The Hindu Business Line : Don’t neglect factoring

These were the slew of questions that had been asked to me by one of my friends when I informed him regarding my plan to join afactoring company. And guess who asked these questions?

An economist of a premier public sector bank of India! It created an obvious confusion in my mind whether I should join the company or not.

But thanks to my preliminary research on factoring and my personal judgment that encouraged me to join the company and finally I joined the company. The main intention to write this article is to attract the attention of the Government, policy makers, economists, and academicians of India to take the concept of factoring seriously for sustainable progress in Indian foreign trade sector.

I am convinced that factoring is an excellent financial instrument to support both domestic and international trade and can do wonders for Indian economy if utilised properly.

A Friend in need…

Before defining factoring let me describe a simple event.“Would you please lend me Rs 5,000 now? I need it very urgently.” My friend Ramu, who is a farmer by profession, asked me.

“Well Ramu I can. But I am leaving for Mumbai within few days”…. and I need the money too.”

“Oh trust me man, I will return your money within 2-3 days as I will be getting my money from Debu by day after tomorrow.”

“ From Debu? You mean our college friend…. who is running a stationary shop in Berhampur? But are you sure that he will lend you? You know how miser he is!”

“Yes. But I am not borrowing from him. He has to pay me Rs 7,000 in exchanges for seven rice bags he bought from me. Two days ago I sent the rice bags to him in my friend’s lorry. Debu is coming to the village day after tomorrow and will pay me the money. See the receipt… ”

“Oh well that is good! Debu is a sincere man in terms of paying money…but why did not you sell it to other business-men who could have paid immediately?”

“Well I explored all the options and, in the end, I found that selling to Debu is the best option…and the transportation cost is also zero as I transported it on my friend’s lorry. Debu is also paying me Rs 100 more than I can get from anyone here in our village. And I don’t know anybody other than Debu in the town whom I can trust when it comes to timely payment.”

“Ok Ramu, I am running late…oh yes take the money…”

“ Thanks yaar. But where are you going?”

“Going to Berhampur to meet my uncle.

“Wonderful. Then why don’t you meet Debu and collect my money from him by showing this receipt. I will give him a call and tell him to give the money to you.”

“Ok Ramu, I doubt if I will be able to meet him. But give me the receipt and inform him …I will try my best.”

“Hey don’t worry friend, I will pay you Rs 200 as commission if meet Debu and collect the money.

Fortunately, that day I was able to meet Debu and collect the money. Then I returned Ramu his balance Rs 2000.

Was it a loan transaction?

No, in this incident the Rs 5000 I gave him was not a loan because I did not ask any valuable collateral as a matter of security. Technically, I had paid him merely on the basis of the receipt (account receivable) and trust.

Thus, in a way, I have purchased Ramu’s credit-worthy account receivables (i.e. the debt of Ramu’s buyer) and facilitated immediate cash-flow that he could use for his personal financial need. He could have also used this money for his business.

Then I came to Mumbai and joined the job. After the initial introductory training in my company, I realised that, inadvertently, I had already worked as a factor. Of course, it was an instance of a simple and old form of factoring. Normally, factors buy the credit-worthy account receivables of the clients at a discount (fee plus interest) and take the responsibility of collecting debts from the buyer.

In this case I bought my friend Ramu’s account receivables, of course at zero discount (I didn’t accept the Rs 200 Ramu had offered to me) because he was my close friend and also because it was a very simple and quick transaction process that did not require any follow-ups and complex procedures. This helped him get the immediate cash he wanted.

And, second, he was able to avoid paying the high interest rate he would have paid had he taken the loan from the village moneylender. In addition, a bank loan would not have been an easy and timely option for Ramu due to several procedural complexities and mandatory collateral requirements.

A friendly instrument

Factoring entities are not so friendly with their clients, who are in need of immediate cash to meet their business needs. The payment terms are in favour of buyers.

When viewed in larger contexts of domestic and international trade, one can see crucial role the factoring industry can play in accelerating the trade transactions of a nation.

Factoring is a trade finance instrument that addresses the risk of non-payment or late payment and increases seller’s rewards by ensuring immediate cash flow by shifting the risk to a third party (i.e. to the factor) and free up cash. It is a post-shipment financing tool, where the seller has to agree to wait minimum 60 days net for payment but prefers to get payment as soon as possible for immediate business growth. By selling its receivables the seller immediately gets 80-90 per cent of the receivables in cash.

Modern Factoring

The scope of global economic integration is expanding rapidly since last two centuries. International trade is the most important instrument of global economic integration.

Factoring is one of the oldest and most commonly used methods of receivable financing, and has evolved to be the most competitive option of the exporters (sellers) to provide flexible open account terms of payment to their overseas buyers.

Under factoring, the firms/exporters sell their credit-worthy accounts receivables at a discount (generally, equal to interest plus service fee) to a factoring company to raise immediate cash. The factor usually advances immediately around 80-90 per cent of the book debts assigned.

According to the terms of contract between exporter and importer, the importer directs his payment to the factor. In fact, a typical factoring mechanism is characterised by a division of labour between the exporter and the factoring company, whereby the former focuses on its core function, which is trade, and the latter assumes the risk of facilitating the smooth flow of funds between the trading parties.

This division of labour results in ‘specialisation’ in the function of all parties involved in the process and therefore injects more efficiency into it.

In a nutshell, modern factoring can be defined as a composite financial product package that combines working capital finance, credit protection, ledger management and collection services.

Factoring is primarily designed for the potential small and medium sector enterprises that are financially deprived and have less exposure and expertise in operating in the highly competitive international trade environment.

Factoring in India

Factoring is a recent but rapidly growing phenomenon in India. It is rapidly penetrating into the Indian trade finance sphere since it was introduced by the RBI in the early 1990s on the recommendation of the Kalyanasundaram Committee, with the primary objective of providing adequate and timely finance to the financially constrained SMEs that were going through sluggish expansion.

According to a World Bank report, India’s factoring activity grew by over 800 per cent between 1998 and 2003.

That clearly shows the growing demand of factoring finance in India. According to the Factors Chain International, Indian factoring grew by 176 per cent during 2002 to 2006.

Nevertheless, the factoring sector is lagging behind a little. While 3 lakh companies in 60 countries across the globe currently use factoring as a means of credit, there are only eight active factoring companies operating in India with as small as 0.32 per cent share of the total global factoring business (as of 2006, according to Factors Chain International).

Apart from this, it has been observed that out of 12 million SMEs, only around 3,000 SMEs have access to factoring.

This reflects that Indian factoring industry is growing far below its real potential. Finally, if we compare its growth (that is 800 per cent) with that of China and Taiwan, that increased by as high as 23,900 per cent and 1,500 per cent respectively during 1998-2003 (according to a World Bank study), we realise that we have to go a long way before catching up with these countries.

The slow pace of factoring growth in India as compared to other emerging economies like China and Taiwan has many reasons.

Apart from this, the Government agencies are not giving adequate attention to the spread and use of factoring. The Government must frame appropriate policies to provide stimulus to factoring activities in the country.

Factoring is a sunrise industry in India. The growth potential for factoring products is staggeringly high.

At present, in the light of continuous appreciation of the rupee and rising inflationary pressure, engendering an uncertainty over credit availability and cost of bank credit, factoring could play the role of a saviour for Indian traders to remain competitive in the global arena, both in the short run and the long run.

This will help accelerate the wheel of foreign trade and add considerable momentum to the process of globalisation.

(The author is an economist with Global Trade Finance Ltd.)

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