash/ Cheques F. Issue Of Travellers Cheques G. Utility Payments like telephone/electricity bills and so on. As a service delivery channel, the merits of ATM are round the clock accessibility, convenient locations, automatic accounting of transaction and cost effectiveness TELE-BANKING: Tele-banking enables customers access their accounts for information/ transaction. But cash deposits/withdrawals are not available through such services. Some banks offer cash delivery/collection to select customers. INTERNET BANKING: Banks can enlarge their market area through internet banking without building new offices.

(i) (ii) (iii) (iv) (v) (vi)

The popular retail banking products are: Cards Home Loans Auto Loans Commercial Durable Loans Personal/Unsecured Loans Educational Loans. *** (PLZ. REFER PP. 11.19 TO 11.23 FOR FURTHER DETAILS)

MFS SEM-IV (2010-12)

Page 9