## Financing Receivables — Factoring
### Meaning
Factoring is the outright sale of accounts receivables to a factor (a financial agency).
- A factor is a firm that acquires the receivables of other firms.
- A factoring agreement lays down the conditions of sale.
- The factor bears the risk of collection and services the accounts for a fee.
### Types of Factoring Arrangement
| Basis | Who bears default risk? | Commission |
|---|---|---|
| Recourse | If the factor cannot collect, it can turn the receivable back to the firm (usually replaced with new receivables). Firm ultimately bears the risk. | Lower |
| Non-Recourse | The factor bears the ultimate risk of loss on default. | Higher |
### Advantages
- Immediate conversion of receivables into cash and a predictable cash-flow pattern.
- Provides liquidity without creating a net liability → no impact on the debt–equity ratio.
- A flexible tool: timely funds, efficient record-keeping, effective collection management.
- Not a loan — no debt repayment, no compromise to the balance sheet, no long-term agreements/delays.
- Frees up cash for the growth needs of the business.
### Evaluation of a Factoring Proposal — Format
A. Annual Savings (Benefit) on taking Factoring Service
- Cost of credit administration saved
- Bad debts avoided
- Interest saved due to reduction in average collection period (where applicable):
$$= \text{Cost of Annual Credit Sales} \times \text{Rate of Interest} \times \frac{\text{Present Collection Period} - \text{New Collection Period}}{360}$$
B. Annual Cost of Factoring to the Firm
- Factoring Commission = Annual Credit Sales × % of Commission
- Interest charged by factor on advance:
- Amount available for advance = Annual Credit Sales − Factoring Commission − Factoring Reserve
$$\text{Interest} = \text{Amount available for advance} \times \frac{\text{Collection Period (days)}}{360} \times \text{Rate of Interest}$$
C. Net Annual Benefit / Cost of Factoring = A − B
### Rate of Effective Cost of Factoring
$$\text{Effective Cost} = \frac{\text{Net Annual Cost of Factoring}}{\text{Amount available for advance}} \times 100$$
or
$$= \frac{\text{Net Annual Cost of Factoring}}{\text{Advances to be paid}} \times 100$$
where Advances to be paid = Amount available for advance − Interest deducted by factor.
(1 year is taken as 360 days.)
### Decision Rule
- Avail factoring if the effective cost of factoring is less than the existing cost of borrowing, or if it yields positive net annual benefits.
- Do not avail factoring if the effective cost is more than the existing cost of borrowing.