Factoring, Forfaiting & Trade Receivables Discounting System (TReDS)

Factoring, Forfaiting & TReDS Explained with Advanced Mathematical Examples | MODULE D: FINANCIAL PRODUCTS AND SERVICES

What is Factoring?

Factoring is a financial service where a business sells its accounts receivables (invoices) to a third party (called a factor) at a discount to obtain immediate cash flow. This helps companies improve liquidity without waiting for the payment terms to mature.

History of Factoring

The concept of factoring dates back to ancient Mesopotamia (around 2000 BC), where traders used agents to collect payments. Modern factoring developed during the 14th century in England, supporting the wool industry. In the United States, factoring became popular in the 19th century, particularly in the textile industry.

Types of Factoring

Recourse Factoring: The seller bears the risk if the customer fails to pay.
Non-recourse Factoring: The factor bears the risk of non-payment.
Domestic Factoring: Both the client and customers are based in the same country.
International Factoring: The client and customers are located in different countries.

Domestic Factoring

Domestic factoring involves the selling of receivables between businesses operating within the same country. The factor helps the client in managing credit control, sales ledger management, and debt collection.

International Factoring

In international factoring, a four-party system (export factor, import factor, exporter, importer) manages export receivables, thereby reducing international payment risks.

Bills Discounting vs Factoring

Aspect	Bills Discounting	Factoring
Nature	Loan against bills	Sale of receivables
Responsibility of Collection	Borrower	Factor
Risk	On business	May be on factor (non-recourse)
Balance Sheet Effect	Liability recorded	Off-balance sheet in case of true sale

Fees Involved in Factoring

Factoring Fees: Charged as a percentage of the invoice value (usually 1%–3%).
Discount Charges: Interest on cash advance against receivables.
Service Charges: For ledger management, credit assessment, and collection services.

Advantages of Factoring

Immediate cash flow improvement
Better working capital management
Reduced credit risk (in non-recourse factoring)
Outsourcing of collection functions
Improved focus on core business operations

Complex Mathematical Example for Factoring:

Suppose Company A has ₹5,00,000 in receivables. A factoring company agrees to purchase them at an 80% advance rate and charges a 2% factoring fee.

Advance received = 80% of ₹5,00,000 = ₹4,00,000
Factoring fee = 2% of ₹5,00,000 = ₹10,000
Net amount received after fee deduction = ₹4,00,000 - ₹10,000 = ₹3,90,000
When the customers pay the full ₹5,00,000, the balance ₹1,00,000 (less any additional charges) is paid to Company A.

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What is Forfaiting?

Forfaiting is a form of export financing where exporters sell their medium- to long-term receivables (usually backed by bills of exchange or promissory notes) to a forfaiter at a discount, in exchange for immediate cash payment. It is typically used for large international trade transactions.

Mechanism of a Forfaiting Transaction

The exporter sells goods to the importer on credit terms.
The importer issues promissory notes or bills of exchange.
The exporter sells these instruments to a forfaiter (usually a bank) at a discount for immediate payment.
The forfaiter assumes all the payment risks.

Fees Involved in Forfaiting

Discount Rate: Applied to the face value of receivables.
Commitment Fee: Charged for holding the forfaiting facility open.
Documentation Fees: Costs associated with documentation and notarization.

Advantages of Forfaiting

Complete elimination of credit and political risks
Immediate cash flow improvement
No impact on the exporter’s balance sheet
Simplified transaction process for exporters

Complex Mathematical Example for Forfaiting:

An exporter has a receivable of $1,000,000 due in 2 years. The forfaiter applies a discount rate of 6% p.a. compounded annually.

Discount Factor (DF) = 1 / (1 + r)^n = 1 / (1 + 0.06)^2 = 1 / 1.1236 ≈ 0.8900
Present Value = $1,000,000 × 0.8900 = $890,000

Thus, the exporter receives $890,000 today instead of waiting 2 years for $1,000,000.

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Differences between Factoring and Forfaiting

Aspect	Factoring	Forfaiting
Scope	Short-term receivables	Medium to long-term receivables
Risk Coverage	Optional (non-recourse factoring)	Full without recourse
Transaction Size	Small to medium	Large, international transactions
Currency	Local and international	Typically foreign currency

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What is TReDS?

Trade Receivables Discounting System (TReDS) is an institutional mechanism set up in India to facilitate the financing of trade receivables of Micro, Small and Medium Enterprises (MSMEs) from corporate buyers through multiple financiers.

Participants under TReDS

MSME Suppliers
Corporate Buyers
Financiers (Banks, NBFCs)

Process Flow under TReDS

The supplier uploads the invoice on the TReDS platform.
The buyer verifies the invoice.
Multiple financiers bid to discount the invoice.
The supplier accepts the best offer and receives the payment.
The financier collects the amount from the buyer on the due date.

Eligibility Criteria to Set Up and Operate TReDS

Must be incorporated as a company in India.
Minimum paid-up equity capital of ₹25 crore.
Should have technological capability to operate an electronic platform.
Requires approval from the Reserve Bank of India (RBI).

Complex Mathematical Example for TReDS:

MSME Supplier raises an invoice of ₹2,00,000. Financier A bids to discount at 8% p.a., and Financier B bids at 7.5% p.a. for a 90-day tenure.

Discount by Financier A = (8/100) × (90/365) × ₹2,00,000 = ₹3,945
Discount by Financier B = (7.5/100) × (90/365) × ₹2,00,000 = ₹3,698

Thus, the MSME will prefer Financier B as it offers a lower discount cost, receiving ₹2,00,000 - ₹3,698 = ₹1,96,302.

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Factoring, Forfaiting & TReDS Explained with Advanced Mathematical Examples | MODULE D: FINANCIAL PRODUCTS AND SERVICES