VTU MBA Lecture Notes - 1st Sem, 2nd Sem, 3rd Sem and 4th Sem || Visvesvaraya Technological University
Unit 4
Factoring, Forfeiting & Securitization of
Factoring
Introduction
- Factoring is a financial transaction whereby a business accounts receivables i.e invoices to a third party called a discount in exchange for immediate money.
- Factoring involves a seller/client and a buyer/customer factor.
- Vaghul committee on money market recommended development of factoring business to benefit SSIs through banks banking financial institutions.
- Kalyanasundaram committee of 1988 recommended 3 - in a zone to start this service through subsidiaries.
- In 1991 SBI and Canara Bank set up factoring services in their 2 subsidiaries in the western and southern region.
- Awareness about factoring services is still very low. Proper marketing efforts needs to be put in this direction.
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
Meaning: Latin term 'factor' which means 'doer'.
"Factor is one who lends money to producers and dealers on the of accounts receivables"
- Factoring is a financial transaction whereby a business sells its receivables to a third party at a discount in exchange for money.
- Factor is a financial institution which manages the collection of receivables of the companies on their behalf and bears the associated with those accounts.
Mechanism
--- Content provided by FirstRanker.com ---
- The customer places an order for goods on credit, client delivers goods and sends credit invoice.
- Client sends invoice to factor
- Factor makes pre-payment upto 80 per cent to client
- Factor starts managing debt with the buyer.
- Customer pays the factor
- Factor pays balance 20 percent to the client, after deducting commission.
--- Content provided by FirstRanker.com ---
Characteristics of factoring
- It is a mode of financing as well as a financial service provided by the specialist companies called factors
- It is a contractual service arising out of the agreement between business firm and the factors
- Continuous arrangement between the factor and the client
- It enables the conversion of outstanding receivables into cash
- It involves an outright sale of book debts to the factor by
- Factor makes an advance payment (80% to 90%) against invoice factored by the clients firm
- Factor may assume the credit risk or may not assume the credit risk arising from the collection of receivables
- Factor undertakes the services of credit collection, sales maintenance etc
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
Functions of Factoring
- Finance: Acts as a source of short term funds. The factor pays upto 80% of the outstanding and pays the balance minus commission on maturity.
- Debt administration: The factor maintains sales ledger showing outstanding position. He sends monthly statements to the client
- Credit risk: The factor will advice the client about the credit worthiness of different buyers and help them in credit protection. Without recourse factoring also helps in credit protection to the clients
- Advisory services: Factor provides clients advice on finance, buyer management, credit sales and also on issues related to sales and finance management
--- Content provided by FirstRanker.com ---
Types of Factoring
- Recourse factoring: Factor purchases trade debtors and pursues to collect receivables. But in case of default factor takes recourse to seller. Therefore this kind of factoring has no bad debt protection and is used in developing countries.
- Non-recourse factoring: If the trade debtor fails to pay, the factor cannot recover the money from the client. This gives bad debts protection to the client and therefore is bit expensive. Famous in developed countries.
- Advance factoring: The factor pays only a specified advance say 90% of the receivables in advance and the balance is paid on actual collection of debt. A drawing limit is opened as soon as the invoice is raised. Client has to pay interest on the factored amount from the date of payment to the date of actual collection.
- Bank participation factoring: Is a modification over advance factoring where a bank provides a part of the factor reserve. Factor reserve is receivables less advance given by the factor. If factor advances 75% the reserve is 25% and bank would pay say 50% of that reserve making total support 87.5%
- Maturing factoring/Collection factoring: No advance payment by the factor. But payment is done on the date of collection or on the payment date which is usually a few days after due date of invoice.
- Notified and Undisclosed factoring: In notified factoring the customer is informed about assignment of debt to the factoring agent and is asked to pay to the factor instead of the firm. In a non-notified or confidential/ undisclosed factoring the factoring arrangement is not disclosed to the customer but the customer is required to pay to the new party.
- Full factoring: This provides all the services involved in factoring like collection, credit protection, sales ledger protection and sales finance. It is also called old line factoring.
- Invoice factoring: The debt due to the client is purchased by the factor providing liquidity but it doesn't provide the service element of factoring.
- Buyer based, seller based and selective factoring: In a buyer based factoring the factor would maintain a list of buyers whose receivables would be factored without recourse to the seller. In a seller based factoring system, the factoring agent keeps a list of seller who they would like to factor with or without recourse. In selective factoring the seller is restricted to sell to the approved buyer.
- Export factoring: Also known as international or cross-border factoring. Deals in export sale and provides financial service, collection, credit advisor service and services pertaining to legal formalities of export.
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
Factoring charges
Finance charges: are levied based on pre-payment and the amount outstanding in clients accounts on a reducing balance basis. It is only for the money lent and is similar to the interest charged by banks on a cash credit account.
Service fee: This is to cover the services provided like credit collection, sales ledger management, periodical reports etc. This is charged on a monthly basis based on sales volume, number of customers, number of invoices, and the degree of credit risk posed by the buyers.
Both these charges compare favourably with interest rates charged by banks for short term borrowings.
--- Content provided by FirstRanker.com ---
Forfeiting
- Forfeit means "relinquish or give up a right"
- It refers to exporter giving up his right to a receivable on a future date in favour of immediate cash, at an agreed discount from a forfeiter, thereby passing all rights of collection to the forfeiter.
- It refers to factoring without recourse to the exporter
- Evolved in 1960s in Switzerland to help German exports to the eastern block countries.
- It mushroomed in Switzerland and now it is concentrated in London.
- RBI approved forfeiting as a mode of export finance
- Exim bank was the first institution to get approved under it.
--- Content provided by FirstRanker.com ---
Characteristics of Forfeiting
It is a pure financial arrangement
- It is related to credit sales of more than 90 days (1 year receivables)
- Forfeiter discounts entire value of the bill thereby providing 100% finance to the exporter.
- Availing bank provides unconditional and irrevocable guarantee, which is a critical element of this arrangement
- Usually a forfeiter finances long term deferred payment upto 5 years
- Forfeiter bears credit risk and exchange risk as well.
- A forfeiter may hold the bills till maturity or sell them in the secondary market
- Forfeiting agreement can be flexible and can be structured around various needs like interest rates, duration, etc
- Usually suitable for high value items like capital goods, consumer durables, projects exports etc.
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
Forfeiting Mechanism
- Forfeiter gives a commitment to the exporter about forfeiting at the time of shipment
- Exporter and importer sign a commercial contract
- A forfeiting certificate issued by the AD is attached to the bill and sent to importer along with commercial documents
- The importers bank gives guarantee at the request of the importer.
- The guarantee is forwarded by the importer to the exporter
- The exporter then assigns the guarantee in favour of the forfeiter
- Forfeiter pays the exporter on a non-recourse basis
- On maturity the forfeiter presents the documents to the importers bank
- Importer pays the guaranteeing bank
- Guaranteeing bank pays the forfeiter
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
Forfeiting charge
- Discount fees: Cost of interest for the credit period on the discounted amount.
- Option fee: Charged for right to withdraw unilaterally from the forfeiting contract
- Collection cost: Cost of collection charged to the exporter
- Commitment fee: Commitment fee charged by the forfeiter for the period between signing of agreement and the actual disbursement to the exporter. It is a percentage on the total sum for the commitment period.
--- Content provided by FirstRanker.com ---
Securitization of Debt
- Securitisation means to convert an asset, specifically a loan into marketable security for the purpose of raising cash or funds.
- It can also be used for financial assets like mortgage loans, automobile loans, receivables, credit card receivables etc
- Illiquid receivable is converted into securities hence the name debt or asset securitisation
- It may involve pooling of assets and selling them to investors through a specialized intermediary created for the purpose.
--- Content provided by FirstRanker.com ---
Features of Securitization of Debt
- Marketability
- Merchantable quality
- Wide distribution
- Homogeneity
- Commoditisation
- Integration and differentiation (pooling and separation of assets)
- De-construction of claims to various cash flows and rearrange them into various buckets and sell them to different investors
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
Parties involved in securitization of debt
- Originator or seller: whose receivables portfolio forms the basis for asset backed security (ABS)
- Special purpose vehicle (SPV): formed to carryout a specific activity. Can be trusts, corporations, limited partnership etc. This helps distancing of the instrument from the originator and mediates between the originator and the investor.
- Investors: individuals or institutional investors who invest and receive interest and principal as per agreed norms
- Other parties
- Obligor: originator's debtor or borrower of the original loan
- Trustee: investors representative to safeguard their interest
- Credit rating agency
- Regulators
- Service providers
- Specialists like legal, accounts, pool auditors
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
Benefits of Securitization of Debt
- Benefits to issuers / originator
- Diversification and reduced cost of funding
- Management of regulatory capital
- Generation of servicing fee income
- Management of interest rate volatility
--- Content provided by FirstRanker.com ---
- Benefits to Investors
- Benefits to borrowers
Issues in securitization of debt
--- Content provided by FirstRanker.com ---
- Debility (incapability) to central bank
- Heightened volatility
- Pressure on profitability
- Eroding capital base
Link for you tube video
--- Content provided by FirstRanker.com ---
Special Purpose vehicle
- SPV is created to carry-out a specific business purpose or activity.
- SPVs are frequently used in structured finance transactions such as in asset securitizations, joint ventures, or to isolate certain company asset or operations. SPVs can be created through a variety of entities, such as trusts, corporations, limited partnerships, and limited liability corporations.
- SPV are used by many companies for an array of financial purposes.
- SPV which as the issuer of the ABS ensures bankruptcy distancing of the instrument from the originator.
- The entity that intermediates between the originator's receivables and the end-investors is known as 'Special Purpose Vehicle'.
--- Content provided by FirstRanker.com ---
Securities issued by SPV
- Mortgage-Backed Securities (MBS), which are backed by mortgages
- Asset-Backed Securities (ABS), which are mostly backed by consumer debt
- Collateralized Debt Obligations (CDO), which are mostly backed by corporate bonds or other corporate debt.
--- Content provided by FirstRanker.com ---
Reasons for creating SPV
- Securitization
- Risk Sharing
- Finance
- Asset Transfer
- Financial Engineering
- Regulatory Reasons
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
This download link is referred from the post: VTU MBA Lecture Notes - 1st Sem, 2nd Sem, 3rd Sem and 4th Sem || Visvesvaraya Technological University