Factoring: demystifying a trillion-dollar industry

This article was written by Kheng Leong Lee, Asia Pacific Representative for HPD Lendscape, for the ICC Academy (an e-learning platform delivered by the International Chamber of Commerce) and serves as an introduction to the common misconceptions about factoring.

Factoring is a growing industry, and according to the survey undertaken by the FCI, the world’s annual turnover (total value of invoices) over the last 7 years has grown at a compounded annual rate of 2.53% per annum from €2.347 trillion in 2014 to €2.726 trillion in 2020.

Additionally, factoring can now be found in all continents - the biggest being Europe (€1,845 billion of factored invoices), followed by the Asia Pacific (€687 billion), South America (€83.5 billion), North America (€66.5 billion), Africa (€25.5 billion) and the Middle East (€ 9.5 billion).

However, according to the study on the Micro, Small and Medium Enterprises Financing Gap, undertaken by IFC in 2017, there are still unmet MSME financing needs of $5.7 trillion each year. as many MSMEs are unable to access financial services or are declined due to poor credit history. However, outstanding invoices form a substantial portion of their total assets and could be used as security in a factoring arrangement to meet this financing gap.

Regardless of the potential, factoring is still viewed by many as a last resort and expensive facility, used by businesses who are in financial difficulty. This negative perception has made it difficult to sell, and the facility has very often been rejected outright by prospective clients without fully considering its features and benefits.

To overcome this negative perception, many factors market and sell factoring under different names, such as accounts receivable purchase, invoice financing, debtor finance, receivable services, receivable financing, cash flow financing, supply chain financing etc. Good intentions aside, this has created more confusion about what exactly factoring is.

To be clear, factoring is the purchase of the receivable by the factor from the seller (purchase, pledge or equitable assignment are all methods by which the factor achieves the legal rights to the ultimate cash value of the invoice). As part of the factoring service, the factor provides the advance (financing), optional credit protection (non-recourse factoring), sales ledger administration, and collection services.

Common Misconceptions about Factoring

Given its potential, many banks, financial institutions and fintechs, would like to get a share of this market but still have reservations due to some commonly held misconceptions.

Factoring is expensive

This misconception arises because there are two principal types of charges in factoring, the service fee, and the interest charge for the amount advanced- which can look expensive when combined. Some factors and fintech companies combine the interest charge and the fee into a single monthly fee which appears expensive when compared to the interest charge for a loan or an overdraft. However, when viewed independently each charge is comparable to charges on similar services in other products.

The interest rate charged by the factor is for the advance and comparable to those charged by a bank on an unsecured working capital loan or overdraft. Unlike loans or overdrafts, the factor also provides credit protection or a non-recourse facility, as well as the collection and sales ledger management services. Service fees are to cover these additional services.

The service fee for credit protection is comparable to the premium paid to a credit insurance company to be insured against buyer failure. The service fee for the collections and sales ledger management services provided by the factor and is comparable to a business outsourcing this effort to reduce internal staff costs professional collection services reduces the days sales outstanding and optimises the cash flow and the risk of default.

Factoring is high risk

In reality, the risk is low. According to a white paper undertaken by the European Union Federation of Factoring and Commercial Finance, the loss given default of factoring is low.

The recent high profile receivables finance fraud cases in Asia may have given rise to concern that factoring is a very risky business, fraught with fraud and other risks such as disputes and uncollectable invoices. However, these high-profile frauds mask the fact that many successful factoring companies have been operating profitably for many years, and with low risks and losses.

Successful factors recognize the risks and ensure their processes have excellent risk mitigation controls and their systems having embedded risk analytics and other defensive mechanisms to prevent fraud.

Furthermore, the domestic debtor risk can also be mitigated through credit insurance and overseas debtor risk can be mitigated either using credit insurance or collaborating with an import factor - who can underwrite the credit risk of the debtor.

In addition, factoring (which is - often structured alongside banking facilities) can enhance the bank’s security position as the procedure can be used to repay the overdue bills.

Factoring is used by small businesses only

On the contrary, many large corporates use factoring. The non-recourse factoring facility enables them to remove the receivable from their books, thereby improving their DSO (Days Sales Outstanding) and return on assets ratio. Large manufacturing companies can also use distributor finance to support and stimulate sales to their resellers. It is worth noting that reverse factoring, also known as supply chain finance, can be used by large corporates to provide early-payment facilities to their suppliers.

Factoring is a last resort facility

In fact, it is a first resort facility for many growing businesses that seek working capital solutions.

During their initial years of operation, many businesses do not have the credit profile to support a banking facility and a large portion of their assets are in their receivables. Through factoring, they can convert the receivables into cash which provides them with much-needed working capital.

Additionally, unlike other facilities, factoring grows with the sales achieved by the business as the amount of financing based on the balance of receivables. Therefore, the more the business sells the more financing they may obtain. This has helped many small businesses grow into large corporates.

Here is an example from a large corporate in its initial years:

Demand was astounding right from the start, and Dell was able to fund his initial growth internally. (That’s one reason he’s become so rich today: He’s never had to share with a venture capital partner.) Later he got bank financing using his receivables as collateral, and before long Wall Street took notice. The company did a private placement through Goldman Sachs in October 1987 (right after the market crash), then raised $30 million in an initial public offering in 1988. Dell’s take: some $18 million. “ FORTUNE Monday, September 8, 1997. By Andrew Serwer  (Micheal Dell turns the PC World inside out)

Factoring is a labour-intensive product, and it is also very cumbersome for businesses that use it

Perhaps historically true, but now new technology can support seamless business processes and reduce administration while creating a simplified, intuitive customer experience. Some factors have digitalized their operation through new platforms that connect the factor, buyer, and seller. Onboarding of new clients, as well as submission of invoices and new debtors, is now done digitally.

In the case of reverse factoring (supply chain finance), suppliers just need to deliver goods and invoice the buyer. Once this is done, they will receive notification from the factor’s platform to their mobile devices to notify them that financing is available.

Factoring is a very difficult product to sell

This need not be the case as it is a very useful tool with many features that help businesses expand their sales, not only domestically but overseas as well. A successful salesperson can identify the needs of the business and help it discover the usefulness of this kind of facility in solving cashflow issues, providing certainty and fuelling growth

Factoring is a loan

In principle, with factoring, there is a transfer of the invoice from the user of the factoring facility to the factor.

Depending on the region, the legal framework would determine whether the receivable would be true sale, equitable assignment, pledge, or some other method of securing title over the asset.

Under the IFRS 9, the arrangement is considered a purchase of debt (if it is done on a non-recourse basis), which allows the factor to record it as an asset and not a loan, while enabling the client to remove the debt from their books. Ultimately, the factor is making sure they have first rights over the receivable.

Factoring will interfere with my customer relationship

Certainly, in a classic factoring arrangement, the factor will chase debtors for late payment of invoices. Many argue that having a third party doing this is a good thing for the business as it helps them avoid this point of friction. In addition, many factors will offer confidential facilities such that the debtors will never know of the existence of the factoring facility.

Factoring is impossible for certain sectors

Main-stream factors may well avoid certain sectors such as construction, due to the contractual uncertainty of the debt, or transportation, due to the risk of invoices not being paid by debtors wanting to offset them against monies owed to them by their supplier. However, there are many factors who specialise in non-traditional sectors and have developed industry-specific ways of supporting businesses within them.

 

Article written by:

Kheng Leon Lee
Asia Pacific Representative, HPD Lendscape

First appeared on: ICC Academy