Factoring is an arrangement in which a financial intermediary called 'Factor' collects the accounts receivables on behalf of the seller of goods and services. Factors who are usually subsidiaries of banks or private financial companies, generally render the following services

1. Purchase all the accounts receivable of the seller for immediate cash

2. Administer the sales ledger of the seller

3. Collects the accounts receivable

4. Assume the losses which may arise due to bad debts

5. Provide relevant advisory services to the seller

The factoring arrangement starts when the seller concludes an agreement with the factor wherein, the limits, charges and other terms and conditions are mutually agreed upon. Then all credit sales of the client are passed on to the factor. When the customer places the order and the goods along with the invoices are delivered by the client to the customer, the client sells the customer's account to the factor and also may inform the customer that the payment is to be made to the factor. A copy of the invoice is also sent to the factor. The factor purchases the invoice and makes prepayment, generally up to 80% of the invoice amount. The factor sends monthly statement showing the outstanding balances of the customers, copies of which are also sent to the client. The factor also carries follow-up if the customer does not pay by the due date. Once the customer makes payment to the factor, the balance amount due to the client is paid by the factor. For rendering the services of collection and maintenance of sales ledger, the factor charges a commission which varies between 0.4% to 1% of the invoice value, depending upon the volume of sales.

Types of Factoring

1. Recourse Factoring:
   Under this arrangement, the Factor purchases the receivables on the condition that any loss arising out of irrecoverable debts will be borne by the client

2. Non-recourse or Full Factoring:
   In this arrangement, the client gets full credit protection and all the components of service, viz. Short-term finance, administration of sales ledger are available to the client.

3. Maturity factoring:
   The factor does not make any advance or prepayment. The factor pays the client either on a guaranteed payment date or on date of collection from the customer. This is opposed to 'Advance Factoring' wherein the factor makes prepayment of around 80% of the invoice value to the client

4. Invoice Discounting:
   Under this arrangement, the factor provides a prepayment to the client against the purchase of account receivables and collects interest (service charges) for the period extending from the date of prepayment to the date of collection. The sales ledger administration and collection are carried out by the client.

While factoring in the modern sense is more than three decades old in Europe and in other developed countries, it came to India as a result of the recommendations of the 'Kalyanasundaram Committee' a study group set up at the request of RBI, much later. The first two factoring companies in India, viz. SBI factors and Commercial Services Ltd., and Canbank Factors Ltd. Commenced operations in 1991. These companies provide only recourse factoring at present

Every investment made by a company is in anticipation of adequate returns. After payment of interest and meeting the statutory obligations for depreciation and taxation, the balance of the earnings are paid as dividends or retained as internal accruals. In fact excepting equity finance, all other sources of long-term sources are repayable out of future earnings of the business. Company's growth and stability therefore solely depends on its capacity to earn adequate surplus and generate cash flows regularly.

Instead of raising a debt initially and repaying the same through earned profits and provisions made for depreciation in subsequently years, the Company also accumulate and retain all or a good part of its earnings and channel it for future expansion or diversification. In fact in conventional industries like Sugar and textiles the practice is to start the unit initially with smaller capacity out of equity and debt capital raised. Thereafter the unit goes in for expansion using retained profits as a major source and supplementing the same nominally with borrowings on long term basis. Retained profits are necessary as built in reserves to create a favourable debit-equity ratio.

The question therefore arises to identify the advantages and disadvantages of retained profits, as a source of long term finance in comparison to other types of sources. The advantages are as under:

1. Retained profits, when available is a ready source with quick and direct access. Even when they are not fully available future accruals during the expansion period of the project can be projected and available internal accruals taken as a source of finance.

2. Retained profits when used, as a source of long term finance does not result in dilution of control, as no new equity shareholders are created.

3. Using retained profits does not create a repayment obligation as in debt capital. Hence it is risk free.

4. In the case of borrowings by way of term loans, the contract with the financial institutions contains restrictive covenants, which may reduce managerial freedom. Further Financial Institutions also put their nominees in the Board of the borrowing company. Utilizing retained savings poses no such problem.

5. Utilizing retained profits as a source of long-term finance minimizes operating cost, as there is no interest payment, makes additional funds available for distribution to the existing shareholders, out of increased profits after expansion. Thus the EPS or earnings per share of the company will increase. It further reduces the overall burden on the company for the expansion project and makes the project more viable. A company going in for an expansion project with retained profits has better viability than a similar company going for expansion using equity or debt capital.

1. Though when available it is a ready source of finance, the Company has to wait initially for several years to generate and accumulate profits into sizeable reserves. Therefore it may not be available in times of need, whereas other sources of long term finances can be secured at will as and when needed.

2. Though internal accruals do not add to the operating cost of the project after expansion, these funds cannot be considered as cost-free, jus as equity capital contributed by the shareholders is not deemed cost-free, though the company has no legal obligation to pay dividends to the shareholders. It is a misconception that retained earnings are cost-free or cost significantly less than external equity, because such reasoning stem from ignoring the opportunity cost associated with retained earnings. When a business retains a portion of its earnings, equity shareholders are denied dividend to that extent. So ask the question "if the company distributes, rather than retains, its earnings what happens?" A reasonable answer to this question is: equity shareholders would have more funds with them, which they would probably invest elsewhere to earn a rate of return comparable to the cost of equity. Hence the opportunity cost of retained earnings is more or less equal to the cost of equity funds.

3. Retained earnings when used for long-term needs reduce the current ratio of the company and thus adversely affects its liquidity. A portion of the retained profits needed for net working capital has to be preserved and the company may go in for fresh borrowings for working capital.

On overall considerations retained earnings is a most suitable source for expansion and diversification projects.

Symptoms of sickness in a unit if detected at the incipient stage can enable quick and easy remedial measures. In the initial stage a healthy unit turns to be weak unit with eroded profitability and then it starts showing loss. Its current ratio turns to 1: 1 and later it turns negative. The accounts with the bank become continuously irregular for several months and erosion of capital takes place at more than 10% per annum. There is continuing default in the payment to creditors, payment of statutory dues like EPF, ESI, finally before the unit becomes totally closed.

The old adage 'prevention is better than cure' is especially true in the case of industrial sickness. The major problem in India is that sickness of a unit is declared at a very late stage, when the net worth is eroded and rehabilitation becomes very difficult. Recent studies on industrial studies have shown that even six years before attaining the stage of cash loss, the profitability index of the sick companies showed marginal decline, followed by sustained decline during the period of three years preceding the cash loss period and then it showed continuous and significant cash loss during the subsequent period. Thus if the sickness is detected at the early stages, remedial measures are easy and more effective.

An industrial unit might become sick due to a variety of factors. Some of these may be indigenous or internal and some exogenous (external). Some of them are as under:

1. Failure to attain required sales turnover.

2. Inadequacy of working capital.

3. Difficulties in getting supply of raw material.

4. Mismanagement or lack of management effectiveness resulting in defective management of finance, inventory or human resources.

5. Bad management of receivables' collection resulting in pilled up sundry debtors.

6. Inability to attain rated production capacity due to mis-match in machinery and equipment.

7. Hasty/premature repayment of term loan installments, not out of profits or depreciation provision, but out of working capital resulting in its erosion.

8. External causes like transport strike.

9. Strikes and lockouts etc.

In most of the above cases, if the root cause is detected immediately it is easy to work out a remedy. Thus in respect of inadequacy of sales turnover, the remedy is market survey and sales promotion. In respect of dearth of working capital, additional equity to be brought it. The Banker may be requested to temporary provide additional fixed working capital or reduce the margin in the case of the existing loan. In the case of management ineffectiveness the services of management consultant can be temporarily availed. In respect of machinery mis-match, balancing equipment can be purchased or leased.

In most cases sickness remains undetected due to the fact that entrepreneurs are inexperienced. They devote more attention to production and marketing and less attention to effective areas of management like Management information system, periodical performance budgeting followed by monitoring or reviewing progress at the end of each period (month or quarter). In many case entrepreneurs do not even keep updated accounts, with the result they are always ignorant of the true state of affairs of their business.

The unit should budget its performance (sales turnover and profits) for every period (year/quarter/month) and fix levels of holding for its different current assets. It should then calculate its requirement of working capital and ensure that adequate working capital is available. Once this advance planning/preparation is over, the performance every month/quarter should be reviewed with actuals and an intelligent appraisal of the actuals with the budgeted parameters will indicate the variations. If the entrepreneur looks to the reasons for the variations carefully, he will be in a position to detect the deficiencies in the working of the business, which ultimately turn the unit in a sick unit.