Advantages and Disadvantages of Factoring

A financial service under which a ‘factor’ provides various services, like discounting of bills and providing information about the credit worthiness of prospective clients, etc., is known as Factoring.

What Services does Factoring Include?

1. Discounting of bills (with or without recourse) and collection of the client’s debts:

Bill discounting (with or without recourse) and debt collection from the customer. The receivables from the sale of products or services are sold to the factor at a particular discount. The factor takes over all credit supervision and debt collection from the buyer and protects the company against any bad debt losses.

Factoring may be done in two ways : recourse and non-recourse :

The customer is not safeguarded against the risk of bad debts under recourse factoring. But non-recourse factoring involves the factor taking on the complete credit risk, which means that the full amount of the invoice is reimbursed to the client if the debt becoming bad.

2. Providing information about the creditworthiness of prospective clients:

Factors retain vast volumes of information on the trading history of businesses, which they use to provide information about the creditworthiness of new clients, among other things. This can be beneficial to individuals that use factoring services and therefore avoid doing business with consumers who have a bad payment history. Factors may also provide appropriate consulting services in areas like finance, marketing, and so forth.

The terms and type of factoring may differ from one financial institution to another. The advance rate might range from 80% to 90% to 95% of the entire invoice amount. After collecting payments from debtors, the factor returns the remaining funds after deducting its charge or commission.

The factor collects fees from customers for services provided. Only in the early 1990s, as a result of RBI initiatives, factoring appeared on the Indian financial scene. State Bank of India, Canara Bank, Punjab National Bank, Allahabad Bank, and SBI Factors and Commercial Services Ltd. are among the organizations that provide these services. Factoring services are furthermore offered by several non-banking finance companies and other organisations.

Advantages of Factoring

The advantages of Factoring are: 

1. Immediate Cash Flow: This sort of financing shortens the cash collection period. It facilitates quick cash realisation by selling receivables to a factor. The availability of liquid cash can often be the factor for grabbing and giving up an opportunity. The cash boost given by factoring is readily available for capital expenditures, completing a new order, or meeting an unexpected condition.

2. Focus on Business Operations and Growth: By selling off invoices, business owners may relieve themselves of the burden of collecting payments from customers. Receivables department resources can be focused on business operations, financial planning, and future growth.

3. Bad Debt Evasion: There are two sorts of factoring: with recourse and without recourse. In the case of bad debts, the factor bears the loss without recourse factoring. As a result, once the seller sells its receivables, it has no responsibility to the factor.

4. Quick Finance Arrangement: Factors provide funds more quickly than banks. Compared to other financial institutions, factoring provides a faster application, less documentation, and faster settlement of funds.

5. No Requirement for Security: The advances are made based on the strength of the receivables and their creditworthiness. Factors, unlike cash credit and overdraft, do not require any collateral security to be pledged or hypothecated. New enterprises and startups with significant receivables can readily qualify for advances. Factoring, unlike typical bank loans, does not necessitate the use of your house or other property as security.

6. Customer Analysis: Factors give significant guidance and insights to the seller on the credit quality of the party from whom receivables are due. It helps in the negotiation of better terms between the parties in futures contracts.

7. Time Savings: Factoring can save the firm time and effort that would otherwise be spent collecting from consumers. That energy can be applied to other business-building tasks such as sales, marketing, and customer development.

8. Cheap Source of Finance: It is a cheap source of finance than any other means such as banking.

9. No charge on Assets: It does not create any charge on the assets.

Disadvantages of Factoring

The disadvantages of Factoring are:

1. Expensive: This can be an expensive source of finance when the invoices are numerous and smaller in amount.

2. Higher Interest Rate: The advance provided is generally available at a higher interest cost than the usual rate.

3. Involvement of Third Party: The factor is the third party to the customer who may not feel comfortable while dealing with it.