by In India, Factoring is subject to the Factoring Regulation Act, 2011 and the RBI Non-Banking Financial Company Factors (Reserve Bank) Directions, 2012. As per the extant laws only certain NBFCs (with atleast 50% of the assets and income representing assets and income from factoring business) or Banks and Gov. bodies can act as factors this resulted in a limited volume of factoring in India, and thus the insignificant global presence. As such the Factoring Regulation (Amendment) Bill, 2020 proposes to widen the scope to all NBFCs along with other proposals to increase factoring volumes in India.
For the Seller
- Reduces the risk of a Working Capital Deficit.
- Positive impact on the balance sheet providing more liquidity and solvency to the company.
- Protects from risk of bad-debt (except in ‘Recourse Factoring’
- Better Administration: The amount of time taken to monitor credit, manage collection and evaluate buyer’s credit worthiness gets saved.
Factoring in India is the selling or discounting of invoices (receivables) by a seller of goods and services, usually micro, small and medium enterprises (MSMEs) to a factoring company or bank. Ideally it should lead to an improvement in collection management, whereby the MSME derives the advantage of realising the receivables quickly against the standard waiting period, which is the usance period of the bill. Large corporates (the buyers) would pay these sellers well after the due dates as per their payment cycle.
These MSMEs play a vital role for the growth of Indian economy, contributing 45 per cent of the industrial output, 40 per cent of exports, 42 million in employment, creating one million jobs every year and producing more than 8000 products for the Indian and international markets. As a result, MSMEs are today exposed to greater opportunities for expansion and diversification across the sectors. The Indian market is growing rapidly and industry is making remarkable progress in various sectors, such as: manufacturing; precision engineering; food processing; pharmaceuticals; textile & garments; retail; IT; agriculture; and service sectors. MSMEs are finding increasing opportunities to enhance their business activities in these core sectors.
One of the key constraints impacting the MSMEs is inadequate finance, particularly working capital. In the case of MSMEs, the need for quick conversion of trade receivables an important component of current assets of their business entities into cash, assumes great importance, since the lack of opportunities affects their liquidity, and thereby their business, quite significantly. It has, however, been observed that, at present, not many avenues exist for these enterprises to convert their receivables before maturity except through availing of a bill finance facility from a bank. One of the principal instruments of working capital is trade finance, including bill discounting and factoring. It is estimated that only 10 per cent of the total receivables market is presently covered under the formal bill discounting mechanism in the financial system, while the rest is covered under conventional cash credit/overdraft arrangements with banks. The MSMEs’ smaller balance sheets and asset quality act as constraint in their ability to avail of banking limits.
Other issues affecting the market environment include weak credit infrastructure and late payment by large buyers. Factoring companies and banks face difficulties in procuring credit information of the buyers, and have to rely largely on self-assessment of these buyers where possible. Late payment has always been an impediment to supplier growth. Most MSMEs can hardly withstand the burden of late payments but still these firms usually extend credit beyond the agreed tenor to accommodate delayed payment, else they can end up losing the buyer’s business. Most of the major corporates, including large public sector enterprises, follow a monthly payment cycle irrespective of the invoice due date. The business orientation of large industries often affects the MSMEs directly, in turn hampering the recycling of funds and business operation of MSME units.
Market Performance and Supply
Letter of credit market share as a trade financing tool is less than 10 per cent of the total country exports, leaving a huge opportunity for open account trade finance. In India, factoring is still to pick up pace, even though it has been around for more than two decades. As per Factors Chain International statistics, 2014 factoring volumes in India stand at around only $5.2 billion, of which $4.2 billion is domestic trade.
Factoring companies in India do offer various types of services depending upon client needs, including recourse and non-recourse factoring, domestic and international factoring, and disclosed and undisclosed factoring. Most deals done in India are with recourse to the corporate, since the factoring company and bank are not able to cover the credit risk on the buyer. This is mainly because credit insurance is not allowed, as per regulations in India, for the purpose of factoring. Thus, there is a need to build a suitable institutional infrastructure which will not only enable an efficient and cost effective factoring and reverse factoring process to be put in place, but also ensure sufficient liquidity is created for all stakeholders through an active secondary market for the same.
In order to address this issue, the Reserve Bank of India (RBI) published a concept paper on ‘Micro, Small & Medium Enterprises (MSME) Factoring-Trade Receivables Exchange’ in 2014. It involved the setting up of an institutional mechanism for financing trade receivable known as a ‘Trade Receivables Discounting System’ (TReDS). The transactions processed under TReDS will be non-recourse to the sellers. TReDS will provide the platform to bring sellers, buyers, and financiers together for facilitating uploading, accepting, discounting, trading, and settlement of MSME invoices. Initially TReDS would facilitate the discounting of these factoring units by the financiers resulting in flow of funds to the MSMEs with final payment of the factoring bill being made by the corporate buyer to the financier on due date. Later on, TReDS would enable further discounting /re-discounting of the discounted factoring units by the financiers, thus resulting in assignment in favour of other financiers. The RBI is expected to release further information on the functioning of the exchange once the TReDS exchange operator is identified.
It is felt by many that things can be done to improve the market opinion and share of factoring in the country, such as: creation of greater awareness, especially among MSMEs, on the benefits of both domestic and export factoring; addressing the liquidity constraints facing factors; factors and regulators simplifying products and transactions; a review of why factoring companies are not allowed to avail of credit insurance; clarification on whether the exemption granted in the Factoring Regulation Act, 2011 overrides existing state stamp laws on assignment; and standardising seller balance sheet treatment with regard to non-recourse factoring.
Future Trends
There have been various measures undertaken recently in trying to address the challenges faced by the factoring industry, and increase the scope for factoring across the country. The Enactment of the Factoring Regulation Act, 2011, was done with the aim of regulating assignment of receivables in favour of factors, and delineating the rights and obligations of parties to assignment of receivables. Broad features of the act include: assignment of debts under factoring being exempted from stamp duty; assignment of debts being provided with legal recognition; and notice of assignment being made mandatory.
In addition to the launch of TReDS, the RBI has introduced factors as a new category of non-banking financial company (NBFC). It has also simplified the eligibility criteria with regard to principal business the NBFC Factor needs to ensure that financial assets in the factoring business constitute at least 50 per cent of its total assets, and that its income derived from factoring business is not less than 50 per cent of its gross income, as against 75 per cent previously. RBI rulings mean factors can now also access credit information from credit bureaus.
In order to facilitate factoring transactions for MSMEs, the government has approved establishment of a Credit Guarantee Fund For Factoring (CGFF), set at Rs. 500 crores. The credit guarantee for factoring has the advantage of motivating the factors to increase their lending to MSMEs against factored debts by partially sharing their risk, and leading to an increase in actual availability of credit to MSMEs.
Benefit for Corporates
Optimize the working capital by maintaining or extending days payable
If the buyer has a payment term of 30 days with a Micro Small or Medium Enterprise (MSME) then, a buyer can enable early payment to its supplier on TReDS by Factoring or Reverse factoring of invoice. The supplier gets the payment before the due date and the buyer further extends its days payable as per its agreement with the bank. This helps the corporates optimize their working capital availability and regularize their cash flow.
Alternate and efficient funding method for making vendor payments.
Through TReDS, the buyer enables early payment to the supplier without taking any borrowing limits on his books. Here the buyer only needs to confirm the trade transaction uploaded by the vendor on the portal while the vendor gets funding from the financial institution. The transaction is that of a purchase and sale of receivables between the financial institution and the vendor.
Bring down the cost of goods and services purchased
Cost is one of the major components in procuring goods and services from a vendor. Since a corporate helps its suppliers get payment against their invoices before the due date and regularize their cash flows through xchange, the buyer gets the power to negotiate better terms with the supplier while enjoying a more stable supplier base by facilitating their access to competitive financing.
Lower vendor administration costs
This entire transformation cuts processing costs, eliminate discrepancies and optimize the cash flow for smooth operations for large corporates.
