The role of factoring: relevance to SMES

Introduction

Factoring companies often claim that they are an ideal financing option for small, young and fast-growing firms. Particular problems for firms may be experienced in the management of working capital. In an attempt to alleviate such problems many firms have sought alternative forms of finance by pledging an important element in their working capital, that of accounts receivable, i.e. factoring.

A second dynamic often quoted by factoring companies in favour of their particular relevance to SMEs is that related to their ability to address skills deficiencies and/or high opportunity costs faced by SMEs in pursuing effective credit management functions.

The importance, volume and structure of factoring differs markedly in different markets during various periods of time. Additional to the variances in market structure and size, the specifics of the various factoring products also differ markedly across different sectors.

The role of factoring

Further in article main types of factoring (fig. 1) and its feature are provided, benefits of each type are allocated and the main schemes of work are described.

Figure 1. Main types of factoring

Recourse factoring

Recourse factoring is a classic scheme of factoring deal:

1. The Supplier makes shipments to the Buyer on the condition of a delay in payment;

2. The Supplier transmits to Factor the shipping documents;

2. Within 3 banking days Factor pays the Supplier up to 90% of the value of goods shipped;

4. On the expiry of the grace period the Buyer transfers to Factor 100 % of the value of goods;

5. Out of the Buyer’s payment Factor deducts the costs of financing and commission and then transfers the remaining amount to the Supplier.

Benefits of this type of factoring for the Supplier are:

- A source of financing without providing collateral (additional working capital, avoiding money shortage);

- Increasing sales volume (competitive terms, broadening the range of products offered);

- Improving balance figures: decreasing accounts receivable without increasing of accounts payable.

Reverse factoring

Reverse factoring - for Buyers of goods and services, willing to:

- obtain or increase the delay of payment;

- decrease expenses;

- improve financing of suppliers;

- receive additional earnings;

Figure 2 shows us how Reverse factoring works.

Figure 2. Scheme of work on reverse factoring

Reverse factoring makes such benefits for Supplier as:

- Fill up working capital, increase sales volumes, improve balance figures;

- Decrease dependence from alterations of Buyer’s payment terms;

- Establish close and durable relation with the Buyer and sign with him long-term Supply Contracts according to the fixed schedule.

Non-recourse factoring

Non-recourse factoring gives to Supplier protection from credit risk. Factor accepts full debtor's risk and couldn't reassign back accounts receivable to Supplier except for cases when accounts receivable are declared invalid.

Non-recourse factoring includes full range of factoring services: financing, analysis of buyers, management of accounts receivables, collection of debts, full protection from credit risks.

Non-recourse factoring has some particular features:

- Supplier should has portfolio of debtors (more than 3-4);

- factoring commission is charged during the whole period of deferred payment and fixed additional period (in case of delay in payment from Debtor);

- deferred payment period usually doesn't exceed 120 days.

Import factoring

2-factor international scheme is risk mitigation scheme in international factoring operations with functions divided between two partner-factors.

Export factor’s functions: financing, accounts receivable management, Exporter’s financial standing assessment.

Import factor’s functions: credit risk insurance (non-payment insurance), timely payment control, Importer’s financial standing assessment.

Advantages of factoring for Exporter:

- Financing without pledge (replenishment of working capital, funds shortage cut-back);

- Increasing sales volume (competitive terms, broadening range of goods);

- Improving balance figures - decreasing accounts receivable without increasing accounts payable;

Advantages of factoring for Importer:

- More convenient payments terms (increased payment delay);

- Increase of purchasing ability;

- Planning repayment schedule;

- One creditor (while having many suppliers).

Export factoring

Export factoring is a complete financial package that combines export working capital financing, credit protection, foreign accounts receivable bookkeeping, and collection services.

A factoring house, or factor, is a bank or a specialized financial firm that performs financing through the purchase of invoices or accounts receivable. Export factoring is offered under an agreement between the factor and exporter, in which the factor purchases the exporter’s short-term foreign accounts receivable for cash at a discount from the face value, normally without recourse. The factor also assumes the risk on the ability of the foreign buyer to pay, and handles collections on the receivables. Thus, by virtually eliminating the risk of non-payment by foreign buyers, factoring allows the exporter to offer open account terms, improves liquidity position, and boosts competitiveness in the global marketplace. Factoring foreign accounts receivables can be a viable alternative to export credit insurance, long-term bank financing, expensive short-term bridge loans or other types of borrowing that create debt on the balance sheet [2].

Factoring is suited for continuous short-term export sales of consumer goods on open account terms.

It offers 100 percent protection against the foreign buyer’s inability to pay - no deductible or risk sharing. It is an option for small and medium-sized exporters, particularly during periods of rapid growth, because cash flow is preserved and the risk of non-payment is virtually eliminated. It is unsuitable for the new-to-export company as factors generally (a) do not take on a client for a one-time deal and (b) require access to a certain volume of the exporter’s yearly sales. It is generally a more expensive option that may erode a significant amount of an exporter’s margin. The advance rate is generally limited to 80 percent of invoices that are factored.

Export factoring best suited for an established exporter who wants:

- to have the flexibility to sell on open account terms,

- to avoid incurring any credit losses, or

- to outsource credit and collection functions.

Maturity factoring

Maturity factoring (guarantee factoring) gives Supplier opportunity to receive financing at the last day of deferring of payment and avoid delay in payment (fig. 3).

Figure 3. Scheme of work on maturity factoring

Advantages of maturity factoring for Supplier:

- guarantee of payment (avoiding money shortages);

- chance to plan your cash flows;

- full factoring service except advance financing;

- Supplier doesn't pay for factoring financing for the whole period of actual delay in payment (as in recourse factoring).

Electronic factoring

Electronic factoring is a possibility for clients to use electronic documents flow with application of digital signature for factoring services.

Electronic factoring can be adjusted to any of factoring products: recourse factoring, non-recourse factoring, reverse factoring, maturity factoring.

Electronic factoring gives clients the following opportunities:

- Simplify all stages of factoring service;

- Reduce time from supply of goods / services till the receipt of financing from factor from several days (under paper document flow) to several hours;

- Reduce costs for printing, delivery and storage of documents.

While using electronic factoring all stages of factoring operations are processed in on-line mode.

Accounts receivables

Use of commercial credit (deferred payment) usually causes for company a number of problems concerned with effective management of accounts receivables. Professional experience of factoring company gives their clients opportunity to gain from effective measures related of management of their accounts receivables:

- Evaluation of existing and new debtors and set up of financing limits for each debtor;

- Tracking of accurate payment from debtors;

- Collection of receivables;

- Protection form debtor’s non-payment.

Professional management of accounts receivables provides Client with:

- Better payment discipline of its debtors;

- Up-to-date information about accounts receivables status;

- Effective collection of overdue receivables;

- Positive history of cooperation with debtors on deferred payment terms;

- Optimization of staff and loan costs.

The question of ‘access’ to factoring

Factoring supports cash flow financing but as a composite product it does this through the integrated provision of:

- Finance - noted as costs being comparative with alternative forms of finance;

- Professional Credit Management Services - accessing a quality of professional service that would normally not reside within an SME and be prohibitively expensive to SMEs; and

- Credit Insurance - accessing this at effectively cheaper rates that an SME could do so through a direct application.

It means that factoring is argued as being relevant to SMEs - particularly over larger companies who would arguably have the internal resources to access professional credit management services, and credit protection.

Therefore, factoring (recourse / non-recourse) is more relevant to SMEs than it is for larger businesses. Conversely, invoice discounting (which is about finance rather than services) is more relevant to larger businesses than SMEs.

The question of ‘access’ to factoring also faces some problems:

- Risk Assessment;

- Security and Collateral;

- Legal Framework;

- Business Sectors;

- Size and Legal Form of Business;

- Costs of Factoring Finance;

- Costs of Factoring Services.

In each case SME’s are not discriminated against in any way against larger businesses. The only real barrier to access of factoring concerns the relevance of factoring to certain types of business / sector. Factoring is suitable for ‘sell and forget’ businesses / products. Factoring is not suitable for businesses / products which are characterized by stage or lumpy payment schedules, retentions. extended warranties or tie ins. This barrier to access is inherently related to the way factoring works i.e. the factoring product itself and as such cannot be addressed through any intervention without changing the ‘essence’ of what factoring is and how it works.

The question of access with respect to various demand side issues related to product understanding and image was also considered. Two key observations were made:

1) Factoring and how to use as a product is generally not well understood by SMEs, nor indeed by advisers to SMEs.

2) Factoring has a lingering perception of being finance of last resort and therefore may signal to buyers that their supplier is in financial difficulties. This is clearly related to point 1.

There are no apparent legal, fiscal or other government obstacles to factoring market development. The only two ‘economic barriers to growth’ observed are:

1) Prevailing Economic and Business Conditions

There is a clear link between availability of bank loans / overdrafts and the use of factoring - i.e. a squeeze by banks leads to more firms seeking alternative options, being factoring. On economic downturn, banks would generally seek to reduce their risk exposure through reducing business credit, and in such conditions, business could turn to factors.

However, it does not necessarily follow that factors will or can take all of this ‘new’ business. Of course, if businesses are increasingly failing, then the factor will consider this closely in its risk assessment procedures.

A similar argument can be made in times of relative economic vibrancy, where businesses have access to increased sales opportunities, but require increased credit facilities to service these orders. Today in the conditions of credit compression and insufficient capitalization banks may not be well placed to meet rapid and increasing demands for working capital through overdrafts. Therefore, under these conditions businesses might also be looking away from banks to alternative sources of finance that can service their needs in line with increased sales volumes.

Review

The Association of Factoring Companies (AFC) published statistics of activities of the Russian Factors following the results of 1 half-year 2016.

According to AFC estimates, turnover of the Russian factoring in January-June of the current year constituted 923 billion rubles that is 11% more, than for the same period of last year.

Among Factors the greatest shares in market turnover following the results of 1 half-year 2016 occupy VTB Factoring (25%), Promsvyazbank (18%), Alfa-Bank (12%), GPB-factoring (6%) and "FC Otkrytiye" Bank (5%) [4].

In 6 months 2016 the Russian Factors paid 665 billion rubles of financing to four thousand Russian supplier companies, processed 4,2 million deliveries to the address of 8,7 thousand buyers debtors. The number of active clients of participants of the market for the last 12 months decreased by 33%, debtors - for 39%.

The total factoring portfolio in the second quarter increased by 30 billion rubles and on 01.07.2016 constituted 239,5 billion rubles.

Shares of types of factoring in turnover of the market were distributed as follows: factoring with regress - 56%, factoring without regress - 32%, without financing - 11%, a share of the international factoring - 0,9%.

The forecast of dynamics of turnover of the Russian market of factoring in 2016 following the results of August poll grew to 17% in comparison with 2015 that corresponds to 2,15 trillion rub on turnover. Participants of the market expect seasonal increase in demand for factoring in the 4th quarter 2016 [3].

In the conclusion it should be noted that:

1) Whilst marked differences occur between different sectors, SMEs typically rely on external financing for more than 50% of their balance sheet value. Traditionally, this external finance has predominantly comprised bank loans and overdrafts. However, the incidence of asset based finance - including factoring - has been increasing rapidly over the past decade.

2) Factoring is not one homogenous product. Rather, it is a composite product offering a mix of finance, credit insurance and financial management services. The main three recognizable forms of factoring are classified as Recourse, Non-Recourse and Invoice Discounting [1].

3) Being a composite product, factoring is unique and does not have any exact substitutes for the whole offering. Of course, it does have substitutes for its constituent components - bank loans and overdrafts for the financial component - financial services companies or direct employment for the credit management component - and explicit commercial credit insurance for the credit protection component.

4) Overall, factoring is seen as highly competitive.

5) Factoring is a business to business service. But it is not suitable for all businesses as not all debts can be factored.

6) Factoring companies typically fall within one of three categories - banks, large industrial companies, or independent.

7) Factoring affords businesses access to finance based on their growth in sales, rather than bank loans and overdrafts which are normally available against an accumulation of tangible assets. As a growing small business, investment in sales is often more a priority than investment in fixed assets.

BIBLIOGRAPHY

1. Официальный сайт BRC Trading Ltd. [Электронный ресурс]. -М., 2016. URL: http: // www. brcglobalstandards. com/ Source: World Factoring Yearbook 2001, BRC Publishing

2. Официальный сайт International Trade Administration [Электронный ресурс]. - М., 2016. URL: http: // www. trade. gov/ Source: Trade Finance Guide

3. Официальный сайт Ассоциации факторинговых компаний [Электронный ресурс]. - М., 2016. http:// asfact. ru/

4 Финансовый информационный портал [Электронный ресурс]. - М., 2016. URL: http:// banki.ru