Advantages and Disadvantages of Factoring

Factoring is a business activity in which a firm sells its receivables to a third party and obtains cash in return. It is somewhat similar to the concept of bail agreement. There are three main participants in this process; seller of the firm (client), customer, and the factor. In most of the cases, the factor is responsible for the bad debt, if the customer is incapable of paying the required amount. This practice may be followed differently in business transactions, and the method followed, depends on the financial and legal structure of a country, which differs from one country to another. For example, recourse factoring is practiced in India, whereas non-recourse form, where the factor does not take responsibility of all bad debts, is prevalent in developed countries like the US and UK.

Factoring Process in Brief

The client (seller), decides to sell the receivables of his company to a factor and provides invoice document. The seller sends the goods to the customer on credit basis. The factor sends a payment to the client which is 80% of the total amount to be paid and the remaining 20% of the total amount is obtained from the customer.

Advantages

• The administrative cost and burden is reduced due to this process.
• The scope of operating leverage is improved and the return is enhanced.
• It helps in enhancing the liquidity of the firm and efficient capital management.
• Credit discipline is achieved, as the client chooses efficient customers due to regular realization of dues.
• The cash flow from the factor and customer to the client is accelerated and the cash inflow of funds is ensured and profitability of the client is improved.
• The acceptance of the receivables mentioned by the client in the invoice is tantamount to the credit certification by the factoring company.
• It provides insurance against bad debts.
• The client will have more time to exploit opportunities and plan to improve the business.
• Constant information flow is maintained and wastage of time in regulating is reduced.
• The bad debts can be cleared with the help of financial units like banks. This kind of linkage helps in better arrangements for business dealings, collection of sales ledgers etc.
• It is complementary to the financial services of banks.
• Efficient production is ensured, as the factor takes up the responsibility of sales ledger administration and debt collection problems.
• It does not infringe upon the rights of the customers.
• It facilitates exporting and other financial assistance related to it.
• Estimating the cash budget is easy for the client, as the percentage of amount and the due balance is known to the client.

Disadvantages

• It will function smoothly only if there are no complicated debts.
• Cost involved in this process should be determined before a factor is involved in the process and it is higher than the cost of short-term borrowings.
• The goodwill of the firm of the seller, may be viewed as a sign of financial crisis or weakness by customers and other creditors, due to this process.
• The factor doesn't work after the invoice maturity is 180 days over and they are very selective in their choice of invoice provided by the client.
• The credit limits are set by the factors, which the customers must accept and take over.
• Maintenance of credit and collection department is expensive.
• It doesn't work well in developing countries because of inadequate financial and legal models in the countries. In Asian countries like India, recourse factoring, is practiced in which the factor recourse to the client, in case of financial crisis.

Small scale sectors are more benefited through this process, because the factor helps to deal with the problem of inadequate working capital. It's quite clear from the process that, most of the important functions is relied on the factor. So, the client firm should choose the right factor, to sell its receivable, to make the process smooth. Though this business activity often proves to be successful, it has certain limitations to it, which is sometimes risky.