Factoring - A Powerful Alternative Source of Working Capital for SMEs

Background

It is well understood that access to capital is the prime bottleneck that stunts the growth of small and medium enterprises (SMEs). For many SME promoters, having invested their own funds in fixed assets, it is the working capital (or the lack of it) that becomes the chief concern in running the business efficiently. While significant progress has been made in the area of channelizing finance to SMEs, the rapid integration of the global economies and rising domestic demand throws up both opportunities to cater to a global market place and challenge to ensure that the demands of their customers are met in terms of quality and timely delivery of products& services. Clearly, the ease of access to finance will continue to be a key factor in determining the competitiveness of the Indian SMEs. One mechanism to counter challenges of globalization faced by SMEs may be the internationally used tool by SMEs for their working capital requirements – Factoring.

What is Factoring?

Factoring is a form of receivables finance whereby a business sells or assigns its accounts receivables (i.e. invoices) to a finance company (called a factor) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a loan in three main ways. First, the emphasis is on the quality of the receivables and not only on the firm’s credit worthiness. Secondly, factoring is not a loan – it is an advance on your outstanding invoices. Because of this, factoring is easier to obtain provided that you do business with reliable customers. Finally, a bank loan involves two parties whereas factoring involves three (borrower – buyer- factor).Factoring is often misused synonymously with invoice discounting - factoring is the sale/assignment of receivables, whereas invoice discounting is borrowing where the receivable is used as collateral.

Worldwide, factoring is a preferred route of accessing working capital for SMEs and even larger organizations. As per the Factors Chain International (FCI), a global network of factoring companies worldwide - the global factoring turnover for the year 2010 was Euro 1648 Billion! Of this Euro 1403 billion was domestic factoring turnover of factoring companies and Euro 245 billion was the international factoring turnover (where the buyer and seller are located in different countries). The fact that factoring is still in a nascent stage in India can be gauged from the fact that the turnover of India as per FCI was only Euro 2750 million - less than half of tiny Singapore and less than 2 % of China’s turnover !

How does Factoring work?

1. You sign factoring agreement for an agreed funding limit .The funding limit is broken down further for your each approved debtor (your customer).

2. You will notify your approved customers that you have assigned the receivables due from them to the factoring company and that they should pay directly to the factor. Your customer will need to acknowledge/accept the notification of assignment.

3. You deliver the goods or services and invoice your debtor.

4. You send the invoices to the factoring company, who advances you up to 85% of your invoice as a pre-payment.

5. You get to use the funds, while the factoring company waits to get paid by your debtor on the due dates – usually 60 -90 days

6. Once the factoring company gets paid, it refunds the remaining 15% as the balance payment, less charges.

Factoring charges are of 3 types - 1) Discount rate similar to interest rate, 2) Service charge depending upon the tenor of the advance usually 0.15%- 0.25% of invoice value and 3) One time processing/set up fee

Leveraging Accounts Receivables – Key to improving profitability

A CRISIL study on 5000 small and medium enterprises (SMEs) reveals that SMEs can enhance profits by at least 15 per cent if they receive payments on time from their large corporate customers. CRISIL estimates that timely payments from large customers will help SMEs reduce interest costs, improve profitability and have a positive impact on the long-term health and sustainability of India’s SME sector. SMEs with large corporate customers have receivables of 90 to 120 days of sales on their balance sheets, as against 45 days stipulated by the Micro, Small, and Medium Enterprises Development (MSMED) Act. The CRISIL study reveals that high receivables are endemic across industry sectors and geographies in the SME space. The smaller the SME, the weaker its receivables position tends to be. Small enterprises constitute a sizeable portion of India’s SME space and are most susceptible to liquidity pressures; it is, therefore, critical that the small entities receive payments on a timely basis from customers. It is in this context that a factoring facility can come in handy for SMEs.

Impact of factoring receivables

SMEs need to have a relatively short cash conversion cycle in order to manage their cash flows efficiently. The cash conversion cycle is the number of days between when a company pays its supplier (creditors) for the raw materials/inputs and when it receives cash for the sale of goods produced from those materials. Studies have shown that shorter the cash cycle –the better the return on equity.

Cash Conversion Cycle= Days Sales Outstanding +Days Inventory Outstanding – Days Payable Outstanding

Days Sales Outstanding = (Accounts Receivable / Total credit sales) X 365

Days Inventory Outstanding = (Inventory/cost of goods sold) X 365

Days Payable Outstanding = (Accounts payable/cost of goods sold) X 365

An illustration will show the impact of selling /assigning receivables and obtaining instant liquidity

Assumptions:

1) Value of Invoices factored Rs 30,000,000
2) Total credit sales Rs 200,000,000
3) Cost Of Goods Sold Rs 180,000,000
4) Overall Factoring cost @ 15 % p.a i.e 2.5 % for 90 days credit period = Rs 750,000/-
5) Prepayment rate : 80%

	Before	‘change’	After
Cash	50,000	Increases-Add 80% of A/R sold less cost	282,500
Sundry Debtors	400,000	Decreases - A/R declines by amount sold	100,000
Balance(Margin) Receivable	-	20% margin receivable of A/R sold	60,000
Inventory	400,000		400,000
S-T Advances	150,000		150,000
Total Current Advances	1,000,000		992,500
Current Liabilities (Accounts payable)	300,000		300,000
L T Liabilities	200,000		200,000
Share holder’s Equity	500,000	Reduces	492,500
Total Liabilities & Share Holder’s Equity	1,000,000		992,500

	Before Factoring	After Factoring
Days Sales Outstanding	73	19
Days Inventory Turnover*	81	81
Days Accounts Payable Turnover*	60	60

Companies choosing to monetize their accounts receivable see multiple capital efficiencies such as:

• Improved Cash Conversion Cycle, in this case by 54 days & reduced Days sales outstanding

• Working capital previously tied up for months can be now ploughed back into operations

Once a receivable is sold, the cash can be reinvested in new inventory, products, employees, or anything that will earn a positive return for the company. Often SMEs can reduce raw material cost by paying for them early. Hence, if the SME in the above example can earn an operating profit of more than 15%, it makes sense to incur the factoring cost and redeploy the cash profitably.

Advantage over traditional lending

In the traditional lending model, SMEs would seek a cash-credit limit (CC) from a bank. The banks assess the CC limit based on the average levels of stock (inventory) and book debts (receivables).So what are the key benefits for SMEs to opt for factoring facility.

1. Unlike bank finance, Factoring is usually an open account facility which means that your credit limit increases as your sales grow provided you have had a satisfactory record of payments. So for fast growing SMEs who would require more and more funding year on year- factoring is an extremely beneficial option.

2. Bank Finance often requires additional collateral in the form of mortgage whereas Factoring normally does not. It is the quality of receivables and the buyer profile that are the key concerns. Hence, small SMEs with good buyers but no collateral to place may find factoring very useful.

3. Unlike bank funding, factoring is not a loan- it is an advance against receivables. Hence, a factoring facility while providing liquidity does not add to the debt of the company. SMEs with fully used bank funding and well leveraged may look at factoring as a viable option.

4. Bank finance is a funding only facility while Factoring offers collection services wherein the factor will collect on your behalf and also maintain the sales ledger leaving you to focus on your core activity.

Clearly, used smartly, Factoring offers several benefits for growing SMEs with increasing funding requirements but relatively weaker balance sheets and little collateral to pledge but relationship with good buyers. In fact, it is most common to avail both bank finance and factoring together with debtors segregated. It must be pointed that double financing is not permitted and the same receivable cannot be used for availing finance from both a factoring company and a bank.

How to get started

Since factoring is focused on receivables, it is important for SMEs to discuss factoring with their buyers at the time of the purchase order contract. Convincing the buyer to agree to pay directly to the factor is often a challenge worth accepting for the growth of your company. Proper transaction documents like Purchase orders/invoices/ lorry receipt help in availing a sanction quickly. Well maintained ledgers are important -Factors will scrutinize your sales ledger and look for payment records/rejections/cheque returns etc. There are many intermediaries who can help you to put together an application. Bibby Financial Services India, SBI Global Factors, IFCI factors, India factors, Can bank Factors are the major factoring companies apart from HSBC and Standard chartered bank who have factoring divisions as well.

Conclusion

SMEs should choose the most appropriate funding options depending upon their need at that stage of their growth. Factoring – a relatively lesser known and under-utilized product is well suited for fast growing SMEs. An alternative source of flexible and non-collateralized funding option is very useful for SMEs. While factoring may be costlier than bank finance, the benefits may outweigh the cost. A factoring legislation is pending for clearance by the Indian parliament and has the potential to provide a major thrust to this product.