and analysis of relevant information is done by a specialised agencywhichagroupofinvestorscantrust. 2. QuickInvestmentDecision In the present day complex world ratings enable investors to take quickest possibledecisionsbasedonassociatedratings. 3. SourcesofAdditionalCertification Credit rating agency provides additional certification to the issue of debt/financialinstrument. A highly rated firm can enter the market with great confidence. Indianexperience shows that individual companies that use credit rating, benefit a greatdealbygettinglargeramountofmoneyfromawideraudienceatalowercost. 4. IncreasetheInvestorsPopulation A sound credit rating system gives an alternative method to name recognition as adeterminingfactorinmakinginvestmentandhelpsincreasethepopulationofthoseinvestingind ebtobligationsofthecompany. 5. ForewarnsRisks Creditratingactsasaguidetocompanieswhichgetalowerrating.Itforewarnsthemanagementoft heperceptionofriskinthemarketandpromptstotakestepson their operating and marketing risks and thereby changes the perception in themarket. 6. EncouragesFinancialDiscipline Ratingalsoencouragedisciplineamong corporateborrowerstoimprove theirfinancialstructureandperformancetoobtainbetterratingfortheirdebtobligations. 7. MerchantBankersJobMadeEasy Merchant bankers and brokers will be relieved of the responsibility of guidinginvestorsastotheriskofaparticularinvestment.Merchantbankersandbrokers,in the absence of objective information, go on the basis of name recognition inguiding their clients. With the advent of credit rating, what they would be requiredtodoistobringtotheattentionoftheirclientstheratingsofdebtobligations. 8. InvestorsProtection Hiring of credit agency implies that the management of the company is ready toshowitsoperationsforindependentscrutiny.So,theinvestorswhoarenotprovidedwithconfid entialinformationcanhaveoverallassessmentbasedonratings. A credible and objective rating agency can provide increased disclosure,betteraccountingstandardandimprovedinvestorprotection. 9. ForeignCollaborationsmadeEasy The foreign collaborators always ask for credit rating while negotiating with anIndiancompany.Creditratingenablestoidentifyinstantlytherelativecreditstanding of the company. The importance of credit rating is being increasinglyrecognizedintheEuro- markets. 151 CU IDOL SELF LEARNING MATERIAL (SLM)
10. Benefitsthe Industryas aWhole Relativelysmallandunknowncompaniesuseratingstoinstillconfidenceininvestors. Higher rate companies get larger amount of money at a lower cost. Thusthe industry as a whole can benefit from ratings by direct mobilization of savingsfromindividualsratherthanfrom intermediarylendinginstitutions. 9.7 CAUTIONTOUSECREDITRATING There is negative side of credit rating also. The users should use credit ratingkeepinginviewitsconstraintsorlimitations.Theratingdoneforaninstrumentshouldnot be taken as rating of the image of the company. Further, it should be appreciated thatinratingthereisscopeforbiasobservation.Itisnotaperfectexercise.Rating,despitethe provision of surveillance, cannot be updated on account of every substantial change inthe influencing factors. This is why credit rating is said to be a static exercise. In case theclientcompanyconcealsmaterialinformationfrom rating agency, then reliability of credit rating will be doubtful. 9.8 RATING PROCESS Anyratingagencyassignsaratingonlywhenthereisadequateinformationavailable to form a credible opinion and only after extensive quantitative, qualitative andif appropriate legal analyses are performed. The process of rating is broadly three tiersystem: 1.Information When the issuer approaches the credit rating agency, it is to provide relevantinformation to them. The information required by the rating agency is such which givestherealpictureoftheissuer.Thenature andsourceofinformationrequiredispresentedin Chart I. The credit rating agency besides depending on the information provided by theissuer collects additional information from its own sources. The information requiredabouttheissuerisnotonlyofthepast butalsoaboutitsfeatureprospects. ChartISourceofInformation Issuer Outsider/ Specific (Banker,Auditors, Independentsources Duringplant Competitors, Voluntarily visit,Interview) Industry, (InProforma oftherater 152 CU IDOL SELF LEARNING MATERIAL (SLM)
experts,Suppliers,Dealers andConsumers) Past as well asfutureprojection Qualitative Quantitative (Businessprofile) (Financeprofile) 2.AnalysisofInformation Theratingprocessofratingagenciesisalmostsimilarsincethebasicparametersto be observed to assess risks associated are same. Rating is a search for long termfundamentals and the probabilities for changes in the fundamentals. Rating fundamentalsanalysenotonlyfinancialprofileoftheconcernedissuerincontextoftheinstrumenttob e rated but also evaluate its business or competitive strengths or weaknesses. Thesefundamentalsarediscussedbelowonebyonebeforetakingupratingprocess: FinancialProfile Financial profile for which an in-depth study is made for issuer, covers liquidityposition,capitalstructure,financialflexibility,cashflowadequacy,profitability,leverage,i nterestcoverageetc.Thehistoricalfactsandfutureprojectionsbothareextensively used for these parameters. Besides considering these, the rating agency alsocritically evaluates accounting policies and practices with particular reference to practicesof providing for depreciation, income recognition, stock valuation, valuation of fixedassets, off balance sheet claims and liabilities etc. Extensive use is made of ratio analysistechniques. Themajorratioscomputedare: Coverage ratio :The main determinant of the quality rating of debt obligation isits coverage ratio. Coverage ratio isa measure of how many times the issuingcompanyearnedincomecouldpaytheinterestchangesandothercostrelatedtothe debt issue. This ratio hints at probability of default in interest payment. Thetrendanalysisofthisratioisalsoof immense use. An upwardtrend indicatesbettertime ahead. Financial leverage ratios :It is a set of ratios used to assess broadly what is themix of fund sources. A leverage is added if a dose of debt fund is used in totalfunds.Highertheproportionofownedfunds,lesseristheleverageandconsequently more solvent the company is. A highly leveraged company’s debtinstrumentsarerankedmorerisky.Primeratiousedhereisdebt-equityratio. Another ratios used can be long term debt to total capitalization (long term debts +short term debts + net worth) and long term debts to equity. Rating analysts 153 CU IDOL SELF LEARNING MATERIAL (SLM)
arealsotoconsideralloffbalancesheetliabilitiesandcommitmentsofthecompanytohaveactualidea aboutsolvency. Liquidity ratios :To know the firms ability to pay debts currently coming due,liquidity ratios are calculated. Most common ratios in this category, also known asshort term solvency ratios, are current ratio and quick ratio. Besides these ratiossome analysts also compute and consider ratios like inventory turnover ratio,receivable turnover ratio and collection period in days. This set of ratios reflect theefficientorotherwiseuseofliquidresourcesbytheissuer. Cash flow ratios :If cash flow of a company is sufficient in relation to interestpayment liability and total long term debts, the debt instrument of the companymay get higher rating. Cash flow is normal operating income before interest, taxand deprecation. If cash flow to total long term debt ratio is less than the firms’interestrateondebts,thereisapossibilitythatfirmmaydefaultinmakingpayments. Profitability ratios :Another significant set of ratios is profitability ratios whichindicate profit earning capacity of a company. Earnings are viewed in relation toburden of fixed changes. This set of ratios indicate the real financial health of thecompany. A company with higher ratios will certainly be better off in times tocome. The ratios to be calculated are operating profit ratio, net profit ratio andreturnoninvestmentratio.Thetrendoftheseratioscanassistprojectionoffinancialhealthinfuture whichisveryrelevantforratingofdebtinstruments. BusinessProfile Theratingprocess,asmentionedearlier,isnotlimitedtotheevaluationoffinancial profile. Quality of debt instruments is influenced by many other variables whicharenotcoveredinexaminationoffinancialprofile.Sayinaratingagencyfinancialevaluation of M/s ABC is presented which is very sound on profitability as well asliquidity front. The agency proposes to give it highest safety symbol. But say one of theanalyst says that despite all these facts I don’t agree to award highest safety symbol. HerevealsthattheproductinwhichM/sABCisdealingabetteroneandcheaperproducthas been recently patented. M/s ABC will no longer have the same segment of market asit use to have earlier. It is a very logical point which needs to be considered since it willinfluence over all earning of the firm. There can be so many other factors which are notconsidered in financial analysis. All such factors for convenience are grouped under theheadbusinessprofile. Themainfactorsconsideredherearediscussedonebyone. Issuer’s industry :The nature of industry to which issues belong has an impactonratingoftheinstrument.Thefollowingquestionsneedtobeanswered: Isthecompanyinacapitalgoodsindustry,consumerdurablegoodsindustry,orconsumernon- durablegoodsindustry? Istheindustryinagrowth,stableordecliningphase? Whatisthenatureandintensityofthecompetitionintheindustry?Isitona regional, national or 154 CU IDOL SELF LEARNING MATERIAL (SLM)
international basis? Is it based on price, quality ofproduct,marketingstrategy? What is the labour situation in the industry? Is the industry unionized? If soarethelabourcontractsnegotiatedonindustrylevel? Whatisthestatusandhistoryofsupplyfactorofkeyrawmaterial? How fast have been the technological upgradation? What have been therecent developments and possibility of future developments not only in thecountrybutabroadalso? Is the industry subject to some controls like in case of price control incement,sugar,steeletc.? Is the company participating in more than one business? What are thepotentialsofallimportantbusinesslines? Answer to these questions enables the analyst to cause the industry risk which canbe introduced in his model of rating. The industries with steady demand, growth andability to maintain margins without impairing future prospect are regarded favorablywhile rating obviously a change in outlook for industry will lead to change in the ratingforthecompaniesinthatindustry. Issuer’s competitors :After general evaluation of industry, specific evaluation ofissuer’spositionintheindustryneedsbestudied.Themainquestionforitare: Doesthecompanyhavealargeenoughportionofthemarketsharetoinfluenceindustrydynamics significantly? Doesthecompanyhasafullrangeofproductsorhaveproprietaryproductsoraspecialrichinthem arket? Isthecompanyarelativelylowcostproducer? Arethetechnicalfacilitieswiththecompanynewerormoreadvancedthantheaveragecompetito rs? Doesthecompanyfacemoreonerouslaboursituationthanitscompetitors? Doesthecompanyhascompetitiveadvancethroughmarketinganddistributionstrength? Whatisthefinancialstrengthofthecompanyincontextofthecompetitors? The response to above mentioned questions give a valuable clue to put a companyinmostsuitablecategoryofriskranking. Issuer’s management :Operating efficiency to a large extent is dependent on themanagement of the issuer company. It is the management’s track record which alsoinfluencesdeterminingrisktolerance.Managementistestedontherelatedpointsimportantofwh ichareasunder: Whatisthebackgroundandhistoryofissuer? WhatistheextentofrelianceonChiefExecutiveOfficerspeciallywhomaybeclosetoretirement ? Towhatextentisthemanagementprofessional? Howeffectiveisthecontrolmechanisminthecompany? 155 CU IDOL SELF LEARNING MATERIAL (SLM)
Whatisthereportofpastandpresentcreditorsofthecompany? Whatistherelationshipbetweenorganizationalstructureandmanagementstrategy? Howismanagementabletomaintainstrategiesandpoliciesorretaincreditworthinessinthetime sofstress? Howcompetentisthemanagementtocopewithshorttermcharges? Issuer’s Instrument :Debt instrument to be rated spells out certain rights of theowners.Thevariousprotectiveprovisionscontainedinthetermsandconditions/prospectus of debt instrument also raises the quality rating for the instrument.Suchprotectionscanbecreatingsecurityagainsttheinstrumenttomakeitsecuredfullyor partly. The issuer can subordinates other legal claims on its assets or income. Theissuer may create redemption reserve or sinking fund to pay off bonds even if the issuerdefaults on its other debts. Trustees may be appointed to protect the interest of investors.ManyofsuchprovisionareobligatoryinIndiancontext. These are the main indicative parameters examined by every rating agency. Thus,methodology used is almost similar. Almost similar information is sought by all agenciesfor rating purposes. The rating methodology thus involves coverage of a vide spectrum ofthe company’s activities and is extremely exhaustive. An issuer, therefore, is scrutinizedthoroughlyonalltheareasmentioned. 3.Granting Rating Symbol : The process starts with the request of the prospectiveissuer’sformalrequestforrating.Theissuerisgenerallyaskedtosubmitrequiredinforma tioninasetproformaofessentialitems.Thisisnotanexhaustivelist. Theissuershouldfeelfreetoprovideadditionalinformationonanyrelevantaspect. The issuer company is also to provide its financial profile for last 4-5 years alongwithauditreports.Theratingagencyassignsananalyticalteamfortheissue.Theanalysttake up the assignment of additional data, which they consider to be relevant. They givechance to issuer to make his presentation. The questions are raised and answers aresought. The team may visit the premises to gather first hand information especially aboutqualitative aspects. They may have access to books of record. They can interact with theexecutivesandotherconcernedofficials. Toreviewindetailtheborrower’skeyoperatingandfinancialplans,managementpoliciesandcreditf actorscanalsobeanalysed. The data base of the rating agency about industry concerned is also extensivelyused. Following this review and discussion, a recommendations is made by the primaryanalystandaratingcommitteemeetingisconvened.Thecommitteediscussestherecommen dations and the pertinent facts supporting the rating. Finally the committeevotesontherecommendations. The borrower is subsequently notified of the rating and the major supportingconsiderations. A borrow can appeal against a rating decision prior to its publication. 156 CU IDOL SELF LEARNING MATERIAL (SLM)
Ifnewormeaningfuladditionalinformationispresentedbytheborrower,itwillbeconsidered by the rating committee. However, rating agencies may not guarantee that thisnewinformationwillaltertheratingcommittee’sdecision. Onceafinalratingisassigned,itwilldisseminatedtoagency’ssubscriberclientele and publicly through the news media if the issuer accepts the rating. If rating isnot acceptable, agency may not make public that rating. Rating agency otherwise alsoensures strict confidentiality of all information collected during the rating process. Oncethe rated company decides to use the rating, the agency monitors the rating till theredemption/repaymentofthedebtobligation. Atregularintervalscompanyissupposedtosubmittheupdateddataandcommunicate major changes in policy matters, if any. This surveillance system continuestillthelifeoftheconcernedinstrument.Underthissystemaformalreviewisconducted annually;newdevelopments,industrytrendsandfinancialperformancereleasesarereviewedregula rly.Asaresultratingmaybechangedorwithdrawn.Ratingagencieshaverighttodisclosesuch changesinratingtopublic. While this general framework applies to all rating exercises, there are some areaswhere additional specific information is needed to make the rating decisions for a specific instrument. 9.9 TYPESOFRATING Theratingmethodologyandprocessdiscussedearlierisprimarilyfordebtinstruments like debentures, fixed deposits, bonds etc. This type of rating constitutes themajor business of a rating company. But with the passage of time these agencies havestartedprovidingothertypesofratingsuchas: Equityrating Rating of equity shares issued in capital market is termed as equity rating. In suchexercisestheopinionontheearningsprospectsandriskassociatedwithsuchearningscan be arrived at through comprehensive information on acquisition, interaction with themanagement of the corporate, critical analysis and collective judgmental process. Thisexercise is also known as ‘equity grading’ which is initiated on the initiative of the issuerof equity before making a public issue. Grading examines very closely the level, quality,growth and substantiality of earnings in the medium term on the expanded equity baseresulting from the present offer and other known future equity expansion. Like creditrating, equity grading can also be communicated both as a symbolic grade and a detailedrational. Surveillance such grading will make it relevant for secondary market of theissued share. The key parameter in the whole exercise is the prospective return on networth. Rating agencies may also make equity assessment at the request of institutionalinvestorswiththeconsentofthecorporatehousewhoseequityissoughttobeassessed. 157 CU IDOL SELF LEARNING MATERIAL (SLM)
Mutualfundrating MutualFundswhicharepopularworldoverareevaluatedbyratingagenciesandit is known as mutual fund rating. It facilitate selection of right fund from the availablefunds. Given the nature of mutual funds, the analysis of performance has to rely to a largeextent,onpastperformance.Therefore,evaluationisprimarilybasedonthetwoindicators‘riska ndreturn’.Expenseratio,turnoverratio,compositionofportfolio,accounting practices, fund management qualities, NAV in past are some of the mainparametersto evaluatemutualfunds. Individualcreditrating Consumer finance is gaining popularity in developing countries. The success ofconsumer finance depends on the credit worthiness of the consumer. Rating agencies maytake up rating of such individuals. Individual credit rating is own objective assessment ofthe risk attached to a financial transaction with respect to an individual at a given point oftime based on qualification of parameters influencing credit risk. Every aspect of creditseeker’shistory;age,qualification,occupation,stabilityatwork,residence,martialstatus,asse ts,repayingcapacity,savingsandearningspotentialsareusedtoassesscreditworthiness of an individual. Agencies broadly rate individuals on social status,economicstatusandfinancialstatus. Ratingofbanksandfinancialcompanies Banksandfinancingcompaniesarealsoissuersofdebtslikebanksissuecertificates of deposits (CD). The issuer’s internal affair is scanned by evaluation of theirbackground and history. Their relation with government and central bank are studied. Theissuer’s innovations and competitive ability to attract cheaper funds is analysed. Maturitypatternbetweenthesourceanddeploymentoffundisstudied.Itscompetitivepositionand market share is also studied. The rating exercise could include a case by case reviewof major non-performing assets to determine the prospect of reliability. The quality ofassetsisjudged.Profitabilityisalsogazed.Thequalityofmanagementisjudgedbytheprofile of operating executives, human resources policies and organizational structure. Incaseoffinancialcompanies,supportofgroupcompaniescouldbeimportantindetermining their success. Accounting figures are considered after adjusting for non- standardaccountingpolicies. Sovereignrating It is primarily rating of a country as to its credit worthiness and probability to risketc. In this process economic parameters and economic policies of the country are underconstant observation. Such rating influences the availability of foreign aids from agencieslike World Bank. All rating agencies may not take up such assignment because of lack ofinfrastructureandspecialists. Ratingstructuredobligation Structured obligation is a negotiable instrument or security which is backed bysome asset. The main role of a credit rating agency in analyzing an asset backed securityor a structured 158 CU IDOL SELF LEARNING MATERIAL (SLM)
obligation is to assess the risk of default in meeting the contractualobligations to the investors. As in the rating of conventional debt instruments, the ratingassesses the default risk rating to other debt instruments available to the investor. Themainthrustintheevaluationofanassetbackedtransactionistoensurethatthecashflows from the assets and the envisaged structure are capable of meeting the committedpayments to the investors even in a “worstcase” scenario. A key point to kept in mind isthat in the rating of a structured obligation it is not rating the issuer but is assessing theriskassociatedwiththetransaction.Morespecially,aAAAratingonaparticularstructured obligation of a particular originator does not necessarily mean that all otherissuesbytheentitywouldalsogetaAAA. 9.10SUMMARY Financial intermediaries play an important role in linking savers and investors, andthus assisting in the mobilization of capital on the one hand, and efficiently allocatingthem between competing users on the other. This calls for the use of reliable marketinformation. An investor in search of investment avenues has recourse to various sourcesof information, such as offer documents of the issuer(s), research reports of marketintermediaries,mediareportsetc.Inaddition,theycanalsobasetheirinvestmentdecisions on the grading offered by credit rating agencies. Credit rating is a process ofassigning a symbol that acts as an indicator of the current opinion regarding the relativecapability of the issuer to service debt obligations in a timely fashion, with specificreferencetotheinstrumentbeingrated. Creditratingisadvantageoustoinvestors,issuers, intermediaries and to regulators alike. Many factors have contributed to thegrowthofthecreditratingsystemintheworld.Theinternationalcreditratingagenciesare Moody’sInvestor Services, S & P, Duff and Phelps Credit Rating company, etc. Some of the domestic rating agencies include CRISIL, CARE, ICRA, etc. The ratingframeworkconsidersbothbusinessandfinancialfactorswhileassessingcreditworthiness and assigning grades. In addition to bond rating, agencies also provide gradesforequityinstruments.Inspiteofallthebenefitsofratingonemustrememberthefactthat rating is merely for guidance and is not a recommendation to buy or sell or retain aninstrument. 9.11 KEYWORDS CreditRating:Processofasymbolicindicationofthecurrentopinionoftherelativecapabilityof theissuertoserviceitsdebtobligationinatimelyfashion. CARE:CreditAnalysisandResearch,acreditratingagencythatoffersratinggradesondebtinstr umentsbesidesprovidingsector-specificindustryreports. ICRA:InvestmentInformationandCreditRatingAgencyofIndiaLimitedthatoffersrating,adv isoryandinvestmentinformationservice. 159 CU IDOL SELF LEARNING MATERIAL (SLM)
EquityRating:Ratingofequityissuesaimedatcontributingtowardstheenhancementofcapital mobilizationprocess. 9.12 LEARNING ACTIVITY 1. Can the issuer appeal if he not satisfied with the rating outcome? __________________________________________________________________________ ___________________________________________________________________________ _ 2. What happens when issuers stop cooperating which respect to Credit Rating? ___________________________________________________________________________ ___________________________________________________________________________ 9.13 UNIT ENDQUESTIONS A. Descriptive Questions Short Questions 1. List the types of ratings 2. Who are called financial intermediaries? Long Questions 1. Whatismeantbycreditrating?Discussthefunctionsofcreditratingfirms. 2. Discusstheratingprocessfollowedbycreditratingfirms. 3. Statethebenefitsofcreditrating. 4. ExplaintheworkingofvariouscreditratingagenciesinIndia. B. Multiple Choice Questions 1. Since money acts as an intermediate in the exchange process, it is called: a. Value for money b. Exchange value c. Medium of exchange d. None of these 2. Modern forms of money include: a. paper notes b. gold coins c. silver coins d. copper coins 3. Who issues currency notes on behalf of the Central government in India? 160 CU IDOL SELF LEARNING MATERIAL (SLM)
a. NABARD 161 b. Reserve Bank of India (RBI) c. World Bank d. State Bank of India (SBI) 4. Deposits in bank accounts withdrawn on demand are called: a. fixed deposits b. recurring deposits c. demand deposits d. None of these 5. Banks in India these days, hold about _______ per cent of their deposits as cash. a. 50 b. 20 c. 15 d. 10 6. Major portion of the deposits is used by banks for: a. setting up new branches b. paying taxes c. paying interest on loans d. extending loans 7. What is the main source of income for banks? a. Interest on loans b. Interest on deposits c. Difference between the interest charged on borrowers and depositors d. None of these 8. In rural areas, farmers take credit for? a. Family b. Health c. Crop production d. Education 9. A ‘debt trap’ means: a. inability to repay credit amount b. ability to pay credit amount c. overspending till no money is left d. None of these CU IDOL SELF LEARNING MATERIAL (SLM)
162 10. What is the ‘collateral’ demand that lenders make against loans? a. Vehicle of the borrower b. Building of the borrower c. Both (a) and (b) d. None of these 11. Terms of credit do not include: a. interest rate b. collateral c. documentation d. lender’s land 12. Formal sources of credit do not include: a. banks b. cooperatives c. employers d. None of these 13. Informal sector loans include: a. NABARD b. State Bank of India c. moneylenders d. both (b) and (c) 14. Banks and cooperatives need to lend more to borrowers because: a. high cost of borrowing from informal sources b. borrowers wish to set up enterprises c. borrowers need more money but cannot ask d. None of these 15. Poor households in urban areas take loans from______ sources. a. formal b. informal c. both (a) and (b) d. None of these 16. What prevents the poor from getting bank loans? a. Complexity of procedure b. Absence of collateral CU IDOL SELF LEARNING MATERIAL (SLM)
c. High rates of interest d. None of these 17. In a SHG, most of the decisions regarding savings and loan activities are taken by: a. bank b. group members c. non-government organisation d. government 18. What is the name of the success story that met the credit needs of the poor, at reasonable rates, in Bangladesh? a. Grameen Bank b. Reserve Bank c. Cooperative Bank d. None of these Answers 1(b) , 2(b) , 3(a) ,4(b) ,5(b) ,6(b) ,7(c) ,8(c) ,9(a) ,10(c) ,11(c), 12(b) ,13(c) ,14(b) , 15(c) ,16(b) ,17(c) ,18(a) 9.14 REFERENCES Text Books: Bhalla, V. K.“ Management of Financial Services” Anmol Publications Clifford Gomez “ Financial Markets, Institutions and Financial Services”, PHI Learning Rose, Peter and Hudgins, Sylvia,“ Bank Management and Financial Services”, McGraw Hills. Reference Books: Padamlatha ,“ Management of Banking and Financial Services”, Pearson Education. Saunders, Antony and Cornett, Marcia,“ Financial Institutions Management: A Risk Management Approach” McGraw Hills 163 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT-10CREDIT RATING AGENCIES OF INDIA STRUCTURE 10.0 Learning Objectives 10.1 Introduction 10.2 CreditRatingAgenciesinIndia 10.3 PracticalProblemsofCreditRating 10.4 FutureofCreditRatinginIndia 10.5 Summary 10.6 Keywords 10.7 Learning activity 10.8Unit End Questions 10.9References 10.0 LEARNING OBJECTIVES After studying this unit, students will be able to: Act as a catalyst for channelizing investment in proper debt instruments, by revealing the risks involved. Helps in creating an environment that facilitates debt rating. Creates awareness about credit rating amongst merchant brokers, corporations, brokers, regulatory authorities and others 10.1 INTRODUCTION Credit rating is an analysis of the credit risks associated with a financial instrument or a financial entity. It is a rating given to a particular entity based on the credentials and the extent to which the financial statements of the entity are sound, in terms of borrowing and lending that has been done in the past .A detailed report based on the financial history of borrowing or lending and credit worthiness of the entity or the person obtained from the statements of its assets and liabilities with an aim to determine their ability to meet the debt obligations. It helps in assessment of the solvency of the particular entity. These ratings based on detailed analysis are published by various credit rating agencies like Standard & Poor's, Moody's Investors Service, and ICRA. 10.2 CREDITRATINGAGENCIESININDIA 164 CurrentlytherearefourcreditratingagenciesinIndia. 1. CreditRatingInformationServiceLtd.(CRISIL) 2. InformationandCreditRatingAgencyofIndia(ICRA) CU IDOL SELF LEARNING MATERIAL (SLM)
3. CreditAnalysisandResearch(CARE) 4. DuffPhelpsCreditRatingPvt.Ltd.(DCRIndia) 1.CreditRatingInformationServiceLtd.(CRISIL) On January 1, 1988 the Industrial Credit and Investment Corporation of India(ICICI) and Unit Trust of India (UTI) joined hands to float CRISIL, first rating agency inIndia with an equity base of Rs.4.00 crores. Each of them holds 18 per cent of the stock.The other promoters are : The Asian Development Bank (15 percent) ; the LIC, the GICanditssubsidiariesandtheStateBankofIndia(each5percent);theHousingDevelopment Finance Corporation (6.2 per cent); 9 nationalized Banks owning 19.5 percent, the remaining equity is distributed among 10 foreign banks i.e. Standard CharteredBank, Banque Indo Suez, Mitsui Bank, Bank of Tokyo, Hongkong and Shanghai BankingCorporation,CitiBank,GrindlaysBank,DeutscheBank,SocieteGeneral,BanqueNational s de Peris. CRISIL became a public limited company in November 1993 and ispresentlyaquotedcompanyontheBombay StockExchange. Objective :The main objective of CRISIL has been to rate debt obligation of Indiancompanies. Its rating provides a guide to the investors as to the risk of timely payment ofinterest and principal on a particular debt instrument. Its ratings create awareness of theconceptofcreditratingamongstcorporations,merchantbankersbrokers,regulatoryauthoritiesa ndhelpsincreatingenvironmentthatfacilitatesthedebtrating. At the time when CRISIL commenced its operations it was contemplated that itwould undertake credit rating for a company at its specific request and subsequently itmight cover all companies on its own initiative with the basic idea to provide informationabout creditworthiness of all companies whether they approach CRISIL or not so thatinvestors know about the company offering securities to the public. It had also envisagedto cover under credit rating all securities viz. equity shares as well as preference shares,debentures,secured,unsecuredconvertibleandnon- convertibleandfixeddeposits.Toachieve the objectives and contribute towards stable and healthy growth of the IndianCapitalmarket,thethrustoftheCRISILoperationswasplannedtowards: Shifting the primary responsibility of established corporate credit qualityfromthemerchantbankers/brokers/underwriters/financialadvisortoCRISILandmaki ngavailablewidelyacceptablestandardanduniformratingfortheinvestors; Providing for increased disclosure, better accounting standards improvedfinancialinformationtotheusersi.e.individualinvestors,financialinstitutions,stock exchangeandcorporateresearchbodies; Reducing the cost of issue by helping direct mobilization of finance withoutdependingonintermediaryagencies;and 165 CU IDOL SELF LEARNING MATERIAL (SLM)
Protecting the interest of investors by constant monitoring of the results ofrated companies and altering the grading to reflect the true and fair state ofaffairsofthefinancialpositionofcompanies. Credit Rating Symbols :CRISILDebentureRatingSymbols HighInvestmentGrades : Highest AAA (Triple : SafetyHighSafe A)AA(DoubleA) ty : InvestmentGrades : Adequate A SafetyModerateS BBB (Triple : afety : B)SpeculativeGrades : Inadequate Safety BB (Double B) : High Risk B Substantial Risk C Default D CRISIL uses the conventional rating symbols used in the USAand widely accepted in many other countries. The above table shows the investmentwiseratingsymbolsassignedbyCRISILandthemeaningofeachratingfromtheangleofsa fetytotheinvestors. Notes: CRISIL may apply ‘+’ (plus) or ‘-‘ (minus) sign for ratings from AA to C to reflect comparative standing within the category. The contents within parenthesis are a guide to the pronunciation of the rating symbols. Preference shares rating symbols are identical to debenture rating symbols except that the letters ‘pf’ are prefixed to the rating symbols, e.g. pf AAA (“pf Triple A”). 166 CU IDOL SELF LEARNING MATERIAL (SLM)
CRISILFixedDepositRatingSymbols: InvestmentGrades FAAA (F-Triple : HighestSafety A)FAA (F-Double : HighSafety A) : AdequateSafety FA SpeculativeGrades : FB : Inadequate FB SafetyHigh : RiskSubstantial FC : RiskDefault Notes: FD (1) CRISILmayapply‘+’(plus)or‘- ‘(minus)signforratingsfromFAAAtoFCtoindicatetherelative position withinthe category. (2) Thecontentswithinparenthesisareaguidetothepronunciationoftheratingsymbols. CreditRatingforShortTermInstruments RatingSymbol Indication (Eachratingindicatesthatthedegreeofsafetyregardingtimely paymentontheinstrumentisshownagainstthesymbol) P-1 Very Strong P-2 Strong P-3 Adequate P-4 Minimal P-5 Expectedtobeindefaultonmaturity orindefault Note: CRISIL may apply“+”signsforratings fromP-1toP-3 toreflectacomparatively higherstandingwithin the category. CRISIL monitors the ratings it assigns constantly. The ratings may be upgraded,downgraded or withdrawn depending upon new information or developments concerningthe company whose debt obligation is rated. It has the right to widely disseminate 167 CU IDOL SELF LEARNING MATERIAL (SLM)
theratingsthroughthemedia,throughitsownpublicationsorthroughanyothermethods. 2.ICRALtd The ICRA Ltd. has been promoted by the IFCI Ltd. as the main promoter to meetthe requirements of the companies based in the northern parts of the country. Apart fromthemainpromoter,whichholds26percentofthesharecapital,theothershareholdersare the Unit Trust of India, banks, LIC, GIC, Exim Bank, HDFC Ltd. and ILFS Ltd. Itstarted operations in 1991. In order to bring international experience and practices to theIndiancapitalmarkets,theICRAhasenteredintoaMOUwithMoody’sInvestorsServicetoprovid e,throughitscompanyFinancialProgrammesInc(FPI),crediteducation, risk management software, credit research and consulting services to banks,financial/investment institutions, financial services companies and mutual funds in India.AsinthecaseoftheCRISIL,themainobjectivesoftheICRAare: To assist investors, both individual and institutional, in making well informeddecisions; To assist issuers in raising funds, from a wider investor base, in large amountsandatalowercostforhighlyratedentities; To enable banks, investment bankers, brokers in placing debt with investors byprovidingthemwithamarketingtooland To provide regulators with market driven systems to encourage the healthygrowthofthecapitalmarketsinadisciplinedmanner,withoutadditionalburdenonthe Government. Over the years, the ICRA has diversified the range of its services. It currentlyprovides three types of services ; (1) rating services; (2) information services and (3)advisoryservices. ICRARatingScale LongTermincludingDebenturesBondsandPreferenceShares LAAA : 168 HighestSafetyLAA : HighSafety LA : Adequate Safety LBBB: Moderate Safety LBB : InadequateSafety LB : RiskProne LC : SubstantialRisk LD : Default, ExtremelySpeculative CU IDOL SELF LEARNING MATERIAL (SLM)
Medium Term includingDepositsFixed MAAA : Highest Safety MAA : HighSafety MA : AdequateSafety MB : InadequateSafety MC : RiskProne MD : Default ShortTermIncludingCommercialPaper A-1 Highest A-2 SafetyHigh A-3 SafetyAdequateSa fetyRisk A-4 ProneDefault Note : A-5 Theratingsymbolsgrouptogethersimilar(butnotnecessarilyidentical)concernsintermsofthei rrelativecapabilityoftimelyservicingofadebts/obligations,aspertermsofcontracts,i.e.,therel ativedegreeofsafety/risk. The sign (+) or (-) may be used after the rating symbol to indicate the comparativepositionof thecompany withinthegroupcovered bythe symbol. Theletter‘P’inparenthesisaftertheratingsymbolindicatesthatthedebtinstrument is being used to raise resources by a new company for financing a newprojectand the rating assumessuccessful completion ofthe project. Theratingsymbolsfordifferentinstrumentsofthesamecompanyneednotnecessarilybythesame. 3.CARELtd. The CARE Ltd. is a credit rating and information services company promoted bytheIndustrialDevelopmentBankofIndia(IDBI)jointlywithfinancialinstitutions,public/private sector banks and private finance companies. It commenced its credit ratingoperationsinOctober1993andoffersawiderangeofproductsandservicesinthefieldof credit information and equity research. Unlike the CRISIL and the ICRA, the CARE isverycautionsinenteringnewareasofbusiness.Currently,itoffersthefollowingservices: CreditRating:TheCAREundertakecreditratingofalltypesofdebtinstruments,both short- termand long-term. AdvisoryServices:TheCAREprovidesadvisoryservicesintheareasof: 169 CU IDOL SELF LEARNING MATERIAL (SLM)
Securitisationtransactions; Structuringfinancialinstruments; Financingofinfrastructureprojectsand Municipalfinances 10.3 PRACTICAL PROBLEMS OF CREDIT RATING 1. The absence of widespread branch network of the rating agency may limititsskillsinrating. 2. Inexperienced, unskilled or overloaded staff may not do justice to their jobandtheresultingratingsmaynotbeperfect. 3. Since rating exercise involves a number of factors, a rigid mathematicalformulacannotbeappliedtofinalizerating&someelementofsubjectivitycreepsin, therebygivingscopeforbias. 4. The time factor greatly affects rating and gives misleading conclusions. Acompany which experiences adverse conditions temporarily will be given alowratingjudgedonthebasisoftemporaryphenomenon. 5. Since the rating agencies receive a sizable fee from the companies forawardingratings,atendencyto inflatetheratingsmaydevelop. 6. Theratingisnotpermanentbutsubjecttochangesandmoreovertheagenciescannotgiveanyguara nteefortheinvestors. 7. Investment which have the same rating may not have identical investmentquality because the number of rating categories is limited and hence can notreflectsmallbutmeaningfuldifferencesinthedegreeofrisk. 8. Borrowing entities give misleading advertisements about the rating symbolsof their instruments. For example, ‘X’ Co. Ltd. which has got AAX for itsdebenture may mobilize fixed deposits instead of revealing the low ratingforfixeddeposits.Suchkindofwindowdressingshouldbecurtailed. 10.4 FUTUREOFCREDITRATINGININDIA At present, commercial paper, bonds and debentures with maturities exceeding 18monthsandfixeddepositsoflargenon-bankingcompaniesregisteredwithRBIarerequired to be compulsorily rated. There are moves to make rating compulsory for othertypes of borrowings such as the fixed deposit programme of manufacturing companies. Inaddition, the rating agencies and expected to be called upon to enlarge volumes ofsecuritisation of debt and structuring of customized instruments to meet the needs ofissuers or different class of investors. There are number of areas where rating agencieswill have to cover new ground in the coming years. The rating of municipal bonds, stategovernment borrowings, commercial banks and public sector undertakings etc. will becovered in the near 170 CU IDOL SELF LEARNING MATERIAL (SLM)
future. So, the outlook for the credit rating industry is positive. Theindustry has to continuously strive to improve professional capabilities and sustain its credibility. 10.5 SUMMARY The term Credit Rating refers to evaluation of debt instruments. Debt instruments include both long term instruments like bonds and debentures, and short-term obligations like Commercial Paper. Apart from these, fuzed deposits, certificates of deposits, inter- corporate deposits, structured obligations, etc. are also rated. Securities and Exchange Board of India (SEBI) has decided to enforce mandatory rating of all debt instruments irrespective of their maturity. Rating serves as a useful tool for different constituents of the capital market namely investors, issuers of debt instruments, financial intermediaries, business enterprises, regulators, etc. High degree of correlation has been observed between bond quality ratings and actual defaults. The ratings assigned to bond issue directly affects its yield.Issuers of high-risk securities have to pay higher rates of return than issuers of low risk securities. A number of difficulties arise in the quality rating assigned to an issue. Primarily the issuers ability to pay, the strength of the security owner's claim, the economic significance and size of the issuer are taken into consideration in Credit Rating determination of rating. The ratings assigned by the credit Agencies in India rating agencies have many limitations. Important among these are : (i) credit rating change infrequently. (ii)Any rating reflects default risk and not the price risk associated with changes in the level or shape of the yield curve, etc. However, the reputation of an agency creates a confidence in investor. In India, at present, there are four credit rating agencies of which the following three are well-known : i) Credit Rating and Information Services of India (CRISIL) ii) Investment Information and Credit Rating Agency of India Ltd. (ICRA) iii) Credit Analyses and Research Limited (CARE) 10.6 KEY WORDS Credit rating – an independent letter grade issued by a credit rating agency that provides the market with an assessment of creditworthiness or likelihood the debt will be repaid. Risk – the possibility of financial loss. Default risk – the likelihood that a bond’s issuers will fail to make interest payments and then fail to repay the principal. 10.7 LEARNING ACTIVITY 171 CU IDOL SELF LEARNING MATERIAL (SLM)
1. If the issuer pays for the rating, how does a credit rating agency maintain its independence? ___________________________________________________________________________ ___________________________________________________________________________ 2. Can the issuer appeal if he not satisfied with the rating outcome? ___________________________________________________________________________ ___________________________________________________________________________ 10.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. what is an debt instrument. 2. what is an risk. What are types of risk. 3. list the credit rating agencies in India. Long Questions 1. discuss the credit rating process. 2. What are the practical problems in credit rating 3. Discuss about the future of credit rating system in India. B. Multiple Choice Questions 1. Who controls the capital market in India? a. SEBI b. RBI c. IRDA d. NABARD 2. Which of the following reasons is not responsible for the ups and downs in the Sensex? a. Rain b. Monetary policy c. Political instability d. None of these 3 How many companies are included in the SENSEX of India? a. 30 b. 50 c. 111 d. 25 4 Which of the following is not a credit rating agency? 172 CU IDOL SELF LEARNING MATERIAL (SLM)
a. CRISIL b. ICRA c. NIKKEI d. CARE 5.Which of the following TERM does not belong to the stock exchange? a. NAV b. NSE c. IPO d. KPO 6 Which of the following might be a reason for a stock market to lose value suddenly? a. A big company going bankrupt b. Fear of a global recession c. A terrorist attack d. All of these 7 What is SP-500? a. A crop of wheat b. The name of Mumbai-based office of SEBI c. A stock exchange of USA d. A scheme announced by the Government of India 8 Which of the following words does not belong to the stock exchange? a. KPO b. NAV c. NSE d. IPO 9 Which of the following cities does NOT have a formal stock exchange? a. Frankfurt b. London c. Monte Carlo d. Hong Kong 10 Which term most accurately describes selling shares at a higher price than the price at which they were bought? a. Loss b. Profit c. Asset 173 CU IDOL SELF LEARNING MATERIAL (SLM)
d. Dividend 11 Which of the following are you unlikely to find traded officially on world stock markets? a. Foreign Currency b. Insults c. Company stock/shares d. Gold 12 The FTSE 100 index is used to measure stock market performance in which country? a. France b. Germany c. Finland d. United Kingdom 13 How many companies are included in the SENSEX? a. 50 b. 111 c. 30 d. None of these 14 Which of the following is responsible for the fluctuations in the Sensex? a. Political instability b. Monetary policy c. Rain d. All of these 15 When was Nifty established? a. 1996 b. 1952 c. 1965 d. None of these 16 Which of the following might you see roaming a stock market? a. Goats b. Bulls c. Cows d. Mice Answers 1(a) ,2(d) ,3(a) ,4(c) ,5(d) ,6(b) ,7(a) ,8(b) ,9(c) ,10(d) ,11(c) ,12(a) ,13(a),14(b) ,15(b) ,16(b) 174 CU IDOL SELF LEARNING MATERIAL (SLM)
10.9 REFERENCES Text Books: Bhalla, V. K.“ Management of Financial Services” Anmol Publications Clifford Gomez “ Financial Markets, Institutions and Financial Services”, PHI Learning Rose, Peter and Hudgins, Sylvia,“ Bank Management and Financial Services”, McGraw Hills. Reference Books: Padamlatha ,“ Management of Banking and Financial Services”, Pearson Education. Saunders, Antony and Cornett, Marcia,“ Financial Institutions Management: A Risk Management Approach” McGraw Hills 175 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT-11CONCEPT, NATURE, SCOPE OF FACTORING STRUCTURE 11.0 Learning Objectives 11.1Introduction 11.2Factoring 11.3ModusOperandioftheFactoring 11.4TermsandConditionin aFactoringAgreement 11.5FunctionsofFactoring 11.6Typesof Factoring 11.7CostandBenefits ofFactoring 11.8BenefitsofFactoring 11.9FactoringinIndia 11.10Summary 11.11Keywords 11.12 Learning activity 11.13 Unit EndQuestions 11.14 References 11.0 LEARNING OBJECTIVES After studying this unit, students will be able to: Explain theconceptsofdiscounting,factoringandforfeiting. Explainthemechanismof factoring. Listoutthetypes,costandbenefitsoffactoring. 11.1INTRODUCTION In India, the financial services sector is developing at a faster rate so as to meet theemerging needs of the economy. Many innovative schemes have been introduced by thissector and one such area wherein it has been introduced is book-debt financing. Financialinstitutions try to extend their financial assistance to a larger cross-section of the tradingcommunitythroughbook-debtfinancing.Akindofbook-debtfinancingisalreadypracticed in India by the commercial banks. It is nothing but bill financing. This type offinancing is done either by way of direct purchase of bills of customers or discountingthem. 11.2FACTORING 176 CU IDOL SELF LEARNING MATERIAL (SLM)
As stated earlier, a lot of working capital is tied up in the form of trade debts.Collection of debts, especially for the small-scale and medium scale companies is thebiggest problem. The average collection period has been on the increase. Delays incollectionprocessinturnleadtoliquidityproblemsandconsequentlytodelayinproduction and supplies. The peculiar situation in India is that a number of small scaleunits are catering to the requirements of a single large buyer. This large buyer is alwaysknownforhisprocrastinationinpayinghissmallsuppliers.Thecruxoftheproblemisnot so much the failure to pay altogether as the failure to pay on time. As a result, theinterest cost of financing book debts is quite heavy. This increase in cost of capitalreducesprofitandcompetitivenessofacompanyparticularlythesmallonesinthemarket. Ultimately, the small unit may become even sick. To overcome this situation, thefactoringservicehasbeenconceived. The word ‘Factor’ has been derived from the Latin word ‘Facere’ which means to‘to make or to do’. In other words, it means ‘to get things done’. According to theWebster Dictionary ‘Factor’ is an agent, as a banking or insurance company, engaged infinancing the operations of certain companies or in financing wholesale or retail tradesales, through the purchase of account receivables. As the dictionary rightly points out,factoringisnothingbutfinancingthroughpurchaseofaccountreceivables. Thus, factoring is a method of financing whereby a company sells its trade debts ata discount to a financial institution. In other words, factoring is a continuous arrangementbetween a financial institution, (namely the factor) and a company (namely the client)which sells goods and services to trade customers on credit. As per this arrangement, thefactor purchases the client’s trade debts including accounts receivables either with orwithout recourse to the client, and thus, exercises control over the credit extended to thecustomers and administers the sales ledger of his client. The client is immediately paid 80per cent of the trade debts taken over and when the trade customers repay their dues, thefactor will make the remaining 20 per cent payment. To put it in a layman’s language, afactorisanagentwhocollectstheduesofhisclientforacertainfee. Robert W. Johnson states “factoring is a service involving the purchase by afinancialorganization,calledafactor,ofreceivablesownedtomanufacturersanddistributorsbythei rcustomers,withthefactorassumingfullcreditandcollectionresponsibilities”. In the words of Kohok “factorings is an asset based means of financing by whichthe factor buys up the book debts of a company on a regular basis, paying cash downagainst receivables, and then collects the amounts from the customers to whom thecompanyhassuppliedgoods”. 11.3 MODUSOPERANDIOFTHEFACTORING A factor provides finance to his client upto a certain percentage of the unpaidinvoices which represent the sale of goods or services to approved customers. The modusoperandiofthefactoringschemeisasfollows 177 CU IDOL SELF LEARNING MATERIAL (SLM)
There should be a factoring arrangement (invoice purchasing arrangement)between the client (which sells goods and services to trade customers oncredit)andthefactor,whichisthefinancingorganization. Whenever the client sells goods to trade customers on credit, he preparesinvoicesintheusualway. The goods are sent to the buyers without raising a bill of exchange butaccompaniedbyaninvoice. The debt due by the purchaser to the client is assigned to the factor byadvisingthetradecustomers,topaytheamountduetotheclient,tothefactor. The client hands over the invoices to the factor under cover of a schedule ofoffer along with the copies of invoices and receipted delivery challans orcopiesofR/RorL/R. the factor makes an immediate payment upto 80% of the assigned invoicesandthebalance20%willbepaidonrealizationofthedebt. 11.4 TERMSANDCONDITIONINAFACTORINGAGREEMENT The existence of an agreement between the factor and the client is central to thefunction of factoring. The main terms and conditions generally included in a factoringagreementarethefollowing: Assignmentofdebtinfavourofthefactor, Sellinglimitsfortheclient, Conditionswithinwhichthefactorwillhaverecoursetotheclientincaseofnon- paymentbythetradecustomer, Circumstancesunderwhichthefactorwillhaverecourseincaseofnon-payment, Detailsregardingthepaymenttothefactorforhisservices,sayforinstance,asacertainpercentage onturnover, Interesttobeallowedtothefactorontheaccountwherecredithasbeensanctionedtothesupplier,a nd Limitofanyoverdraftfacilityandtherateofinteresttobechargedbythefactor. 11.5FUNCTIONSOFFACTORING As stated earlier the term ‘factoring’ simply refers to the process of selling tradedebts of a company to a financial institution. But, in practice, it is more than that.Factoringinvolvesthefollowingfunctions: 1.Purchaseandcollectiondebts Factoring envisages the sale of trade debts to the factor by the company, i.e., theclient.Itiswherefactoringdiffersfromdiscounting.Underdiscounting,thefinancier simply discounts the debts backed by account receivables of the client.He does so as an agent of the client. But, under factoring, the factor purchases theentire trade debts and thus, he becomes a 178 CU IDOL SELF LEARNING MATERIAL (SLM)
holder for value and not an agent. Oncethe debts are purchased by the factor, collection of those debts becomes his dutyautomatically. 2.Creditinvestigationandundertakingofcreditrisk Sales ledger management function is a very important one in factoring. Once thefactoring relationship is established, it becomes the factor’s responsibility to takecare of all the functions relating to the maintenance of sales ledger. The factor hasto credit the customer’s account whenever payment is received, send monthlystatementstothecustomersandtomaintainliaisonwiththeclientandthecustomer to resolve all possible disputes. He has to inform the client about thebalancesintheaccount,theoverdueperiod,thefinancialstandingofthecustomers,etc.Thusthefac tortakesuptheworkofmonthlysalesanalysis,overdueinvoiceanalysisandcreditanalysis. 3.Creditinvestigationandundertakingofcreditrisk The factor has to monitor the financial position of the customer carefully, since, heassumes the risk of default in payment by customers due to their financial inabilityto pay. This assumption of credit risk is one of themost importantfunctions whichthe factor accepts. Hence, before accepting the risk, he must be fully aware of thefinancialviabilityofthecustomer,hispastfinancialperformancerecord,hisfuture ability, his honesty and integrity in the business world etc. For this purpose,thefactoralsoundertakescreditinvestigationwork. 4.ProvisionofFinance After the finalization of the agreement and sale of goods by the client, the factorprovides 80% of the credit sales as prepayment to the client. Hence, the client cango ahead with his business plans or production schedule without any interruption.This payment is generally made without any recourse to the client. That is, in theeventofnon- payment,thefactorhastobearthelossofpayment. 5.RenderingConsultancyService Apart from the above, the factor also provides management services to the client.He informs the client about the additional business opportunities available, thechangingbusinessandfinancialprofilesofthecustomers,thelikelihoodofcomingrecessionetc. 11.6TYPESOFFACTORING The type of factoring services varies on the basis of the nature of transactionsbetween the client and the factor, the nature and volume of client’s business, the nature offactor’ssecurityetc.Ingeneral,thefactoringservicescanbeclassifiedasfollows: 1. Fullservicefactoringorwithoutrecoursefactoring 2. WithRecourseFactoring 3. MaturityFactoring 4. Bulk Factoring 5. InvoiceFactoring 179 CU IDOL SELF LEARNING MATERIAL (SLM)
6. AgencyFactoring 7. InternationalFactoring 8. Suppliers GuaranteeFactoring 9. Limited Factoring 10. Buyer Based Factoring 11. Seller Based Factoring 1.FullServiceFactoring Under this type, factor provides all kinds of services discussed above. Thus, afactor provides finance, administers the sales ledger, collects the debts at his riskand renders consultancy service. This type of factoring is a standard one. If thedebtors fail to repay the debts, the entire responsibility falls on the shoulders of thefactor since the assumes the credit risk also. He can not pass on this responsibilityto his client and hence, this type of factoring is also called ‘Without Recourse’Factoring. 2.WithRecourseFactoring As the very name suggest, under this type, the factor does not assume the creditrisk. In other words, if the debtors do not repay their dues in time and if their debtsare outstanding beyond a fixed period, say 60 to 90 days from the due date, suchdebts are automatically assigned back to the client. The client has to take up thework of collection of overdue account by himself. If the client wants the factor togo on with the collection work of overdue accounts, the client has to pay extrachargescalled‘RefactoringCharges”. 3.MaturityFactoring Under this, the factor does not provide immediate cash payment to the client at thetimeofassignmentofdebts.Heundertakestopaycashasandwhencollectionsare made from the debtors. The entire amount collected less factoring fees is paidto the client immediately. Hence it is also called ‘collection Factoring’. In fact,underthistype,nofinancingisinvolved.Butallotherservicesareavailable. 4.BulkFactoring Under this type, the factor provides finance after disclosing the fact of assignmentof debts to the debtors concerned. This type of factoring is resorted to when thefactorisnotfullysatisfiedwiththefinancialconditionoftheclient.Theworkrelating to sales ledger administration, credit control, collection work etc. has to bedone by the client himself. Since the notification has been made, the factor simplycollects the debts on behalf of the client. This is otherwise called as “DisclosedFactoring”orNotifiedFactoring”. 5.InvoiceFactoring Underthistype,thefactorsimplyprovidesfinanceagainstinvoiceswithoutundertaking any other functions. All works connected with sales administration,collection of dues etc. have to be done by the client himself. The debtors are not atallnotifiedandhencetheyarenotawareofthefinancingarrangement.Thistypeof factoring is very 180 CU IDOL SELF LEARNING MATERIAL (SLM)
confidential in nature and hence it is called ‘ConfidentialInvoicediscounting’or‘UndisclosedFactoring’. 6.AgencyFactoring Thewordagencyhasnomeaningasfarasfactoringisconcerned. Underthistype,thefactorandtheclientsharetheworkbetweenthemselvesasfollows: Theclienthastolookafterthesalesledgeradministrationandcollectionwork and Thefactorhastoprovidefinanceandassumethecreditrisk. 7.InternationalFactoring Underthistype,theservicesofafactorinadomesticbusinessaresimplyextended to international business. Factoring is done purely on the basis of theinvoice prepared by the exporter. Thus, the exporter is able to get immediate cashtotheextentof80%oftheexportinvoiceunderinternationalfactoring.International factoring is facilitated with the help of export factors and importfactors. 8.SuppliersGuaranteeFactoring This type of factoring is suitable for business establishments which sell goodsthrough middlemen. Generally, goods are sold through wholesalers, retailers orthrough middlemen. In such cases, the factor guarantees the supplier of goodsagainstinvoicesraisedbythesupplieruponanothersupplier.Thebillsareassigned in favour of the factor who guarantees payment of those bills. Thisenablesthesuppliertoearnprofitswithoutmuchfinancialinvolvement. 9.LimitedFactoring Underthistype,thefactordoesnottakeupalltheinvoicesofaclient.Hediscountsonlyselectedinvoice sonmeritbasisandconvertscreditbillsintocashinrespectofthosebillsonly. 10.BuyerBasedFactoring In most cases, the factor is acting as an agent of the seller. But under this type, thebuyer approaches a factor to discount his bills. Thus, the initiative for factoringcomes from the buyers’ end. The approved buyers of a company approach a factorfor discounting their bills to the company in question. In such cases, the claims onsuch buyers are paid by discounting the bills without recourse to the seller and theseller also gets ready cash. This facility is available only to reputed credit worthybuyersandhenceitisalsocalledselectedbuyerBasedFactoring. 11.SellerBasedFactoring Under this type, the seller, instead of discounting his bills, sells all his accountsreceivables to the factor, after invoicing the customers. The seller’s job is over assoon as he prepares the invoices. Thereafter, all the documents connected with thesale are handed over to the factor who takes over the remaining functions. Thisfacility is extended to reputed and credit worthy sellers and hence it is also called‘SelectedSellerBasedFactoring’. 11.7 COSTANDBENEFITSOFFACTORING 181 CU IDOL SELF LEARNING MATERIAL (SLM)
The cost of factoring comprises of two aspects namely finance charges and servicefees. Since the factor provides 80% of the invoice as credit, he levies finance charges.This charge is normally the same interest rates which are in vogue in the banking system.Factoring is a cheap source because the interest is charged only on the amount actuallyprovided to the client as repayment of his supplies. Apart from this financial charge, aservice charge is also levied. This service fees is charged in proportion to the gross valueof the invoice factored based on sales volume, number of invoices, work involved incollections etc. Generally, thefactor chargesaservicefeeonthetotal turnover of thebills. It is around 1%. If the bills get paid earlier, service charges could be reduceddependinguponthevolumeofworkinvolved. Thebenefitsoffactoringtothebusinessaresavingsincostofcreditadministrationandcostofbaddebt. A business concern has to evaluate the cost and benefit to arrive at a decisionbeforeusingthefactoringservice. Illustration AmanufacturingconcernhasatotalsalesofRs.16,00,000anditsaveragecollection period is 90 days. The past experience indicates a bad debt loss around 1.5% ofcredit sales. The company spends Rs.25,000 on credit administration and collection. Afactorispreparedtobuythefirm’sreceivablesbycharging2%commission.Thefactorwillpayadva ncereceivableataninterestof18percentafterwithholding10percent as reserve. Calculatethecostandbenefittothecompanyandalsoeffectiverateofannualcostoffactoring CostandBenefit = Rs.16,00,000 CreditSales = 90Days AverageCollectionPeriod = Rs.4,00,000 Averagereceivables = 4,00,000 Factoringcommission x2 Reserve 100 = Rs.8,000 = 4,00,000 x 10 100 Amountavailableforadvance = Rs.40,000 = 4,00,000–8,000 –40,000 182 CU IDOL SELF LEARNING MATERIAL (SLM)
= Rs.3,52,000 = 3,52,000x18 x90 Interestonadvance 100x360 = Rs.15,840 = Rs.3,52,00–15,840 Advancetobepaid = Rs.3,36,160 Savings:(Annual) Costofcreditadministration = Rs.25,000 CostofBaddebts Rs.24,000 = 16,00,000x1.5 100x360 = Rs.49,000 = 8,000x 360 Cost(Annual) ---------------------- 90 Factoringcommission = Rs.32,000 InterestCharge = 15,840x360 ----------------------90 = Rs.63,360 TotalCost = 32,000+63,360 = Rs.95,360 95,360–49,000 = Rs.46,360 NetcostoffactoringRateofAnnualC = 46,360x100 ost = = 13.79% 3,36,160 183 CU IDOL SELF LEARNING MATERIAL (SLM)
11.8 BENEFITSOFFACTORING Factoring offers anumber ofbenefitsto theclients. Someof theimportant benefitsare: FinancialService Many of the manufacturers and traders find their working capital being locked upin the form of trade debts. This has been a great handicap to the small and medium scalemanufacturers because they have to wait for 3 months to 9 months to realize their debts.In the meantime, the business may suffer due to want of funds. Infact, many businessconcerns fail more as a result of inadequate cash flow than anything else. The key tosuccessfulworkingcapitalmanagement liesintheabilityofanenterprisetoconvert salesintocashflowandthespeedatwhichitisdone.Themajorbenefitofthefactoringservice is that the clients will be able to convert their trade debts into cash upto 80%immediately as soon as the credit sales are over. They need not wait for months togethertogetcashforrecycling. Anothermajoradvantageisthattherearenoconstrainsbywayoffixedlimitsasin the case of cash credit or O.D. As sales grow, the financial assistance also grow andbotharedirectlyproportionaltoeachother.The greatest advantage is that factoring assures immediate cash flow. When thecash position improves, the client is able to make his purchases on cash basis and thus, hecanavailofcashdiscountfacilitiesalso. CollectionService Collection of debts is another problematic area for many concerns. It is found thatover 60% of the total sales of the SSI sector and over 50% of total sales of the mediumand large scale sector are made on “On Account Terms of Payment” i.e. credit sales. Itmeans that collection of debts becomes an important internal credit management and itrequiresmoreandmoretime.So,industrialistscannotconcentrateonproduction.Delayin collection process often leads to delay in production and supplies. Moreover, theinterest cost of financing book debts is also on the increase. Ultimately, it affects theprofitability of the company. Now, this collection work is completely taken up by thefactoring organization, leaving the client to concentrate on production alone. This is animportantservicerenderedbyafactortohisclient.Thecostofcollectionisalsocutdownasaresultof theprofessionalexpertiseofafactor. ‘Creditrisk’Service In the absence of a factor, the entire credit risk has to be borne by the clienthimself. Bad debts eat away the profits of a concern and in some cases, it may lead to theclosure of a business. But, once the factoring relationship is established, the client neednotbotheraboutthelossduetobaddebts.Thefactorassumestheriskofdefaultinpayment by customers and thus, the client is assured of complete realization of his bookdebts.Evenifthecustomerfailstopaythedebt,itbecomestheresponsibilityofthefactortopaytha tamounttotheclient.Itisthegreatestadvantageoffactoring. ProvisionofExpertise‘SalesLedgerManagement’Service 184 CU IDOL SELF LEARNING MATERIAL (SLM)
Administration of sales ledger is purely an accounting function which can beperformed efficiently only by a few. Infact, the success of any organization depends uponthe efficiency with which the sales ledger is managed. It requires a specialised knowledgewhich the client may not possess. But, the client can receive services like maintenance ofaccountingrecords,monthlysalesanalysis,overdueinvoiceanalysisandcustomerpayment statement from the factor. Besides, he maintains contact with customers toensure that they repay their dues promptly. Thus, it becomes the factor’s responsibility totake care of all the functions relating to the maintenance of sales ledger. Thus, factoringoffersanexcellentcreditcontrolfortheclient. ConsultancyService Factors are professionals in offering management services like consultancy. Theycollect information regarding the credit worthiness of the customers of their clients,ascertain their track record, quality of portfolio turnover, average size of inventory etc.,and pass on the same to their clients. It helps the clients avoid poor quality and riskycustomers. They also advise their clients on important financial matters. Generally notime is available to the client for investigating his customer’s credit standing. Now, thefactortakesupthisworkonbehalfofhisclient. EconomyinServicing Factors are able to render very economic service to their clients because theiroverhead cost is spread over a number of clients. Moreover, their service charges are alsoreasonable. Factoring is a cheap source of finance to the client because the interest rate ischargedonlyontheamountactuallyprovidedtotheclient,say,forinstance,80%ofhistotalinvoices andnotonthetotalamountoftheinvoices.Thus,clientsareabletogetfactoringservicesateconomicrat es. Off-balanceSheetFinancing Factoringisanoff-balancesheetmeansoffinancing.whenthefactorpurchasesthe book debts of the client, these debts no longer exist on the current asset side of thebalance sheet. It leads to reduction in debts and less collection problems. The client canutilise the money so received to reduce his current liabilities. It means an improvedcurrentratio. This can be better understood by means of an illustrationGivenbelowistheBalanceSheetofXCo.Ltd. BalanceSheetbeforefactoringarrangement Liabilities Rs. Assets Rs. Bankloan-againststock 5,00,000 Stock 8,00,000 Bankloan-againstbills 4,00,000 Receivables 6,00,000 185 CU IDOL SELF LEARNING MATERIAL (SLM)
2,00,000 Others 2,00,000 5,00,000 Others Networkingcapital 16,00,000 16,00,000 Nowthecurrentratiocomesto16,00,000:11,00,000=1.45:1 Now,receivablesofRs.6,00,000arepurchasedbythefactoringagent.Thefactorpays80%cashimme diately.SothecompanygetsRs.4,80,000whichisusedforpayingsomeliabilitieslikebankloanandot hers.TheamountduefromthefactorcomestoRs.1,20,000being20%ofthebalanceofreceivables. Thenewbalancesheetafterfactoringarrangement Liabilities AssetsCurrentAssets CurrentLiabilities Rs. Rs. Bank loan-against5,00,000 StockReceivables 8,00,000 (Duefromfactor) stockOthers 1,20,000* 1,20,000 2,00,000 Networkingcapital 5,00,000 Others 11,20,000 11,20,000 Nowthecurrentratiocomesto11,20,000:6,20,000=1.8:1 * Note : Bank loan against bills is paid out of Rs.4,80,000 received from the factor. ThebalanceRs.80,000ispaidtootherliabilities.Hence,otherliabilitiesappearasRs.1,20,000inthen ewbalancesheet. Tradebenefits Availability of ready cash against bills enables the supplier to negotiate betterprices for the inputs and also offer finer terms to customers. It ensures a steady flow ofinputs on the one hand and better market prospects on the other. Again, factoring enablesthe supplier to concentrate on production and materials management without botheringabout the financial 186 CU IDOL SELF LEARNING MATERIAL (SLM)
management. Factoring enables clients to offer longer credit facilitiestotheircustomersandthustoattractmorebusiness.Thusmanytradebenefitsareavailableun derfactoring. MiscellaneousService Generally,factorsareabletocomputerizetheiroperationsfully.Sotheyareableto render prompt service at reasonable rates. They spend more on M.I.S. analysis. Theyalso build bigger credit library of debtors by means of collecting information about newdebtors. Thus, improved cash flow through realization of trade debts by factoring, efficientfollow up of collections, computerized sales ledger maintenance and the competitive ratesarethemainbenefitsoffactoring. 11.9 FACTORINGININDIA InIndia,theideaofprovidingfactoringserviceswasfirstthoughtofbytheVaghulWorkingGroup.Ith adrecommendedthatbanksandprivatenon-bankingfinancial companies should be encouraged to provide factoring services with a view tohelping the industrialists and traders to tide over their financial crunch arising out ofdelays in the realisation of their book debts. The RBI subsequently constituted a studygroup in January 1988 under the chairmanship of Mr. C.S. Kalyansundaram, formerManagingDirectoroftheSBI,toexaminethefeasibilityofstartingfactoringservices.On the recommendation of the committee, the Banking Regulations Act was amended inJuly 1990 with a view to enabling commercial banks to take up factoring services byformingseparatesubsidiaries. Inthepublicinterestandintheinterestofbankingpolicy,theRBIisoftheviewthat: Thebanksshouldnotdirectlyundertakethebusinessoffactoring. Thebanksmaysetupseparatesubsidiariesorinvestinfactoringcompaniesjointlywithotherban ks. A factoring subsidiary or a joint venture factoring company may undertakethefactoringbusiness.But,theyshouldnotfinanceotherfactoringcompanies. The banks can invest in the shares of factoring companies not exceeding 10%ofthepaidupcapitalandreserveofthebankconcerned. But, in February, 1994, the RBI has permitted all banks to enter into factoringbusiness departmentally. Perhaps, this step would have been taken with a view to givingfurtherimpetustothefactoringsystem.Sincefactoringrequiresspecialskillsandinfrastr ucture,theRBIhasfurtherstipulatedthat: Factoring activities should be treated on par with loans and advances andshould accordingly be given risk weight of 100 per cent for calculation ofcapitaltoriskassetratio. A bank’s exposure shall not exceed 25% of the bank’s capital funds to anindividual borrower and 50% to a group of borrowers. Factoring would alsobe covered within the above exposure ceiling along with equipment leasingandhirepurchasefinance. 187 CU IDOL SELF LEARNING MATERIAL (SLM)
Factoring services should be provided only in respect of those invoices whichrepresentgenuinetradetransactions. In India, the factoring service was first started by the State Bank of India inassociation with the Small Industries Development Bank of India, Union Bank of India,State Bank of Sourashtra and State Bank of Indore. The pioneering factoring companyfounded by the SBI is called “SBI Factors and Commercial Services Pvt. Ltd. (SBIFACS)”. It was started in July 1991 with a subscribed capital of Rs.25 crores. It has beenallottedtheWesternZonecomposingofMaharashtra,Gujarat,Goa,MadhyaPradesh,The Union Territories of Dadra, Nagar Haveli, Daman and Diu. Similarly, the RBI hasallotted the Southern Region to the Canara Bank, the Northern Region to the PunjabNational Bank and the Eastern Region to the Allahabad Bank for providing necessaryfactoringservicestotheclientsofthoseregions.Thiszonalrestrictionhasbeenremove dbytheRBIin1993.InSouth,CanaraBankhasalreadyestablishedCanFactorsLtd.Now, these two factoring companies can operate in the centers outside their given zones.Besides the above, some non-banking companies also have made a bid for entering intofactoring services. Thus factoring service has got a very bright future in India due to itssuperiorityoverother formsoffinancing. 11.10 SUMMARY Factoringisafinancialservicewherebyaninstitution,calledthefactor,undertakesthetaskofreal izing,accountsreceivables,bookdebtsandbillreceivables,and in the process provides financial accommodation to traders. Factoring is of differenttypes such as domestic factoring, export factoring, cross border factoring, with recoursefactoring, without recourse factoring, etc. Many advantages accrue from factoring such aseasy and convenient mode of short-term financing for a trader, facilitating acceleratedcash flows, inculcating credit discipline, facilitating information flow, etc. Importantplayers in the realm of factoring are the buyer, the seller, and the factor. A factor rendersseveral functions, such as sales ledger administration, provision of collection facility,financing trade debts, credit control, protection and advisory services. Factoring costsinclude commission for collection of book debts and the interest charges for the creditperiod. RBI has come out with guidelines designed to regulate the functioning of thefactors in India. Accordingly, factoring can be started as an associate business of abanking company, with prior permission from RBI. Developments in Indian factoringscenariostartedtakingplacewiththerecommendationoftheKalyanasundaramcomm ittee on factoring. At present factoring is undertaken by a limited number of bankson a small scale such as SBI and Canara Bank, in addition to certain institutions in theprivatesector.Aformoffinancingofreceivablesarisingfrominternationaltradetransactions 188 CU IDOL SELF LEARNING MATERIAL (SLM)
is known as ‘forfaiting’. Forfaiting essentially involves a non-recourse billdiscounting. 11.11 KEYWORDS Factoring:Afinancialservicethatundertakestocollectaccountreceivablesonbehalfoftheselle rofgoodsandmakesadvancetoatraderonthatbasis. Forfaiting:Financingofreceivablesarisingfrominternationaltrade. Factor:Abankorafinancialinstitutionthatrendersthefactoringservice. WithoutRecourseFactoring:Arrangementwherebythefactorhasnorecoursetotheclientfir mintheeventofnon-recoverabilityofbookdebts. 11.12 LEARNING ACTIVITY 1. What is the difference between factorization and securitization of loan ___________________________________________________________________________ ___________________________________________________________________________ _____ 11.13 UNIT ENDQUESTIONS A.Descriptive Questions Short Questions 1. Definefactoringandstatehowisitsuperiortobillfinancing. 2. Explainthedifferenttypesoffactoringandtheirsignificance. 3. Discussthevariousservicesrenderedbyfactoringintermediaries Long Questions 1. How is factoring done in India? 2. Discuss the benefits of factoring B. Multiple Choice Questions 1. The availability of cash and other cash like marketable instruments that are useful in purchases and investments are commonly known as _______ a. Liquidity b. Credit c. Marketability 2. Banking sector comes under which of the following sectors ________. 189 a. Marketing sector b. Service sector c. Industrial sector CU IDOL SELF LEARNING MATERIAL (SLM)
3. A set of complex and closely connected instructions, agents, practices, markets transactions, claims and liabilities relating to financial aspects of an economy is referred as: _____. a. Financial system b. Financial market c. Financial institution 4. ________ is a market for financial assets which have a long or indefinite maturity. a. Financial market b. Capital market c. Money market 5. ________was constituted to protect the interests of investors in securities and to promote the development of and to regulate the securities market through appropriate measures. a. RBI b. SEBI c. BSE 6. The maximum load that a fund can exchange is determined by ________ a. SEBI b. RBI c. AMFI 7. NBFC performs great role for finance in _______ a. Wholesale sector b. Big Scale industries c. Small scale and Retail sector 8. NBFC is a company registered under _________. a. The Indian Contract Act b. The Companies Act, 1956 c. The RBI Act 9. Finance is not available in the following factories service _________ a. Without Recourse factoring b. With recourse factoring c. Maturity factoring 190 CU IDOL SELF LEARNING MATERIAL (SLM)
10. Sales Ledger Administration is available in the following factoring services_____ a. Without Recourse factoring b. With recourse factoring c. Invoice discounting 11. Credit Protection is available in ______ a. Without Recourse factoring b. With recourse factoring c. None of these 12. Under forfaiting the client is able to get credit facility to the extent of_______ a. 100% of the value of the export bill b. 80% of the value of the export bill c. 90% of the value of the export bill 13. Full service factoring is often_________ a. Recourse factoring b. Non-recourse factoring c. Agency factoring 14. The process of selling trade debts of a client to a financial intermediary is called______ a. Factoring b. Securitisation c. Materialisation 15. _______ __ services are mainly provided to foreign investors. a. Custodial Services b. Financial Services c. Factoring Services 16. The Idea of providing factoring services was first thought of in India by_____. a. Tandem committee b. Malhotra committee c. Vaghul committee 17 The central theme of forfaiting is the purchasing of ________by a financial service company. a. Trade bill b. Export bill c. Import bill 191 CU IDOL SELF LEARNING MATERIAL (SLM)
18. Refactoring charges have to be paid in the case of _________ a. With recourse factoring b. Invoice factoring c. Full service factoring 19. Buying a company’s accounts receivable on a nonrecourse basis is known as _________ a. Trading b. Billing c. Factoring Answers 1(c ), 2(c) ,3( c) ,4(b) ,5(a ),6(c ), 7(c) ,8(c) ,9(a) ,10(c) ,11(c) ,12(a) ,13(b),14(b) , 15( c) ,16(b) ,17(a) ,18(b) ,19 (a) 11.14 REFERENCES Text Books: Bhalla, V. K.“ Management of Financial Services” Anmol Publications Clifford Gomez “ Financial Markets, Institutions and Financial Services”, PHI Learning Rose, Peter and Hudgins, Sylvia,“ Bank Management and Financial Services”, McGraw Hills. Reference Books: Padamlatha ,“ Management of Banking and Financial Services”, Pearson Education. Saunders, Antony and Cornett, Marcia,“ Financial Institutions Management: A Risk Management Approach” McGraw Hills 192 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT-12EVALUATION OF FACTORING STRUCTURE 12.0 Learning Objectives 12.1 Introduction 12.2 Need for evaluation of factoring proposal 12.3 Types of Factoring 12.4 Procedure 12.5 Non-Banking Financial Company-Factors 12.6 Summary 12.7 Key words 12.8 Learning activity 12.8 Unit End questions 12.9 References 12.0 LEARNING OBJECTIVES After studying this unit, the student will be able to Evaluate the various methods of factoring Explain about the concept of NBFC Appreciate the need for evaluation of factoring 12.1 INTRODUCTION Factoring is a financial alternative, in financing and management of account receivables. It states the terms and conditions of the sale in the factoring agreement. In finer terms factoring is a relationship between the factor and the client, in which the factor purchases the client’s account receivables and pay up to 80% (sometimes 90%) of the sum immediately, at the time of entering into the agreement. The factor pays the balance sum, i.e. 20% of the amount which includes finance cost and operating cost, to the client when the customer pays the obligation. 12.2 NEED FOR EVALUATION OF FACTORING PROPOSAL Factoring in business organizations is used to obtain cash that is required to accommodate immediate cash needs. Thus, it helps in the firms’ small ongoing cash balance. Although cash flow is directly proportional to several factors, evaluation of factoring proposal maintains a balance with a simple case study. Hence, numbers of organizationsare willing to consider factoring is one of the important factors in lifting their business to the next level. 5 1 CU IDOL SELF LEARNING MATERIAL (SLM)
Moreover, factoring a business account requires approving of the organization. To complete the whole process, it sometimes needs two days practically. 12.3 TYPES OF FACTORING Recourse and Non-recourse Factoring: In this type of arrangement, the financial institution, can resort to the firm, when the debts are not recoverable. So, the credit risk associated with the trade debts are not assumed by the factor. On the other hand, in non-recourse factoring, the factor cannot recourse to the firm, in case the debt turn out to be irrecoverable. Disclosed and Undisclosed Factoring: The factoring in which the factor’s name is indicated in the invoice by the supplier of the goods or services asking the purchaser to pay the factor, is called disclosed factoring. Conversely, the form of factoring in which the name of the factor is not mentioned in the invoice issued by the manufacturer. In such a case, the factor maintains sales ledger of the client and the debt is realized in the name of the firm. However, the control is in the hands of the factor. Domestic and Export Factoring: When the three parties to factoring, i.e. customer, client, and factor, reside in the same country, then this is called as domestic factoring. Export factoring, or otherwise known as cross-border factoring is one in which there are four parties involved, i.e. exporter (client), the importer (customer), export factor and import factor. This is also termed as the two-factor system. Advance and Maturity Factoring: In advance factoring, the factor gives an advance to the client, against the uncollected receivables. In maturity factoring, the factoring agency does not provide any advance to the firm. Instead, the bank collects the sum from the customer and pays to the firm, either on the date on which the amount is collected from the customers or on a guaranteed payment date. Based on the factoring type, the collection of the debt is performed by the factor or the client, as the case may be. 12.4 PROCEDURE 1. Borrowing company or the client sells the book debts to the lending institution (factor). 2. Factor acquires the receivables and extend money against the receivables, after deducting and retaining the following sum, i.e. an adequate margin, factor’s commission and 5 2 CU IDOL SELF LEARNING MATERIAL (SLM)
interest on advance 3. Collection from the customer is forwarded by the client to the factor and in this way, the advance is settled. 4. Other services are also provided by the factor which includes: Finance Collection of debts Maintenance of debts Protection of Credit Risk Maintenance of debtors ledger Debtors follow-up Advisory services The factor gets control over the client’s debtors, to whom the goods are sold on credit or credit is extended and also monitors the client’s sales ledger. 12.5 NON-BANKING FINANCIAL COMPANY-FACTORS The Non-Banking Financial Company-Factors (NBFC-Factors) is yet another financial company that deals in the principal business of Factoring. The Factoring is a financial transaction wherein the company sells its bills receivables i.e. invoices to a third party called as “factor” at a discount. As per the RBI, the company can be registered as a non-banking financial company-Factors if it complies with the following conditions: The company seeking registration as NBFC-Factor must have a minimum net owned fund (NOF) of Rs 5 Crore. In the case of an existing company that want to get registered as NBFC-Factor but does not fulfill the minimum criteria of NOF i.e. 5 Crore may approach the bank to seek time 5 3 CU IDOL SELF LEARNING MATERIAL (SLM)
to comply with the requirement. The company must ensure that the assets in the factoring business must constitute at least 50% of its total assets and also, the income derived from the factoring business should not be less than 50% of its gross income. The Non-Banking Financial Company registered with the bank and is already into the factoring business that constitutes less than 75% of its total assets/income is required to submit the bank a letter of its intention to whether become a factor or unwind the business totally. The company is required to raise the asset/income percentage as required or unwind the factoring business within two years from the date of the notification. Thus, NBFC shall be granted to function as a factor only if it meets the required percentage of asset/income percentage. The factoring is done so that business can receive cash quickly against the invoices rather than waiting for the time period (usually, 30 to 60 days) the customer makes the payment. 12.6 SUMMARY Factoring business is much lower compare with the other developing countries in the world. India’s factoring volume share is less than 1% of the world factoring business. And contribution of working capital requirement of the company by the factor is less than even .5%. Where as globally this is above 5%.Thus Factoring business in india is dominated by public sector bank and financial institution like sbi global factor and canbank factor. Bank such as hsbc etc also provide factoring. Sbi global factor is the market leader with nearly 80% market capitalization. Government passed factoring bill in parliament to attract more factoring company in the field. 12.7 KEY WORDS Counter - party credit risk related to clients and risk-covered debtors. Risk - covered debtors can be reinsured, which limit the risks of a factor. Legal, compliance and tax risks: large number of applicable laws and regulations in different countries ,Operational risks, such as contractual disputesUniform Commercial Code (UCC-1) securing rights to assets.,IRS liens associated with payroll taxes, etc. ICT risks: complicated, integrated factoring system, extensive data exchange with client 12.8 LEARNING ACTIVITY 5 4 CU IDOL SELF LEARNING MATERIAL (SLM)
1 What are the sources of funds for an NBFC? ___________________________________________________________ ___________________________________________________________ 12.9 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Define factoring. 2. what is an NBFC 3. What is called as risk. Long Questions 1. How Does Freight Bill Factoring Work 2. What Is Invoice Factoring 3. Can you help with my company’s payroll funding? 4. What industries benefit from invoice factoring? 5. How Does Invoice Factoring Create Working Capital for Businesses? 6. How does payroll financing work? B. Multiple Choice Questions a. The factor assumes credit risks associated with the ‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐. a. Collection of accounts b. collection of securities c. Collect the fund d. collect the goods b. ‐‐‐‐‐‐‐‐‐‐‐‐ is the charge for short term financing in the form of advance part payment is in the form of interestcharge for the period of advance payment. a. interest b. Deficit c. Discount charge d. Factor age. c. Who is the chairman of high powered committee constituted by the R B I under factoring services. a. U.K. Singha b. PranabMugharjee c. C.S. KalyanaSundaram d. None of these. 5 5 CU IDOL SELF LEARNING MATERIAL (SLM)
e. The minimum under writing obligation of a load merchant banker is ‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐ of the total underwritingcommitment. a. 15% b. 5% c. 50% d. 10%. f. The maximum number of lead merchant bankers that can be appointed in the case the issue exceedsRs.100crore less than Rs.200crore is ‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐. a. 2 b. 3 c. 4 d. 5 Answers 1(b) ,2(b) ,3(a) ,4(c) ,5(b) 12.10 REFERENCES Text Books: Bhalla, V. K.“ Management of Financial Services” Anmol Publications Clifford Gomez “ Financial Markets, Institutions and Financial Services”, PHI Learning Rose, Peter and Hudgins, Sylvia,“ Bank Management and Financial Services”, McGraw Hills. Reference Books: Padamlatha ,“ Management of Banking and Financial Services”, Pearson Education. Saunders, Antony and Cornett, Marcia,“ Financial Institutions Management: A Risk Management Approach” McGraw Hills 5 6 CU IDOL SELF LEARNING MATERIAL (SLM)
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