PROJECT TITLE: ANALYSIS OF USE OF FACTORING DG ENTERPRISE ACCESS TO FINANCE UNIT ETD/00/ FINAL REPORT GREATER LONDON ENTERPRISE LTD

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1 PROJECT TITLE: ANALYSIS OF USE OF FACTORING DG ENTERPRISE ACCESS TO FINANCE UNIT ETD/00/ FINAL REPORT GREATER LONDON ENTERPRISE LTD

2 CONTENTS PAGE NO. 1.Background to the Study Introduction Access to Finance by SMEs The Role of Factoring 4 2.Executive Summary & Recommendations 7 3.Study Objectives and Methodology Primary Study Objectives Study Methodology and Approach Desk Research Supply Side Survey - European Factoring Industry Demand Side Survey European SME Associations 15 4.How Relevant is Factoring for SMEs? What is Factoring? Definition of Factoring Process and Products Recourse and Non-Recourse Factoring Invoice Discounting Other Factoring Related Products What is the Incidence of Factoring by SMEs? 22 5 HOW ACCESSIBLE IS FACTORING TO SMES? How do Factors Assess Risk? Security and Collateral Legal Framework for Factoring 33

3 5.4 Factoring for all Business Sectors? Factoring for all Types of Business? Size of Business by Turnover Legal Form of Business Trading History Costs of Factoring Finance Cost of Factoring services Image and Product Understanding 46 6.Structure of European Factoring Markets Factoring Products and Relative Importance Number of Factoring Companies Market Concentration Structure of Ownership of Factoring Companies Government Influence on Factoring 54 7.Size of European Factoring Markets Volume of Aggregated Factoring Turnover Factoring Relative to GDP Factoring Relative to Cashflow Financing Volume of Factoring Turnover Disaggregated by Product Volume of Factored Turnover Domestic / International Volume of Domestic Factoring by Product Volume of International Factoring by Product 63 8.Summary Conclusions 67 Annex 1: Annex 2: Supply Survey Respondent Organisations Contacts Supply Side Sample Survey Questionnaire

4 Annex 3: Annex 4: Annex 5: Demand Side Sample Survey Questionnaire Demand Survey Respondent Organisations Contacts Economic and Factoring Statistics

5 1. BACKGROUND TO THE STUDY 1.1 INTRODUCTION Greater London Enterprise (GLE) was commissioned in January 2002 by the European Commission (EC) Directorate General for Enterprise (DG Enterprise) to conduct a detailed analysis of the use of factoring within and across EU Member States. The EC has a defined long term strategy addressing different aspects of the leading issues around access to finance by enterprises, with a special focus related to access to finance by SMEs. This study, being undertaken on behalf of the Access to Finance Unit of DG Enterprise, forms an integral component of the EC s strategy to identify and stimulate access to finance for all European SMEs and more specifically, and possibly most importantly, access to, appropriate, finance. This study specifically investigates the incidence and appropriateness of the role of factoring in meeting European enterprise finance needs. 1.2 ACCESS TO FINANCE BY SMEs Whether due to supply or demand constraints, on average one in five SMEs in Europe considers access to finance as a barrier to growth. Clearly, stimulating a competitive financing environment for all companies is a key element in promoting an entrepreneurial economy and strengthening economic growth. SMEs can finance their activities from internal or external sources. As shown in Table 1.1, there are considerable differences between Member States in respect of the financial structure of SMEs between the share of own internal capital versus external financing. In some Member States (for example, in Germany and Austria) small businesses rely much less on own capital and more on readily available bank loans. In others (France, Belgium, Portugal) own capital financing is more prevalent. What is common though is that in most cases SMEs reuire external finance for business expansion be it loans, other types of debt, or euity

6 Table 1.1: Share of Own Capital in Total Balance Sheet by Enterprise Size Size by turnover Austria Belgium France Germany Italy Portugal Spain Less than 7m 13 % 40 % 34 % 14 % 26 % 31 % 42 % Between 7m and 40m 27 % 38 % 35 % 22 % 25 % 40 % 43 % 40m and more 31 % 39 % 35 % 31 % 28 % 51 % 37 % All sizes 28 % 39 % 35 % 30 % 27 % 42 % 38 % Source: The European Observatory for SMEs, Sixth Report Figure 1.1 below, generated from the Exco Grant & Thornton survey of European SMEs 2001, depicts the relative use by SMEs of various forms of external financing. It clearly shows the prevalence of overdrafts, bank loans and leasing as financing alternatives for SMEs. Figure 1.1: Use of External Financing by SMEs 60% 50% 46% 50% 40% 39% 30% 20% 10% 9% 9% 11% 0% External Investors Subventions Factoring Leasing Bank Loans Overdrafts Source: Exco Grant & Thornton survey of SMEs

7 As banks usually ask for collateral against their lending, (reflecting their conservative approach to risk), the availability of collateral is an essential factor in SMEs securing access to bank financing (overdrafts and loans). Banks will generally reuire either real estate or other tangible assets as collateral, or a guarantee from a person or an institution. Typically, SMEs use what collateral they have to secure start up business financing, and therefore may lack additional assets to secure against raising additional debt finance for short term and long term expansion. Overall, some 46 % of SMEs indicate that they use bank credit. Research evidence 1 exists showing that in countries where overdraft use is high, recourse to bank loans tends to be low (Italy, Greece, Denmark, United Kingdom). Further, a causal relationship is apparent in that, where access to bank credit is more difficult, payment periods and payment delays tend to be the longest (Italy, Greece, Portugal, Spain). Late payment of sales invoices is a key issue exacerbating the need for shortterm finance by SMEs. The average payment period for sales invoices across Member States is shown in Table 1.2 below. Table 1.2: Average Payment Period for Sales Invoices: Days (%) Country Av. Days >89 Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden UK EU Average Grant Thornton European Business Survey, See Commission Staff Working Paper, Enterprises Access to Finance, CEC

8 As shown above, payment terms vary considerably in Europe, although overall they have been reduced by 20% over the last decade to an average of 50 days. Variability is high, from 26 days in Finland and 31 days in Germany, up to 78 days in Italy and 83 days in Greece. Supplier credits are an important source of meeting the short term financing needs for SMEs, and between 20% and 50% of outstanding loan finance can consist of supplier credits. The use of supplier credit depends on the length of the payment period, on the availability of own funds, and on access to bank loans. For a considerable number of SMEs suppliers credits are more important source of working capital than bank loans. Supplier credit is generally conceived to be more expensive than bank loans and overdrafts, as often clients receive a discount in the case of immediate payment. However, as is often the case, companies with liuidity constraints have no choice except to opt for the more expensive solution, and absorb the negative impact on the business that these high costs bring. In this vein, the Exco Grant & Thornton European Business Survey 2002, noted that, on average across the EU, 15% of businesses reported lack of working capital as a constraint to short term expansion plans, and of finance that was available, 24% of businesses reported that the cost of this finance was prohibitive to short term expansion. 1.3 THE ROLE OF FACTORING Factoring companies often claim that they are an ideal financing option for small, young and fast-growing firms. As shown in the previous sub-section, many SMEs confront problems when attempting to gain access to external funding because of the difficulties faced by financial institutions in producing consistently reliable risk-assessment processes. Particular problems for firms may be experienced in the management of working capital. In an attempt to alleviate such problems many firms (See Figure 1.1) have sought alternative forms of finance by pledging an important element in their working capital, that of accounts receivable, i.e. factoring. A second dynamic often uoted by factoring companies in favour of their particular relevance to SMEs is that related to their ability to address skills deficiencies and/or high opportunity costs faced by SMEs in pursuing effective credit management functions

9 Despite impressive development in the factoring market, little academic work has actually been undertaken to establish the role of the factoring industry in small business development and the profile of businesses constituting its client base. This is as true for Europe, as it is for the USA and elsewhere. Similarly, national and international industry statistics and data for factoring are also relatively scarce, with only one reasonably comprehensive source, certainly for European countries, being the World Factoring Yearbook. This study has collaborated with the World Factoring Yearbook who advised on the design of the study survey uestionnaires to ensure that data collected under this study built on, rather than replicated, the existing levels of knowledge and data on the European factoring industry. Whilst data might be relatively scarce, factoring is clearly an important, and growing, source of business finance. For example, factoring and invoice discounting is estimated to contribute around 6% in additional finance to UK SMEs, compared with 6.5% provided through venture capital (British Chamber of Commerce, 1994; Cambridge Small Business Research Centre, 1995; Bank of England 1997, 1998, 1999). Furthermore, the UK Factors and Discounters Association (FDA) indicated that currently factoring and invoice discounting now accounts for more than 35% of the total cash flow financing reuirements of UK SMEs the balance comprising bank loans, bank overdrafts, retained profits and internal financing sources, leasing, external investment and this figure is expected to continue rising. The importance, volume and structure of factoring differs markedly between EU Member States. Figure 1.2 below shows aggregate factoring volumes by selected Member States for Compare the UK and Italy, both with a long established history in factoring, demonstrating high volumes and many players, with, for example, Greece, where the first factoring company established only in 1995, whilst growing rapidly, is doing so from an obviously very small base

10 Figure 1.2 Aggregate Volumes of Factoring by Member States (Million Euro) 140, , ,000 80,000 60,000 40,000 20,000 0 United Kingdom Italy France Germany Spain Sweden Ireland Denmark Greece Source: World Factoring Yearbook 2001, BCR Publishing Additional to the variances in market structure and size, the specifics of the various factoring products also differ markedly across Member States. This is because the roots of factoring products are based on and around specific and uniue national laws permitting the effective assignment of receivables. Therefore, this study is intended to provide a strong baseline investigation in the European factoring market. It builds on previous effort, presenting additional comparative data on the relative size, structure, market development, volumes, and profile of factoring across Europe. Specifically, it considers the supposition that factoring is highly appropriate for SMEs. Against all the above mentioned analysis we consider the possible role of policy interventions to correct, address, and/or stimulate access to factoring for SMEs in Europe

11 2. EXECUTIVE SUMMARY & RECOMMENDATIONS 1. The purpose of this paper is to investigate the incidence and role that factoring plays in the financing of SMEs across Europe. 2. Whilst marked differences occur between Member States, SMEs typically rely on external financing for more than 50% of their balance sheet value. Traditionally, this external finance has predominantly comprised bank loans and overdrafts. However, the incidence of asset based finance including factoring has been increasing rapidly over the past decade. 3. Factoring is not one homogenous product. Rather, it is a composite product offering a mix of finance, credit insurance and financial management services. The main three recognisable forms of factoring are classified as Recourse, Non-Recourse and Invoice Discounting. All three products are offered in each Member State, however, the volume of market mix by these three products is not at all consistent across Member States. 4. Being a composite product, factoring is uniue and does not have any exact substitutes for the whole offering. Of course, it does have substitutes for its constituent components bank loans and overdrafts for the financial component financial services companies or direct employment for the credit management component and explicit commercial credit insurance for the credit protection component. 5. Factoring charges separately for the financial and service components. On average, financial charges, calculated on an interest basis, typically range between 2-3% above bank base rates. 6. The service fee differs depending on the level and breadth of service offered, but average fees range between 0.5-2%. The service function typically offsets two areas of business costs employing a credit controller on the one hand, and in many cases ualifying for a suppliers discount for prompt payment. Overall, factoring is seen as highly competitive. 7. Factoring is a business to business service. It is not suitable for all businesses as not all debts can be factored

12 8. With the exception of merger based contraction in three markets, the number of factoring companies across Europe has increased by 55% over the past 10 years. However, the level of market concentration is typically high with only 1 or 2 firms on average accounting for 50% of market share by volume applying for each Member State. 9. Factoring companies typically fall within one of three categories banks, large industrial companies, or independent. However, the majority of factoring companies in Europe are owned by banks and in several markets, more recently banks are buying deeper into the factoring sector. 10. The total volume of factoring across Europe has grown by a massive 57% over (albeit from a relatively low base), with increases demonstrated in each Member State. In 2000, the total aggregate factoring volume for Member States stood at a not insignificant Euro 370,968 million. 11. Whilst factoring is used for financing international trade sales, the vast majority of business is concerned with domestic sales. 12. Factoring is specifically targeted and suitable for smaller businesses. On average, 50% of the total number of European factoring company clients have turnovers of less than Euro 2mn, 81% of less than Euro 5mn, and 91% of less than Euro 15mn. This view is shared by European SME Associations where all of those who reported under this study indicated without exception that factoring was a useful and useable source of finance. 13. Factoring affords businesses access to finance based on their growth in sales, rather than bank loans and overdrafts which are normally available against an accumulation of tangible assets. As a growing small business, investment in sales is often more a priority than investment in fixed assets. 14. Factoring appears to function in fairly competitive markets, with little reported impact on growth being attributable to legal, fiscal or regulatory issues. 15. Further, with banks taking factoring business more seriously, they are increasingly selling factoring products to their established clients in lieu of increasing overdraft limits. This can only increase the incidence of factoring across Europe. 16. Whilst it is not within the scope of this study to analyse the impact of Basel II on factoring, it is arguable that the impact of reforms to bank - 8 -

13 legislation as proposed under Basle II may lead to a sueeze on traditional bank lending to SMEs. With factoring companies measuring client risk on a completely different basis to banks, any contraction in bank lending to SMEs may well represent a realisable opportunity for factoring companies to take up this slack. 17. With no reported undue distortionary influences, continued growth in the European factoring market will continue according to prevailing economic and market forces. 18. The impressive growth in factoring business over the past decade is characterised as supply driven with more intensive market competition, leading to more informed and aggressive marketing to client SMEs. 19. However, on the demand side there appears several areas reuiring facilitated development if the market is to operate to its full potential. Specific demand side building measures would include: Raising Awareness of Professional SME Advisers Engaging with respective government SME departments to agree initiatives for raising professional awareness of factoring as a valid financing option by government SME agencies, and professional business advisers engaged by these agencies and other government service delivery organisations. Raising Awareness by SMEs Engaging with banks, professional advisory organisations, and SME representative organisations to agree a series of information and education awareness raising initiatives targeting companies understanding of factoring as a financing option. Professional Engagement of Finance Providers Engaging with banks to seek their views as to raising awareness of their staff, and seeking to develop more effective referral mechanisms to factoring companies / subsidiaries. Whilst nothing was reported under this study, it would still be useful to engage with banks and NBFI s to determine if public sector support is reuired to further develop the market financial (guarantees) or non-financial

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15 3. STUDY OBJECTIVES AND METHODOLOGY 3.1 PRIMARY STUDY OBJECTIVES The stated objectives of this study are recalled as: an initial analysis of the use of factoring in all the countries of the EU (only short term economic risk should be considered; neither long term nor political risk should be evaluated). Examine the conditions of access to the relevant instrument within the EU for SMEs, identifying costs and obstacles to access. Establish a link between the conditions of access and the potential level of use for the development and export capacity of SMEs. Draft a final report with recommendations for possible policy actions to be taken in order to stimulate the use of factoring in the EU. 3.2 STUDY METHODOLOGY AND APPROACH The primary methodology used for this study is confirmed as: Desk Research confirmation, collection and review of headline publications documenting activities of the European factoring industry. Supply Side Survey of the European Factoring Industry given the paucity of published data on European factoring markets, this study determined to conduct a primary survey of European factoring markets. This survey is the primary source of market data presented in this study. Demand Side Survey of European SME Representative Associations to balance the supply side survey and give insight into the level of understanding of factoring, and how it applies to SMEs, a survey uestionnaire was put to a large sample of European SME representative organisations

16 3.2.1 DESK RESEARCH Desk research concentrated on effective liaison with the following key organisations: World Factoring Yearbook Factors Chain International Europafactor EURADA Specifically, with each organisation the study team, Introduced the study objectives; Confirmed respective organisational support to the study; Confirmed and collected key documentation sources on factoring data and market information (which are extremely limited); Confirmed certain possible key contacts to serve as national factoring associations in several countries. Reviewed existing published factoring data and information. It was clear that sources of data on European Factoring markets are extremely limited. In fact, only the World Factoring Yearbook presents any common analysis and data. Therefore, the importance of this study s primary survey research was critical to generate added value information on market supply and demand factors SUPPLY SIDE SURVEY - EUROPEAN FACTORING INDUSTRY Relating to the definition of a survey methodology, and implementation of this survey, the supply side survey aimed at primary data collection from national factoring associations. Specifically the study,

17 Generated a sample frame of possible contacts prepared to serve as national factoring associations in each EU member state; Contacted, introduced the study, and confirmed support from representatives prepared to serve as national factoring associations in each EU member state; Based on information gaps, and reuirements of the study, drafted outline survey uestionnaire targeting data collection from national factoring associations ; Discussion with leading factoring industry figures on the structure, wording, and depth of the survey uestionnaire; Incorporation of comments received through above activity, and revision of the survey uestionnaire the uestionnaires being tailored to be individual country specific. Details of the lead factoring industry organisations in each Member State that were approached under the supply side survey are given in Annex 1. An example supply side survey uestionnaire is presented in Annex

18 Compiling and confirming the sample frame was particularly fraught for a number of reasons, as detailed below. Not all EU member states have formal national factoring associations, and fewer still have what might be termed proactively meaningful associations; Of those member states boasting a defined national factoring association, few of these were staffed with full time secretariats; The majority of defined national factoring associations hold limited published uantitative national factoring data, and rather engage in perhaps what might be termed general advocacy, co-ordination and general representation functions. In those countries where no formal association exists (such as the Netherlands, Ireland, Denmark and Greece) the approach was to make direct contact with senior management of leading factoring companies in these countries, reuesting their support in serving in the role as pseudo national factoring association. The supply side survey targeted all EU Member States, with the exception of Luxembourg, where given its highly immature factoring industry it was agreed with the EC that this Member State would not be a focus of the study and is therefore excluded from all subseuent analysis and commentary. Survey responses were achieved for all other Member States, with the following two exceptions: Netherlands no formal association exists. A number of management contacts within commercial factoring companies were approached but no support was confirmed. Portugal a formal association does exist, and repeated reuests for assistance were made of its Principal. However, there appears a strong reluctance to support the study, and as of now no new data for Portugal has been compiled

19 3.2.3 DEMAND SIDE SURVEY EUROPEAN SME REPRESENTATIVE ASSOCIATIONS As shown in the previous section, this study dedicated considerable resource to investigating and generating supply side statistics, analysis and views from the European factoring industry. As valuable as this supply side view is to the study, a demand side view is also important to ensure a balanced picture of market dynamics. Therefore, this study determined to approach a wide range of European SME representative associations and national chambers of commerce. A short demand side survey uestionnaire, reproduced in Annex 3, was drafted. Its aim was to confirm or otherwise some of the basic presumptions of the factoring industry that factoring is appropriate for smaller businesses. Details of those organisations that were approached under this survey are given in Annex 4. Demand side survey responses were achieved from eight organisations, indicating a reasonable 23% response rate; sufficient to present a demand side balance to the study analysis. The data generated through the supply and demand side survey s are the primary source for analysis for this report as presented in subseuent sections

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21 4. HOW RELEVANT IS FACTORING FOR SMES? The following two uestions are key to the focus of this study: How Relevant is Factoring to SMEs; and How Accessible is Factoring to SMEs This chapter tackles issues related to the first uestion of relevance. The uestion of accessibility is tackled in Chapter 5. As shown in Chapter 1, to greater or lessor degrees, all European SMEs rely heavily on access to external finance to run, and particularly to expand, their businesses. There are a range of external financing products available to SME s including bank loans and overdrafts, leasing, and venture capital. Factoring is an alternative route by which a business can increase its cashflow to fund expansions. However, factoring is the only method of external financing that reacts instantaneously to both increasing and decreasing sales alike. Further, factoring offers more than simply finance. Through matching finance with professional credit management services, and in some cases credit protection, factoring stands out as uniue from these other competing sources of external finance. 4.1 WHAT IS FACTORING? Factoring is a financial facility offering improved cashflow for client businesses. However, factoring is not one homogenous product. It is wise, then, to define what we mean by factoring. Perhaps this can be best described by defining what is a factor? A factor is a person that purchases a debt for a discount owed to another, in order to make a profit by collecting it. So, factoring is the sale and purchase of debts? This is true, however, it is the relationship between a factor and its client with specific regard to the embedded credit management services offered by the factor for collecting on these debts that really defines factoring

22 So, all factoring companies pay their clients for their invoices as they are issued. However, factoring companies also offer a range of professional services that might typically include: Collecting payments from their customers Pursuing late payers Providing advice to clients on credit management Protecting the client against bad debts This means that the benefits of factoring do not simply include an immediate cash payment. If the factor provides credit management services too, then there is also the prospect of an improvement in the speed at which debts are collected, giving a further positive impact on cashflow, and reduced interest charges. The headline costs and benefits of factoring are discussed in detail in Chapter 5. As shown below, the scope of these embedded credit management services define the various factoring products typically available in the marketplace. 4.2 DEFINITION OF FACTORING PROCESS AND PRODUCTS In structuring this study it was necessary to distinguish between and to define the various common types of factoring product. These are defined as: Recourse Factoring; Non-Recourse Factoring; and Invoice Discounting The factoring process associated with of the above products is presented diagrammatically and explained below

23 4.2.1 RECOURSE AND NON-RECOURSE FACTORING Recourse factoring involves a factor taking responsibility for their clients debt collections but retains the right to seek full recourse from the client for any bad debts. The client may buy credit insurance separately but no cover is provided by the factor. Non-recourse factoring offers the client full credit management service cover on approved debts against the eventuality of the factor being unable to secure full payment of factored invoices. However, the process for recourse and non- recourse factoring is the same, as highlighted in Figure 4.1. Figure 4.1 Process of Recourse and Non-Recourse Factoring Step 2 Debt assigned in with Factoring Agreement Step 1 Copy of Invoice FACTOR Step 2 Prepayment e.g. Step 4 Balance on Collection/Maturity Step 3 Collection Activity incl. statements, letters, telephone Step 3 Payment on Due Date CLIENT Step 1 Goods + Invoice CUSTOMER To clarify the various steps in the process shown above: Step 1 The Client ships goods with original invoice to the Customer. This invoice would normally instruct the Customer to pay the Factor (giving full payment details). At the same time, the Client sends a copy of the original invoice to the Factor

24 Step 2 On receipt of the copy invoice by the Factor the associated debt is assigned to the Factor in accordance with the Factoring Agreement. Simultaneously, the Factor makes available a credit line (normally of upto 80% of the invoice value) against which the Client can choose to immediately draw down a pre-payment (factors usually provide finance within one day of receiving the Client invoice). Step 3 The Customer pays the full invoice balance directly to the Factor on the due date. In case of overdue payment against an unchallenged invoice, the Factor initiates the process of credit collection from the Customer (details of typical services provided, and costs, are presented in Chapter 5). In the case of continued non-payment, it is normally the Factor who proceeds with legal action and foreclosure against the Customer. In case of Recourse Factoring, the Factor has recourse to the Client for any outstanding uncollected debt. Conversely, under non-recourse factoring the Factor assumes any loss (in some cases such loss may be protected through credit insurance held by the factor). Step 4 On payment by the Customer (or in case of late payment on an agreed date) of the full invoice amount, the Factor credits the balance (less the prepayment and fees) to the Client account. The Factoring Agreement with the Client is, in almost all cases, on a Whole Turnover Basis (rather than individual invoices), and as such, the factoring process is perpetual. This is an important point and means that factoring involves the Client selling its entire sales ledger to the Factor INVOICE DISCOUNTING In the case of recourse and non-recourse factoring, the involvement of the Factor is normally disclosed to the Customer. However, most invoice discounting agreements are managed on a confidential basis, where the Customer is unaware of the involvement of the Factor. The invoice discounting process is shown in Figure 4.2 below

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