Businesses are often stuck between debtors who won’t pay on time and creditors who won’t wait. In between, a businessperson often ends up offering higher discounts to their debtors for early clearing of receivables or buying at higher prices from its creditors who may offer a longer credit period to settle the bills. If you are a businessperson, you might have already experienced how essential it is to manage working capital and review it periodically. Many studies suggest that poor management of working capital was most often the reason behind the failure of businesses. This is because if a few receivables turn bad, bankrupt or won’t pay owing to pending litigations and even deliberately sometimes, it affects your working capital, although it seems healthy on your balance sheets.
India is a developing country and our economy majorly consists of micro, small and medium enterprises (MSMEs). The MSME sector comprises small businesses, manufacturers, wholesale and retail traders who belong to the middle-class strata of the society. For a long time, this section of the economy has been neglected as the early focus after independence was on large scale industrialisation and self-sufficiency, and later the focus shifted on liberalisation and foreign investments. In between raising people from poverty and serving the rich industrialists by policy-making, the MSME sector never received the push that it needed from the economy and the middle-class people have stayed where they were. However, the Governments have realised that a small push or an initiative for the MSMEs can have a ripple effect on the economy. And thus, lately, the Governments have been bringing up initiatives with a focus on the MSME sector. One such initiative taken recently has been ‘factoring’ – solving the principal problem of the MSMEs – blocked working capital.
Post-pandemic, most businesses have faced one of the toughest times in managing their working capital. Although their receivables exceed the payables, they are still unable to clear the dues as their customers haven’t paid the outstanding bills. MSMEs are usually unorganised and therefore, there are long chains of businesses that buy from one business and sell to the other, before the goods ultimately reach the retail customers. Similarly, in industries where products are processed at multiple stages such as food processing, textile manufacturing, etc. the goods from farms have a long distance to travel before they reach the ultimate customers. In such situations, if one of the businesses in a chain of such businesses defaults, or is unable to pay his dues, the entire chain preceding such buyer is blocked, as MSMEs have limited funds in their business. Factoring can resolve such problems by financing a business with funds and avoids failure of the entire chain of business.
What is Factoring?
When you sell your goods, you offer a credit period. Selling to smaller customers is riskier as your receivables are more to bad debts and hence, the focus is always on bringing in bigger customers who also place orders in bulk. However, big customers come with large negotiation power as well and one area which gets negotiated without many talks is the credit period. Small businesses are in the realm of large customers and have to live by their terms. This often results in blocked working capital funds and borrowings from banks and sometimes even friends and relatives. Factoring aims at solving this exact problem.
A factor is an intermediate financial agent who provides cash or financing to the selling party by purchasing their bills receivables. Factoring services are usually provided by banks and finance companies. So, if you sell to a buyer, the factor will pay you instantly against the bill and release your working capital pressure. Later, when the bill becomes due and the buyer pays the same, the factor collects the proceeds of the bills. The factors earn by way of commission and fees based on the value of the bill and other factors such as the dependency of the buyer, the turnover and records of the seller, etc. So when factor pays you instantly they deduct their commission and fees, and you receive the balance proceeds. Factoring of bills receivable is also known as ‘Bill Discounting’ as you receive the discounted value of the bill. Factoring helps the seller by providing them with short-term cash needs by selling their receivables in return for an injection of cash from the factoring company. For the buyer, it is usual business, except that the payment when due is to be paid to the factor and not the seller.
Basics of Factoring
Following are a few things, you must know about factoring.
Full Factoring and Recourse Factoring
Usually, the factor pays your proceeds of the bill after discounting and later collects the payments from the buyer. What if the buyer fails to pay the proceeds and the receivables turn into bad debt? In such cases, depending on the factoring arrangement, the liability may or may not fall back to you. If you enter into a ‘Full Factoring’ or ‘Factoring without Recourse’, your liability will be dismissed as soon as the factor pays you. If the debt thereon turns bad, it won’t fall back to you. However, if you enter into a ‘Recourse Factoring’ or ‘Factoring with Recourse’, you will not be resolved of your liabilities until the buyer pays the factor on the due date. If the buyer fails to pay, it would become your liability to pay the factor. Thus, in recourse factoring, there is no debt protection. Accordingly, it is obvious, the bank charges a higher commission for ‘Full Factoring’ as it involves more risk than in ‘Recourse Factoring’.
No collateral securities
The key feature of factoring arrangements is that it does not involve any kind of mortgage of collateral properties as in the case of term loans. Further, there is no need to submit any working capital statement every month as in the case of working capital overdrafts or cash credits. The factors collect documents such as business registrations, past financial statements, current business profile and details of top customers. They have access to your credit scores and the same of your buyers. There is a processing fee involved at the time of registration. Once registration i.e. factoring agreement has been signed, merely submission of the invoice and related documents, and thereafter acceptance of the same by the buyer is sufficient to receive the funds from the factor.
Disclosure to buyer
A factoring arrangement is usually disclosed to the buyer, as the buyer has to pay directly to factor, instead of the seller. The name of the factor and other details are to be disclosed in the invoice. However, there are also Undisclosed Factoring Arrangements where the details of factoring are not disclosed to the buyer or in the invoice. There are different ways of dealing with collections in such cases. Usually, the documentation is made in such a way as if the goods have been sold to the factor first who in turn sells the same to the intended buyer and appoints the seller as an agent to recover the debt from the buyer. Instead of merely financing the arrangement, the factor assumed the responsibility of non-payment. Sometimes, the factor maintains the sales record of the seller and the amount advanced is recorded as borrowing by the seller and the seller is liable to repay the debt when his dues are cleared.
Benefits of Factoring to Seller
Instant availability of finance helps in maintaining the liquidity in the business. The factoring arrangement regularises the business’s cash flow and increases the working capital. Thus, making more funds available at your realms and thereby more power to negotiate with your vendors.
One of the major risks for businesses is certainly that of being unable to collect the proceeds of their sales i.e. bad debt risk. In a factoring arrangement, the factor who is often a bank or financial company whose job is to provide finance, the risk can be eliminated by opting for factoring without recourse.
The factor makes a thorough investigation of the buyer’s creditworthiness, financial strength, and market reputation. This also helps you minimize your collection risks and develop a high-quality customer portfolio for your business.
Time is money. Wasted time is a luxury that no one can afford in a business. Investigating the customer, managing and making collections, handling credit procedures, etc can all take up time and by taking advantage of factoring services you can put the time to better use by developing better business plans and competitive advantages.
Factoring reduces the time, effort and money involved in bookkeeping. It allows you to make cash payments to your suppliers and thus, you can avail cash discounts from vendors and reduce costs. As against loans from banks, it does not involve heavy documentation or mortgage of properties which take way too much time and attention away from the core business activity.
Factoring makes it possible for a business to finance its operations from its receivables. The average collection time of receivables will be lowered and thereby, your trade payables as well. The reputation of the business will improve owing to prompt payment of dues and thus, the financial structure will also be stronger. The need for loans or funds from investors for working capital purposes can be avoided completely.
How does a factoring company make money?
Factoring companies are not one-size-fits-all. Many companies cater to specific industries such as automobiles, construction or staffing. Banking companies also offer factoring services, but the majority of factoring companies are independent financers. When a business factors their invoices, the factor advances up to 90% of the invoice value to the business. When the factor collects the full payment from the end customer, they return the remaining 10% to the business, minus a factoring fee. The fee is typically between 1% and 5% depending on multiple factors, like the age of the invoice, the risk involved and creditworthiness.
The factoring company usually has investors or borrowings from other financiers. Against the funds available, the factoring company offers the seller instant payment of their bill. The factoring fee covers their interest dues to investors and lenders, the collection costs, the administration costs and the profit margin for the risk undertaken. The business model is similar to banks who lend money to businesses except that the financing here is of smaller quantum, for a brief period like 3 to 12 months, and riskier as there is no collateral security. To cover the risks, the factors also take insurance against all such outstanding collections. Of course, the factoring business has more margin than the banks have in their loans, however, the stake is also higher.
Why is factoring not popular?
Factoring is a popular mode of working capital financing in the developed economies, as it provides a complete financial package that combines working capital financing, credit risk protection, accounts receivable bookkeeping and collection services. However, factoring hasn’t been much successful in India owing to a few reasons.
Double-credit on same receivables
The factoring companies often offer their services to customers who already have working capital borrowings from the banks who offer the same as a ‘Cash Credit’ against the working capital gap. Many borrowers do not exclude the factored receivables from their Receivables Statements while submitting to the bank periodically for the cash credit facility. This results in double financing of the same receivables. The loopholes have been exploited by many sellers in the past.
Availability of loans
Banks have deeper roots in India than factoring companies. Most MSMEs who are located in smaller towns and cities have banks available to finance but not the factoring companies. Most factoring companies are also sector-specific and thus, they haven’t been able to reach their intended customers.
Frauds and Collusions
Factors in India have to face frauds and collusions such as fake bill scams, deliberate rejection of goods by buyers to avoid payments, direct cash settlements with sellers, etc. There is no authenticated document verification mechanism in place and also no credit insurance cover against the same. Documentations for sales are weaker in India and MSMEs usually do not maintain a thorough record of inventory, shipping, delivery and acceptance of goods. This further makes the process cumbersome.
The weak legal system for recovering
Factors are unsecured lenders and thus, in case of bankruptcy of the buyer or the seller, the factor would always be amongst the last ones in the queue. In the absence of access to debt recovery tribunal (DRT), factoring litigations take time as the legal system in India is already overburdened. Thereby, the risk appetite of factors is significantly deterred.
Deterrence by buyers
Often buyers avoid agreeing to a factoring arrangement by the seller, in fear of being chased by third party financing companies who are equipped to take legal actions in case of non-payment.
What are the latest amendments in Factoring?
The Parliament has cleared the amendments to Factoring Regulation (Amendment) Bill, 2020. Following are the changes that have been approved which will improve the factoring market in India.
The amendments make it possible for approximately 9,000 Non-Banking Financial Companies (NBFCs) in India, to participate in a factoring arrangement. Earlier, only companies with banking license from the Reserve Bank of India (RBI) were allowed to act as a factor and only NBFCs whose (i) 50% of financial assets were in factoring business, and (ii) 50% of the gross and net income was from factoring business, were allowed to act as factor. The amendment now removes this threshold for NBFCs to engage in the factoring business.
The Government will soon make it mandatory for all companies with a turnover above INR 250 crores to register on the Trade Receivables Discounting System (TreDS) platform.
Partial factoring of bills is now being allowed. The earlier assignment was defined to mean a transfer of an undivided interest in any receivable due from the debtor in favour of the factor. However, now after the amendment, such transfer can be in whole or in part.
Factors are required to register the details of every transaction within 30 days. These details were recorded with the Central Registry setup under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002. The company and each officer failing to comply could face a fine of up to five thousand rupees per day if they fail to do so. The bill has now removed the 30 days period and new rules concerning the period, manner of registration, and a late fee will be announced soon.
Factoring business was defined as the business of (i) acquisition of receivables of an assignor by accepting assignment of such receivables, or (ii) financing against the security interests of any receivables through loans or advances. The bill now amends this to define factoring business as the acquisition of receivables of an assignor by assignment for consideration. Thus, now the acquisition should be only for the collection of the receivables or for financing against such assignment.
The Future of Factoring
Factoring is capable of unlocking the blocked working capital funds of MSMEs and also help them resolve the problem of delayed collection of bills. The new changes have been brought keeping in mind the difficulties faced by the MSME sector during the lockdown and pandemic. The government’s official website ‘MSME Samadhan’ which mediates the problem of bad debts and delayed payments of MSMEs displays that at the end of July 2021, 84,362 applications have been filed by MSMEs of which only 8,134 cases have been resolved by the council, 22,106 are under consideration while 30,676 cases are not yet opened by the MSME. Other applications were either mutually settled or rejected. This explains that the earlier system of monitoring payments has failed to serve its purpose and therefore, a new mechanism was necessary.
The government feels that factoring can solve the problems of the MSME sector in India. The changes are promising and make factoring more accessible and reliable, however, the lack of a legal system to support the factors is a hurdle that needs to be addressed soon. Factoring arrangements are a great option for MSME businesses and if successfully implemented and nurtured thereon, this can lead to a major economic revival of the MSME sector which the sector has been waiting for, for a long time.