Session 4: Financing Instruments for Internationalization of SMEs

Abstract The Role of Factoring for SMEs: Benefits and Challenges

Shigehiro Shinozaki, Financial Sector Specialist (SME Finance) Office of Regional Economic Integration Asian Development Bank, sshinozaki@adb.org
Factoring is generally interpreted as a short-term supplier financing scheme where companies sell their accounts receivable to the factor with or without recourse and in return receive cash-in-advance at a discount from the factor. It is referred to as domestic factoring when the seller and the buyer domicile in the same country and as international factoring when the seller (exporter) and the buyer (importer) are located in different countries. The factoring industry has grown rapidly around the world. Annual global turnover increased 22.3% in 2011 and reached two trillion euro according to the Factors Chain International (FCI). The factoring business is quite active in Europe (60.4% of global volume in 2011), but relatively inactive in Asia (25.2%). The leading factoring companies are mostly bank subsidiaries or bank divisions and dominated the global factoring market. In general, factoring enables companies to improve their business efficiency and risk management by (i) improving cash flow or providing working capital necessary for businesses in a flexible and timely way; (ii) not counting as a liability on the balance sheet but rather as an off-balance-sheet transaction; and (iii) transferring risk to the factor, resulting in a hedge against settlement risks. Basically, factoring companies do not see SMEs as an underwriting risk due to factorings nature of individual-transaction-based financing. Therefore, factoring is beneficial for start-ups, rapidly growing SMEs with weak credit history and no collateral, and SMEs in emerging economies with less developed commercial laws and regulations. Particularly, reverse factoring enables factoring companies to reduce information costs and finance even risky SMEs.1 International factoring complements trade finance for SMEs through guaranteeing (i) cross-border payment and settlement (credit protection), (ii) individual transactions (SMEs have no disadvantage), and (iii) non-letter-of-credit-based trade. This scheme enables SME exporters to increase business opportunities, rationalizing the process of supplier financing in terms of time and cost. International factoring also facilitates SMEs and new entrants to participate in trade in goods and services, and as a result promotes intra-regional trade in the Asian context. Nevertheless, the factoring industry has encountered challenges: (i) Limitations of the business model. Factoring is not a universal funding solution for enterprises. Due to its nature of short-term working capital financing for enterprises with constant sales to reliable buyers, factoring does not fit firms long-term funding and capital investment needs. Moreover, there are many non-factorable businesses with unpredictable processes such as construction. (ii) Lack of awareness and capable professionals. The awareness level of factoring is still low, especially in emerging economies. The shortage of factoring professionals will also cause the factoring industry to decline. It is crucial to enhance factoring literacy on both the supply and demand sides.
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In the reverse factoring scheme, the factor purchases all accounts receivable from suppliers of a single high-quality buyer, such as a creditworthy large company, and in return respective suppliers receive cash-in-advance at a discount from the factor. Before concluding factoring contracts, the factor collects credit information and calculates the credit risk only for high-quality buyers, which is less costly than traditional factoring. Because the credit risk is basically equal to the default risk of a high-quality buyer, reverse factoring is a promising financing tool for risky SMEs.

(iii) Data availability and financial infrastructure. FCI and the International Factors Group (IFG) have published annual country statistics on the factoring industry, which are based on surveys of their respective memberships. In the absence of publicly available data, the current statistics give only a partial picture of the factoring industry. The development of financial infrastructure such as a credit risk database is critically important for reducing the information cost for the factoring industry, not to mention the banking sector. (iv) Funding for business. Active factoring companies are mostly bank-oriented and their funding is largely dependent on banks. Meanwhile, there are independent factoring companies that encounter funding difficulties. (v) Regulatory framework. Because of the small number of factoring companies in Asia, the establishment of a regulatory framework for factoring companies, including licensing, will encourage new entrants into the factoring industry and support its overall growth. A well-organized regulatory environment will also supplement the lack of factoring data (e.g., statistics compiled by the regulator through monitoring reports). However, there are several questions on regulating factoring companies: Legal status of factoring business. If a commercial law regards factoring as buying and selling, the factor will not be a creditor and factored receivables will be a part of the factors property (bankruptcy remote for the seller). If factoring is regarded as a financial service, the factor will be a creditor and the legal framework will be necessary, especially in the case of default by the seller. Self-regulation. The legal framework for factoring has generally not been well established in emerging economies (e.g., Russia and India). Self-regulation and rules set by factoring groups and networks have been used to supervise the factoring industry in several countries.

(vi) International factoring. Only 13.6% of global factoring volume is international factoring (FCI). To make it more functional, the role of factoring networks such as FCI and IFG has been increasing under the two-factor system, where the expanded networks of factoring companies help match more export factors with import factors. At present, there is the general rule of international factoring (GRIF), which was developed by FCI and IFG, and covers key rules such as the assignment of receivables and the wire transfer of the payment under the two-factor system. However, there are some external conditions that differ by country such as financial and currency systems, taxation, the legal environment, and social and political conditions. Thus, standard-setting for international factoring may need to be proportionate to regional and country contexts and needs. Factoring is a growing business in the world and Asia is tracing the same path, though it is still small in scale. Ideally, factoring takes on a catalytic role in leading growth-oriented SMEs to the growth-andgraduation cycle of enterprises. To this end, the factoring industry may target growing SMEs to develop its niche market. In this regard, the factoring industry in Asia has dual potential. At the national level, domestic factoring as a part of diversified financing mechanisms will support growth-oriented SMEs to expand further given funding flexibility. At the global level, international factoring as a complement to trade finance will support SME exporters and promote intra-regional trade that serves global rebalancing. Increased trade in Asia is creating more business opportunities for the factoring industry. The majority of enterprises are SMEs in any country and their contribution to total exports is not so small. The more SMEs are internationalized, the more intra-regional trade is encouraged. The factoring industry is in part expected to promote SMEs internationalization in support of intra-regional trade. The more SMEs savings are mobilized through intra-regional trade, the more that global rebalancing is promoted. At the same time, the factoring industry can support financial inclusion in Asia.