Factoring is a growing industry.
According to the survey undertaken by the FCI, (FCI statistics) the world’s factoring volume over the last 7 years has grown at a compounded annual rate of 2.53% per annum from Euro 2.347 trillion in 2014 to Euro 2.726 trillion in 2020.
Factoring is now found in all continents. The biggest being Europe (Euro 1,845billion), followed by Asia Pacific (Euro 687 billion), South America (Euro 83.5 billion), North America (Euro 66.5 billion), Africa (Euro 25.5 billion) and Middle East (Euro 9.5 billion).
However, according to the study on the MSME financing gap undertaken by IFC in 2017, (IFC MSME financing gap) there are still unmet MSME financing needs of US5.7 trillion each year. As many MSMEs are unable to provide tangible security to support the financing, receivables, which form a substantial portion of their total assets, could be used to meet this financing gap.
But despite the potential of factoring, it is still viewed by many as a last resort and expensive facility, used by MSMEs who are in financial difficulty.
This negative perception has made it difficult to sell. Very often it is rejected outright by prospective clients without fully considering its features and benefits.
To overcome this negative perception, many factors market factoring under different names such as accounts receivable purchase, invoice financing, debtor finance, receivable services, receivable financing, cashflow financing, supply chain financing etc.
However, 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. As part of the package, the factor provides the advance (financing), credit protection (non-recourse factoring), sales ledgering, and collection services.
Common Misconceptions about Factoring
In view of its potential, many banks, financial institutions as well as fintechs would like to get a share of this market but still have reservations due to some commonly held misconceptions.
In the rest of this post we will address some of these common misconceptions.
- Factoring is expensive.
This misconception arises because there are the two types of charges in factoring. The service fee and the interest rate which look expensive when they are combined. Some factors and fintech companies combine the interest charge and the fee into a single monthly fee which appears expensive when compared to interest charge for a loan or an overdraft. However, on its own 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 receivable services.
The service fee is for these two services. The service fee for credit protection is comparable to the premium paid to a credit insurance company to be insured against buyer’s failure. The service fee is also for the collection and sales ledgering services provided by the factor.
- Factoring is high risk.
On the contrary, the risk is low. According to a white paper undertaken by European Union Federation of Factoring and Commercial Finance (EUF white paper) the loss given default of factoring is low.
The recent high profile receivable 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 contra and set off etc. However, these high-profile frauds mask the fact that there are many successful factoring companies which have been operating profitably for many years with low risks and losses.
Successful factors recognize the risks of and hence set up their operations with good mitigation controls. Their systems are embedded with many risk analytics to prevent fraud.
Furthermore, the domestic debtor risk can also be mitigated through credit insurance. While overseas debtor risk can be mitigated through credit insurance and an import factor who can assume the credit risk of the debtor.
In addition, factoring (which is well structured with other banking facilities) can enhance the bank’s security position as the proceed can be used to repay the overdue bills.
- Factoring is used by MSMEs only.
On the contrary. There are many large corporates which use factoring as well. The non-recourse factoring facility enables them to remove the receivable from their books, thereby improving their DSO (Days Sales Outstanding) and return on asset ratio. Large manufacturing companies can also use distributor or back-to-back factoring to support sales to their distributors with a weak credit standing.
- Factoring is a last resort facility.
Factoring is not a last resort facility. In fact, it is a first resort facility for MSMEs.
During their initial years of operation, many MSMEs do not have any collateral to support a banking facility. 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.
Also, unlike other facilities, factoring grows with sales as the amount of financing quantum is based on the receivables. Therefore, the more the client sells the more financing they can get. This has helped many MSMEs to 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 labor-intensive product, and it is also very cumbersome for clients
This is true historically, but by using new technology, it is now a seamless process. Some factors have digitalized their operation through new platforms that connect the factor, buyer, and seller. Onboarding of clients as well as submission of invoices are now done digitally.
In the case of reverse factoring, clients 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 clients expand their sales, not only domestically but overseas as well. Instead of selling based on features, successful salespeople convert features into benefits and needs, helping their client to discover the usefulness of this facility.
- Factoring is a loan.
This misconception is due to some agreements which are structured as financing. Factoring is the purchase of a receivable from the client and not a loan.
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 book. (Debt factoring under IFRS9)
In some countries purchase of debt enables the factor to take legal action against the debtor directly as the debt belongs to the factor.
Factoring appears to be risky and complicated, but with a better understanding, it is not as risky and complicated as it appears to be. It can be a profitable business with low risks.
In January, ICC Academy will launch a new course; Factoring, which will not only help you to uncover many misconceptions, but also enable you to market and operate factoring more confidently. The course covers the following areas:
- Fundamentals of factoring
- International factoring
- Reverse factoring
- Operational aspects
- Seller, buyer, import factor and credit insurance management
- Legal and accounting aspects
- Selling skills and risk mitigation
About the author
Lee Kheng Leong acquired his factoring knowledge through training attachments in the US and UK in 1975.
Upon his return he set up DBS factor and when DBS factors was absorbed into DBS Bank, he became the head of DBS regional factoring in 2001. He was involved in providing services to companies ranging from MSMEs to large corporates.
In 2012 he became the MD of Bibby Financial Services Singapore, a subsidiary of Bibby Financial of UK, the world’s largest independent factoring group.
In 2015 he became the Asia Chapter Director of FCI and he travelled widely in Asia to promote international factoring as well as to conduct training to factors in the emerging markets.
He is currently the Asia Pacific Representative of HPD Lendscape, the world’s leading digital factoring, SCF and asset based lending platform provider.