Explain trade credit and factoring as a source of finance for a business enterprise.
Trade Credit: Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. It is a short-term financing source. It is granted to those customers who have a reasonable amount of financial standing and goodwill. Terms of trade credit may vary from one industry to another and from one person to another. A firm may also offer different credit terms to different customers.
- It is a convenient and continuous source of funds.
- It is readily available in case the creditworthiness of the customers is known to the seller.
- It helps in promoting the sales of an organisation.
- It does not create any charge on the assets of the firm while providing funds.
- It may induce a firm to indulge in overtrading, which may add to the risks of the firm.
- Only a limited amount of funds can be generated through it.
- It is a costly source of funds as compared to most other sources.
Factoring: Factoring is a financial service under which the ‘factor’ renders various services which include: Discounting of bills (with or without recourse) and collection of the client’s debts. Under this, the receivables on account of sale of goods or services are sold to the factor at a certain discount. There are two methods of factoring—recourse and non-recourse. Under recourse factoring, the client is not protected against the risk of bad debts. On the other hand, the factor assumes the entire credit risk under non-recourse factoring. Providing information about the creditworthiness of prospective client’s etc., Factors hold large amounts of information about the trading histories of the firms.
- Cheaper than financing through other means such as bank credit.
- Factoring as a source of funds is flexible and ensures a definite pattern of cash inflows from credit sales. It provides security for a debt.
- It does not create any charge on the assets of the firm.
- The client can concentrate on other functional areas of business as the responsibility of credit control is shouldered by the factor.
- This source is expensive when the invoices are numerous and smaller in amount.
- The advance finance provided by the factor firm is generally available at a higher interest cost.
- The factor is a third party to the customer who may not feel comfortable while dealing with it.