Factoring (fnance)

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This article is about fnance. For other uses, see Factor (disambiguation).
Factoring is a fnancial transaction whereby a business sells its accounts
receivable (i.e., invoices) to a third party (called a factor) at a discount. In
"advance" factoring, the factor provides fnancing to the seller of the accounts in
the form of a cash "advance," often 70-85% of the purchase price of the
accounts, with the balance of the purchase price being paid, net of the factor's
discount fee (commission) and other charges, upon collection. In "maturity"
factoring, the factor makes no advance on the purchased accounts; rather, the
purchase price is paid on or about the average maturity date of the accounts
being purchased in the batch. Factoring difers from a bank loan in several ways.
The emphasis is on the value of the receivables (essentially a fnancial asset),
whereas a bank focuses more on the value of the borrower's total assets, and
often considers, in underwriting the loan, the value attributable to non-accounts
collateral owned by the borrower also, such as inventory, equipment, and real
property,
[1][2]
i.e., matters beyond the credit worthiness of the frm's accounts
receivables and of the account debtors (obligors) thereon. Secondly, factoring is
not a loan it is the purchase of a fnancial asset (the receivable). Third, a
nonrecourse factor assumes the "credit risk", that a purchased account will not
collect due solely to the fnancial inability of account debtor to pay. In the United
States, if the factor does not assume credit risk on the purchased accounts, in
most cases a court will recharacterize the transaction as a secured loan.
It is diferent from forfaiting in the sense that forfaiting is a transaction-based
operation involving exporters in which the frm sells one of its transactions,
[3]
while factoring is a Financial Transaction that involves the Sale of any portion
of the frm's Receivables.
[1][2]
Factoring is a word often misused synonymously with invoice discounting, known
as "Receivables Assignment" in American Accounting ("Generally Accepted
Accounting Principles"/"GAAP" propagated by FASB)
[2]
- factoring is the sale of
receivables, whereas invoice discounting is borrowing where the receivable is
used as collateral.
[2]
The three parties directly involved are: the one who sells the receivable,
the debtor (the account debtor, or customer of the seller), and the factor.
Thereceivable is essentially a fnancial asset associated with the
debtor's liability to pay money owed to the seller (usually for work performed or
goods sold). The seller then sells one or more of its invoices (the receivables) at
a discount to the third party, the specialized fnancial organization (aka the
factor), often, in advance factoring, to obtain cash. The sale of the receivables
essentially transfers ownership of the receivables to the factor, indicating the
factor obtains all of the rights associated with the receivables.
[1][2]
Accordingly, the
factor obtains the right to receive the payments made by the debtor for the
invoice amount and, in nonrecourse factoring, must bear the loss if the account
debtor does not pay the invoice amount due solely to his or its fnancial inability to
pay. Usually, the account debtor is notifed of the sale of the receivable, and the
factor bills the debtor and makes all collections; however, non-notifcation
factoring, where the client (seller) collects the accounts sold to the factor, as
agent of the factor, also occurs. There are three principal parts to "advance"
factoring transaction; (a) the advance, a percentage of the invoice face value that
is paid to the seller at the time of sale, (b) the reserve, the remainder of the
purchase price held until the payment by the account debtor is made and (c) the
discount fee, the cost associated with the transaction which is deducted from the
reserve, along with other expenses, upon collection, before the reserve is
disbursed to the factor's client. Sometimes the factor charges the seller (the
factor's "client") both a discount fee, for the factor's assumption of credit risk and
other services provided, as well as interest on the factor's advance, based on
how long the advance, often treated as a loan (repaid by set-of against the
factor's purchase obligation, when the account is collected), is outstanding.
[4]
The
factor also estimates the amount that may not be collected due to non-payment,
and makes accommodation for this in pricing, when determining the purchase
price to be paid to the seller. The factor's overall proft is the diference between
the price it paid for the invoice and the money received from the debtor, less the
amount lost due to non-payment
In trade fnance, forfaiting is a fnancial transaction involving the purchasing
of receivables from exporters by a forfaiter. The forfaiter takes on all the risks
associated with the receivables but earns a margin.
[citation needed][1]
The forfaiting is a
transaction involving the sale of one of the frm's transactions.
[1]
Factoring is also
a fnancial transaction involving the purchase of fnancial assets,
but Factoring involves the sale of any portion of a frm's receivables
The characteristics of a forfaiting transaction are:
Credit is extended to the exporter for a period ranging between 180 days
to seven years.
Minimum bill size is normally $250,000, although $500,000 is preferred.
The payment is normally receivable in any major convertible currency.
A letter of credit or a guarantee is made by a bank, usually in the
importer's country.
The contract can be for either for goods or for services.
Merchant banks and investment banks, in their purest forms, are different kinds
of financial institutions that perform different services. In practice, the fine lines
that separate the functions of merchant banks and investment banks tend to blur.
Traditional merchant banks often expand into the field of securities underwriting,
while many investment banks participate in trade financingactivities. In theory,
investment banks and merchant banks perform different functions.
Pure investment banks raise funds for businesses and some governments by
registering and issuing debt or equity and selling it on a market. Traditionally,
investment banks only participated in underwriting and selling securities in
large blocks. Investment banks facilitate mergers and acquisitions through share
sales and provide research and financial consulting to companies. Traditionally,
investment banks did not deal with the general public.
Traditional merchant banks primarily perform international financing activities
such as foreign corporate investing, foreign real estate investment, trade finance
and international transaction facilitation. ome of the activities that a pure
merchant bank is involved in may include issuing letters of credit, transferring
funds internationally, trade consulting and co!investment in pro"ects involving
trade of one form or another.

The current offerings of investment banks and merchant banks varies by the
institution offering the services, but there are a few characteristics that
most companies that offer both investment and merchant banking share.
#s a general rule, investment banks focus on initial public offerings $IP%s& and
large public and private share offerings. Merchant banks tend to operate on
small!scale companies and offer creative equity financing, bridge
financing, me''anine financing and a number of corporate credit products. (hile
investment banks tend to focus on larger companies, merchant banks offer their
services to companies that are too big for venture capital firms to serve properly,
but are still too small to make a compelling public share offering on a large
exchange. In order to bridge the gap between venture capital and a public
offering, larger merchant banks tend to privately place equity with other financial
institutions, often taking on large portions of ownership in companies that are
believed to have strong growth potential
A merchant bank is a fnancial institution which provides capital to companies in the form of
share ownership instead of loans. A merchant bank also provides advisory on corporate matters
to the frms they lend to.
Today, according to the US Federal Deposit Insurance Corporation (acronym FDIC), "the term
merchant banking is generally understood to mean negotiated private equity investment by
fnancial institutions in the unregistered securities of either privately or publicly held
companies."
[1]
Bothcommercial banks and investment banks may engage in merchant banking
activities.
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Definition
Merchant banks, also known as investment banks, offer various services in international finance and long!
term loans for wealthy individuals, multinational corporations, and governments.
#n investment bank is split into the so!called front, middle, and back office functions. The front office deals
with investment bankingand management, sales and trading, structured products, private equity investment,
research, and strategy. The middle office deals with risk management, finance, and compliance. The back
office deals with transactions, operations, and technology.
The main function of a merchant bank is to buy and sell financial products. They manage risk through
proprietary trading, carried out by special traders who do not interface with clients. The trader manages the
risk for the principal after they buy or sell a product to a client but does not hedge their total exposure. )anks
also try to maximi'e the profitability of certain risk on their balance sheets.
Merchant banks manage debt and equity offerings. They assist companies in raising funds from the market.
This can include designing instruments, pricing issues, registering offer documents, underwriting support,
issue marketing, allotment and refund, and stock exchange listing. They also help in distributing securities
such as equity shares, mutual fund products, debt instruments, insurance products, and fixed deposits
among others. Merchant banks use a mix of institutional networks*mutual funds, foreigninstitutional
investors, pension funds, private equity funds, and financial institutions*and retail networks, depending on
how they interact with specific clients.
Merchant banks offer corporate advisery services to clients for their financial problems. #dvice may be
sought in such areas as determining the right debt!to!equity ratio, the gearing ratio, and the
appropriate capital structure. %ther areas of advice may be in areas of refinancing and seeking sources of
cheaper funds, risk management, and hedging strategies. +urther areas for advice are rehabilitation and
turnaround management. Merchant bankers may design a revival package in con"unction with other financial
institutions.
Merchant bankers assist clients with pro"ect advice, helping them from the pro"ect concept stage,
through feasibility studies to examine a pro"ect,s viability, to the preparation of documents such as a detailed
pro"ect report.
Merchant banks arrange loan syndication for their clients. This begins with an analysis of the client,s cash
flow patterns, helping to determine the terms for borrowing. The merchant bank then prepares a detailed
loan memorandum to be circulated to the banks and financial institutions that are to "oin the syndicate.
+inally, the terms of lending are negotiated for the final allocation.
Merchant banks provide venture capital and me''anine financing $a hybrid of debt and equity financing that
is typically used to finance the expansion of existing companies&. In this way they can help companies to
finance new and innovative ventures.
+ollowing the global financial crisis of -../, which saw the collapse of several prominent investment
banks in 0urope and the 1nited tates in eptember of that year, the viability of using a business model that
is based heavily on banks purchasing each others, debts has been severely questioned. 2ertainly in the
1nited tates, the view is that this business model is no longer sustainable and is unlikely to continue in the
same form in the future. It remains to be seen how merchant banks will restructure in the aftermath of the
financial turbulence of -../.
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Advantages
Merchant banks perform functions that cannot be carried out by businesses on their own.
Merchant banks have access to traders, financial institutions, and markets that companies or
individuals could not possibly reach.
)y using their skills and contacts, merchant banks can get the best possible deals for their clients.
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Disadvantages
Merchant banks are really only for large corporate customers, or extremely wealthy smaller
businesses owned by individual clients.
3ot all deals carried out by merchant banks meet with unqualified success.
There is always risk attached to the kinds of deal that merchant banks undertake