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Factoring- secret behind smooth business

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  • June 6, 2017
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INTRODUCTION

Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables (essentially a financial asset), not the firm's credit worthiness. Secondly, factoring is not a loan - it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three.

Factoring enables you to:

  1. Instantly turn your receivables into cash.
  2. Grow business with adequate working capital.
  3. Take well informed credit decisions.
  4. Concentrate in marketing initiatives.
  5. Outsourse your sales ledger administration.

Factoring thus not only helps you in expanding your business, but also provides you with an efficient collection mechanism and protection against bad debts.

The three parties directly involved are: the one who sells the receivable, the debtor, and the factor. The receivable is essentially a financial asset associated with the debtor's Liability to pay money owed to the seller (usually for work performed or goods sold). The seller then sells one or more of its invoices (the receivables) at a discount to the third party, the specialized financial organization (aka the factor), to obtain cash. The sale of the receivables essentially transfers ownership of the receivables to the factor, indicating the factor obtains all of the rights and risks associated with the receivables. Accordingly, the factor obtains the right to receive the payments made by the debtor for the invoice amount and must bear the loss if the debtor does not pay the invoice amount. Usually, the account debtor is notified of the sale of the receivable, and the factor bills the debtor and makes all collections.

Critical to the factoring transaction, the seller should never collect the payments made by the account debtor, otherwise the seller could potentially risk further advances from the factor. There are three principal parts to the factoring transaction; a.) the advance, a percentage of the invoice face value that is paid to the seller upon submission, b.) the reserve, the remainder of the total invoice amount held until the payment by the account debtor is made and c.) the fee, the cost associated with the transaction which is deducted from the reserve prior to it being paid back the seller. Sometimes the factor charges the seller a service charge, as well as interest based on how long the factor must wait to receive payments from the debtor.

CHARACTERISTICS OF FACTORING

  1. Usually the period for factoring is 90 to 150 days. Some factoring companies allow even more than 150 days.
  2. Factoring receivables is an ideal financial solution for new and emerging firms without strong financials. This is because credit worthiness is evaluated based on the financial strength of the customer (debtor). Hence these companies can leverage on the financial strength of their customers.
  3. Bad debts will not be considered for factoring.
  4. Credit rating is not mandatory. But the factoring companies usually carry out credit risk analysis before entering into the agreement.
  5. Factoring is a method of off balance sheet financing.
  6. Cost of factoring=finance cost + operating cost. Factoring cost vary according to the transaction size, financial strength of the customer etc. The cost of factoring varies from 1.5% to 3% per month depending upon the financial strength of the client's customer.
  7. For delayed payments beyond the approved credit period, penal charge of around 1-2% per month over and above the normal cost is charged (it varies like 1% for the first month and 2% afterwards).

DIFFERENT TYPES OF FACTORING

  1. Disclosed and Undisclosed
  2. Recourse and Non-recourse

DISCLOSED

In disclosed factoring client's customers are notified of the factoring agreement. Disclosed type can either be recourse or non-recourse.

UNDISCLOSED

In undisclosed factoring, client's customers are not notified of the factoring arrangement. Sales ledger administration and collection of debts are undertaken by the client himself. Client has to pay the amount to the factor irrespective of whether customer has paid or not. But in disclosed type factor may or may not be responsible for the collection of debts depending on whether it is recourse or non-recourse.

RECOURSE FACTORING

In recourse factoring, client undertakes to collect the debts from the customer. If the customer don't pay the amount on maturity, factor will recover the amount from the client. This is the most common type of factoring. Recourse factoring is offered at a lower interest rate since the risk by the factor is low. Balance amount is paid to client when the customer pays the factor.

NON-RECOURSE FACTORING

In non-recourse factoring, factor undertakes to collect the debts from the customer. Balance amount is paid to client at the end of the credit period or when the customer pays the factor whichever comes first. The advantage of non-recourse factoring is that continuous factoring will eliminate the need for credit and collection departments in the organization.

Factoring Industry Environment

Factoring in Bangladesh is the selling or discounting of invoices (receivables) by a seller of goods and services, usually micro, small and medium enterprises (MSMEs) to a factoring company or bank. Ideally it should lead to an improvement in collection management, whereby the MSME derives the advantage of realizing the receivables quickly against the standard waiting period, which is the usance period of the bill. Large corporates (the buyers) would pay these sellers well after the due dates as per their payment cycle.

These MSMEs play a vital role for the growth of Bangladesh economy, contributing 45 per cent of the industrial output, 40 per cent of exports, 42 million in employment, creating one million jobs every year and producing more than 8000 products for the Bangladesh and international markets. As a result, MSMEs are today exposed to greater opportunities for expansion and diversification across the sectors. The Bangladesh market is growing rapidly and industry is making remarkable progress in various sectors, such as: manufacturing; precision engineering; food processing; pharmaceuticals; textile & garments; retail; IT; agriculture; and service sectors. MSMEs are finding increasing opportunities to enhance their business activities in these core sectors. 

 

One of the key constraints impacting the MSMEs is inadequate finance, particularly working capital. In the case of MSMEs, the need for quick conversion of trade receivables - an important component of current assets of their business entities - into cash, assumes great importance, since the lack of opportunities affects their liquidity, and thereby their business, quite significantly. It has, however, been observed that, at present, not many avenues exist for these enterprises to convert their receivables before maturity except through availing of a bill finance facility from a bank/FIs. One of the principal instruments of working capital is trade finance, including bill discounting and factoring. It is estimated that only 10 per cent of the total receivables market is presently covered under the formal bill discounting mechanism in the financial system, while the rest is covered under conventional cash credit/overdraft arrangements with banks. The MSMEs’ smaller balance sheets and asset quality act as constraint in their ability to avail of banking limits.

 

Other issues affecting the market environment include weak credit infrastructure and late payment by large buyers. Factoring companies and banks face difficulties in procuring credit information of the buyers, and have to rely largely on self-assessment of these buyers where possible. Late payment has always been an impediment to supplier growth. Most MSMEs can hardly withstand the burden of late payments but still these firms usually extend credit beyond the agreed tenor to accommodate delayed payment, else they can end up losing the buyer’s business. Most of the major corporates, including large public-sector enterprises, follow a monthly payment cycle irrespective of the invoice due date. The business orientation of large industries often affects the MSMEs directly, in turn hampering the recycling of funds and business operation of MSME units. 

Market Performance and Supply

CASH flow is often the biggest worry for any company, and small and medium enterprise (SMEs) seem to bear the burden when servicing big customers. Long payment periods which can stretch for up to 60-90 days from delivery and the reluctance of banks to extend them credit can lead to a perilous dance between black and red.

SME owners facing this struggle and concerned about the working capital and the survival of the company-funding the day-to-day operations or taking on a big order from a customer all require cash flow. But there is financial product that can ease these cash flow worries. Called “factoring,’ it is a practice in which companies can sell their accounts receivables or invoices to third party at a discount for immediate cash advance.

Letter of credit market share as a trade financing tool is less than 10 per cent of the total country exports, leaving a huge opportunity for open account trade finance. In Bangladesh, factoring is still to pick up pace, even though it has been around for more than two decades.

Factoring companies in Bangladesh do offer several types of services depending upon client needs, including recourse, domestic and international factoring, and disclosed and undisclosed factoring. Most deals done in Bangladesh are with recourse to the corporate, since the factoring company and bank are not able to cover the credit risk on the buyer. This is mainly because credit insurance is not allowed, as per regulations in Bangladesh for factoring. Thus, there is a need to build a suitable institutional infrastructure which will not only enable an efficient and cost-effective factoring and reverse factoring process to be put in place, but also ensure sufficient liquidity is created for all stakeholders through an active secondary market for the same.

Future Trends

There have been various measures undertaken recently in trying to address the challenges faced by the factoring industry, and increase the scope for factoring across the country.

As a factoring professional, I see synergies and opportunities to help SMEs in a new, flexible way, giving them better access to financing. Thus, few FIs & Banks in Bangladesh was spawned as a peer-to peer invoice trading for SMEs to discount.

Factoring remains relatively unknown amongst SME owners and spreading the word has proven to be a challenge. Many business owners are too reticent to admit they would need such funding, worried that bankers and financers would turn them away when they do face an actual financial crunch. Instead, the first thing they think of when trying to raise cash is to get a loan.

We want to create greater awareness that “there is a more flexible and targeted way for SMEs to solve cash flow needs via invoice financing and advance payment up to 80%-90%, which IPDC can provide.”

IPDC provide the flexibility to decide the actual invoice, the amount and duration, as well specifically target the cash flow gap SMEs are experiencing. SMEs which finance themselves using this financing tools “factoring” achieve better control in managing their cash flow and financing cost.

The good thing is that once they understand & use “factoring”, they realize that this could suit them better if they are looking for flexibility and business growth.

More flexible than other FIs/Banks

While banks have been providing factoring for years, they lack the flexibility that SMEs need and which IPDC can provide.

There are minimum charges as well, even if the business does not utilize or draw down on the facility, as well as other feed on top of the financing charges.

But IPDC is fully transparent-customers know exactly how much they are going to pay before they get funding, and it’s a pay-as-you-go system. We are much faster at disbursing the fund than other banks/FIs-our approval & sign-up process takes three days and customers get their funds within 1 hour after valid invoice submission.


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