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Factoring - A Powerful Alternative Source of Working Capital for SMEs

Background

It is well understood that access to capital is the prime reason 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 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. The increasing challenges of

globalization faced by SMEs may be countered by 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 value of the receivables and not only on the firms credit

worthiness. Secondly, factoring is not a loan it is an advance on your outstanding invoices. Because

of this, factoring invoices is easy to obtain provided that you do business with reliable customer.

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 the preferred route of accessing working capital for SMEs and even mid-sized

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 to 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 Chinas

turnover !

How does it work?

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

2. You will notify your approved customers that you have assigned the receivables due from them tothe 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 customer (debtor)4. You send the invoice 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 customer (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, lesscharges.

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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 profitsby 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, and improve

profitability by around 15 per cent, and have a positive impact on the long-term health andsustainability of Indias SME sector. SMEs with large corporate customers have receivables of 90to

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 Indias 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. The key reason for this could be the fact that the SMEs

usually sell to larger companies and hence find it difficult to extract shorter payment terms. 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.

Purchase Raw Materials

Cash Cycle

Produce & Stock

Finished GoodsCollect cash from sales

Sell Finished Goods

CashConversionCycle= DaysSalesOutstanding +DaysInventoryOutstandingDaysPayableOutstanding

DaysSalesOutstanding = (Accounts Receivable / Total credit sales) X 365

DaysInventoryOutstanding = (Inventory/cost of goods sold) X 365

DaysPayableOutstanding = (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 30,000,0002) Total credit sales Rs 200,000,0003) Cost Of Goods Sold Rs 180,000,0004) Factoring cost @ 15 % p.a i.e 2.5 % for 90 days credit period = Rs 750,000/-

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5) Prepayment rate - 80%

In Rs 00s

Before AfterBalanceSheet

Cash 50,000 Add 8 0 % o f A/Rsoldless cost 282,500

Sundry debtors (A/R) 400,000 A/Rdecli nesbyam ou ntsold 100,000

Balance Receivable - 20% receivable of A/R sold 60,000

Inventory 400,000 400,000

S-Tadv anc es 150,000 150,000

TotalCurrentA ssets 1,000,000 992,500

Curre ntLiabilities(AccountPayable) 300,000 300,000

LTLiabilities 200,000 200,000

Shareho lde rsEquity 500,000 492,500

TotalLiabilitiesandShareh olde rEquity 1,000,000 992,000

DaysSalesO utsta ndin g 73 19

DaysInventory Turnover* 81 81

DaysAccount sPayableTurnover * 60 60

(* Assumption)

Aftersellingthereceivables,thecompany hasexcesscash

thatitcaninvestinoperations.Companieschoosingtomonetizetheiraccountsreceivable seemultiple

capitalefficienciessuch as:

ImprovedCashConversionCycle,inthiscas eby54days& reduced Days sales outstanding

Workingcapitalpreviouslytiedupformon ths ca n be no w plough ed ba ck into oper ations

Onceareceivable issold,thecash canbereinvestedinnewinventory,products,

employees,oranythingthatwillearn apositivereturnforthecompany. Often SMEs can reduce raw

material cost by paying for them early. Hence, if an SME can earn an operating profit of more than

15%, it makes sense to incur the factoring cost and redeploy the cash

Advantage over traditional lending

In the traditional lending model, SMEs would seek a cash-credit limit (CC) from. 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 yourcredit limit increases as your sales grow provided you have had a satisfactory record of

payments. So fast growing SMEs who would require more and more funding year on year-

factoring is an extremely beneficial.

2. Bank Finance often requires additional collateral in the form of mortgage whereas Factoringnormally 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, afactoring 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.

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