(The Factoring and Assignment of Receivables Bill, 2011 has at last made it to Parliament. The contents of the Bill is not yet available in the public domain. The Bill reportedly seeks to offer stamp duty exemption on sales of accounts receivables. This should give a push to factoring services in India.)
Financing of MSMEs remains a major policy concern. As the sector is characterised by information asymmetries and high processing costs, MSMEs often find it hard to access funds. In India, MSMEs manage their working capital requirements through internal resources such as loans from relatives and acquaintances and internal accruals or through external resources such as bank credit, short-term loans, bill finance, commercial papers and factoring of account receivables. Despite the availability of various means of working capital finance, MSMEs are unable to get credit, owing to various reasons, mainly for the lack of collateral and clear financial records. In such a scenario, factoring services have the potential to emerge as an important means for raising working capital. Factoring is also the most suited product for MSMEs since it does not require collateral.
Under factoring services, the service provider offers a range of financial services like receivables financing, sales ledger administration, accounts receivables collection and management, credit protection, and advisory services. Under a factoring agreement, there are usually three players— the factor (banks/NBFCs), the client (the seller of goods/services) and the debtor (the buyer of goods/ services). This arrangement of financing and receivables management suits well for the operation of MSMEs as they usually face severe resource constraints in managing collections and sales ledger.
Though introduced in April 1991 (factoring service was initially recommended by the 1988 Kalyansundaram committee report), the penetration of factoring services in India is very low. Factoring turnover in India in 2008 constituted merely 1.24% of total bank credit. Factoring services have a high potential to solve the working capital needs of MSMEs. Still, the concept hasn’t caught on in India, as both MSMEs and factor companies remain suspicious of each other.
Unaware of the utility of different factoring products MSMEs are usually suspicious of factoring. They are hesitant about disclosing commercial details to a third party and also apprehensive about the recovery procedures used by the factoring companies. Moreover, poor knowledge of the product also acts as a deterrent.
Most units also view factoring only as a financing mechanism and thus factoring services are usually compared with other lending products, which has prevented this mechanism from gaining popularity over traditional lending methods. MSMEs often find the cost of factoring services very high when they compare it with alternative bank finance products. Moreover, the narrow branch network of factoring companies also limits the access of MSMEs to factoring companies.
Factoring companies face several bumps in India. The absence of a consolidated legal framework with specific provisions covering all aspects of factoring transactions, legislative and regulatory hurdles like heavy stamp duty on assignment of debt, inadequate legal recourse for enforcement of claims by factors/clients, poor support infrastructure like credit availability and credit insurance are some of the problems faced by factoring services in India. Moreover, while banks can undertake factoring activities departmentally without prior RBI approval, NBFCs require prior RBI approval for doing factoring activities.
Factoring could be a highly advantageous service for MSMEs, given that it provides the benefit of instant availability of cash and eliminates the risk of default (in case of non-recourse factoring). Some major benefits that factoring services could provide to MSMEs are listed below:
Improved cash flow: MSMEs often face the twin challenge of delayed release of funds by their financiers and delayed payments on receivables by their customers. As a majority of the MSMEs, especially exporters, is highly dependent on large buyers, non-receipt of payments on time often leads to financial disruptions. Since factoring provides instant availability of cash on receivables, it resolves the funding problems of the MSMEs.
Elimination of default risk: Under ‘without recourse factoring’ services, the factoring company undertakes the credit risk, thereby eliminating the same for the MSMEs. This provides immense benefits to MSMEs as their sensitivity to default risk is very high.
Fixed assets freed up for collateralisation elsewhere: Given that factoring services generally do not require fixed assets as collateral against advances, these assets can then be used as collateral for other kinds of loans.
Resources freed up from sales ledger management: As factoring companies undertake collections and sales ledger management of their clients, MSMEs are able to save their resources and utilise them for other business needs such as marketing or business development.
Increased ability to extend open account terms to clients: Since extending open account terms of credit involves higher risk, MSMEs offer these terms only to long-standing reliable clients, in the absence of open-account receivables finance and adequate credit protection. However, with factoring, MSMEs can enjoy better cash flows and reduced default risks, which would enable them to offer open account terms of credit to their clients, which would in turn help their businesses to grow.
Recommendations
In order to help MSMEs adopt factoring services as a mode of financing, factor companies should endeavour to extend their reach by developing a large, well-connected network backed by state-of-the-art technology and devise appropriate marketing strategies.
Companies providing factoring services should provide accounts receivables management to their MSME clients so that they can reduce the collection cost and benefit from factoring. Industry associations and factoring companies can jointly organise workshops, seminars, and education & training sessions for MSMEs to improve awareness about factoring products. Taking examples from factoring setups like the NAFIN of Mexico or ?The Receivables Exchange? of the US, the government and the industry bodies can develop innovative factoring establishments conducive to Indian industrial environment.
The author is senior economist, Dun & Bradstreet India
