MANAGEMENT AND FINANCING OF RECEIVABLES IN CONSTRUCTION INDUSTRY DURING TIMES OF POST CRISIS PERIOD THE FACTORING OPTION

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1 MANAGEMENT AND FINANCING OF RECEIVABLES IN CONSTRUCTION INDUSTRY DURING TIMES OF POST CRISIS PERIOD THE FACTORING OPTION Václav Vlasák Klíčová slova: Management pohledávek, factoringové financování, stavebnictví, rizikově vážená aktiva, Banky, small and medium size business Key words Receivables management, factoring financing, construction industry, risk weighted assets, banking, male a střední podniky Abstract It is already 4 years since first announcement of global crisis appeared in media. Lot of things happened and may be more things are changed and will never be the same as before The most striked industry is building and construction. Oversized prices of real estate caused quick growth of inputs and services in construction industry. Now as the real estate bubble is over, companies in real estate business are very hardly surviving. Industry is troubled by almost zero margins, further pressure on prices, demand on delayed payments and overall aversion of private individuals and corporate to invest in such a long term assets. Modern construction is narrowly connected to external financing either in form of bank working capital loans, investment loans or mortgages in case of private individuals. The objective of this study is to show, how working capital bank loan can be switched into factoring management of receivables. Banks play most important role in financing of construction companies and construction projects. Banks carry troubled assets since the times of real estate boom. Financiers are to follow contemporary lending rules expressed in the ratio of capital to risk assets. Banks must hold more capital to all credits granted. The riskier the asset, the more capital the bank has to hold to cover the potential losses. Banks cut the risk weighted assets by selling them, just to avoid profit and dividend shortage. In such an environment, financial institutions are to find alternative options to meet the 9% of capital held against risky assets. Banks are to find alternatives in risk transfer for assets clean-up, where factoring is one of possible options. Introduction Factoring is a complete financial package that combines working capital financing, credit risk protection, accounts receivable bookkeeping and collection services (Soufani, 2002). Factoring as a type of financial instrument was known already few thousand years ago. People of Mesopotamian culture used 4000 years ago factoring as a sort of pre cashing of their deliveries. Also most developed ancient part of world Rome Empire used factoring in a way of selling promissory notes at a discount. (Best invoice factoring, 2009). Unlike other main form of assets based lending, receivables are purchased by the factor, rather than used as a collateral in a loan. Title and ownership shifts from seller to the factor.(bakker, 2004). Factoring is convenient for small and medium size enterprizes, as a option to working capital loans credited by banks. Alternative risk transfer facilitates approach to money for high risky transactions and companies, as risk is shifted on creditworthiness of debtors (Banks, 2004). Factoring helps, when risk is spread between wider portfolio of customers, who are more crediworthy than seller. Companies in insolvency or bankruptcy can still go on with factoring 373

2 receivables, as receivables are sold to factor the seller has money for further activity, factor has valuable receivables for encashment.(bakker, 2004). The risk of transaction for the creditor is lower when creditor is familiar with financial stading of customer typically for banks, where seller and the customer are both bank s clients. Construction companies usually do not demand factoring financing, as invoicing is very seasonal, cash flow needs are spread through the whole 12 month of a year. Outstanding receivables do directly estreat the season, or with one month delay of invoicing period. 1. Contemporary outlook on construction industry Banks require higher proportion of equity in comparison with total debt in case of balance sheet financing. Reason is in lower risk, when equity is higher. As well as low risky finacing structures consumes lower portion of risk weighted assets, and makes transaction more profitable. Well performing companies are getting into troubles due to further decreasing demand for new projects, where contracts in neighbour countries don t bring much prospect. Builders are to submit for zero or loss making business, just in order to survive contracts on 120 day payment term for state authorities describe, how desperate certain companies are. As outlook on construction is not perfect, creditors are trying to mitigate and lower the risk of transactions with construction companies. Well established players have better approach to external financing than smaller ones, just because of long term cooperation, higher ability to cover complex construction projects and higher equity ratio. In fact, few big names in construction tend to be an administrator of complex construction project, where the building operations are divided into smaller parts. This is challenge for small and medium size builders, who can compete for sectional construction work. Big name wins a tender for large construction site, already having the aim to split the work into smaller pieces and subcontract the work on the site. This brings opportunity for small companies together bigger need for working capital financing, as payment periods are important factors for gain of subcontract. Schema 1 Tender and division of construction contract Complex construction site contract annouced by state or investor Payments Contract Winner of tender Big construction corporate Project administrator Contract, payments Subcontractor Small, medium size business Construction, invoicing Contract, payments Subcontractor Small medium size business Source: Author s own work 374

3 2. Factoring service and its attributes Factoring is a financial service based on assignment and financing of receivables which are not due. This service combines working capital financing, assessing customer s credit risk, payment collection and operations connected with bookkeeping. It is a very common source of financial help mainly for small and medium enterprises, especially among developed countries. Factoring transaction is three party agreement, where supplier gets advance payment for invoice on delivered goods. As receivable is sold on to factor or bank, debtor has to settle receivable on factor s account. Supplier is to bear risk of non payment in case of recourse factoring in case debtor does not settle the receivable, factor has the option to assign, recourse, receivable back on supplier. On the contrary, factor buys receivable in non recourse factoring without any chance to demand the money on supplier. Factoring benefits everyone indirectly by being something that encourages business and spurs economic growth (Ravas David, 2010). As factoring is not credit, but asset based lending, acts as very common source of financial help from the financing company. Company sells or assigns this part of assets and gets cash in form of advanced payment, in general 80% of receivable value. The remaining 20 % seller gets, as debtor settles money on the factor s account. Money gained can be immediately used for further needs in company s day to day business. Schema 2 Factoring transaction Factoring business transaction Supplier, Producer 1) Delivery of goods 2) Invoice 6) Additional payment - 20% Debtor, Business partner 3) Assignment of receivable 4) Advance payment - 80 % 5) Payment for goods -100% invoice value Factor (ev. Bank) Source: Author s own work Recourse factoring is based on factor s possibility to demand on client back the advanced payments for receivable, as the debtor is either not willing or could not settle the receivable onto factor s account.. Financing with recourse demands more of client s creditworthiness as in case factor recourse back higher amount, some clients could easily get into troubles. Factoring without recourse stands for assignment of receivable without client s responsiveness for debtors insolvency, with exception of legal dispute or claim for not 375

4 correct delivery of goods or services. Factor could either buy receivable just on decision on very good financial performance of debtor or use credit insurance company, who settles the limit for transaction with specific customer and insures receivables up to % of nominal value. In case factoring company uses non- recourse factoring with insurance, and the debtor is either not willing or unable to pay, credit insurance company settles after certain period of time, usually up to 1 year, the % of receivables value on to factors account, as factor was insurer and insuree. In case factor decides to do non- recourse factoring just on good credit risk statement of certain debtor, and the debtor fails to pay, factor is to bear the costs connected with defaulted receivable and have to depreciate this amount simply as a loss. Geographical pattern is of important parameters when doing decision about factoring financing. Homeland, also called import factoring or foreign, in financial language term export factoring, both serve as instrument for receivables financing. Homeland, import factoring is based on three party relation, where factor signs factoring agreement with supplier of goods, supplier delivers good, issues invoice as a paper form of receivable and assigns receivable on to factor. Debtor is either announced about assignment or not. All in all has the debtor pay on to certain account, in fact in ownership, or in a full controllership of factoring company, even though seller could declare account number as property of himself. For transactions with foreign customers few possible ways are to be chosen. One option is in same relation schema like import factoring is, just only debtor stems from foreign land, but factor and supplier are of the same geographically pertinence. Other, in these days very massively enforced kind is so called two factor system or export factoring schema. Two factor system, base its functioning on two factoring companies, one operating in the land of seller and second operating in the land of debtor. Seller and factoring company in land A sign factoring agreement, seller provide debtor in land B with goods. In this instance debtor is not going to settle its liabilities on account of factor in land A but contrary, on the account of factoring entity in land B, as both factors are connected either via ownership, specific contract, groups established for reason to do two factor system. Main task of two factor system, sometimes called back to back factoring, is to facilitate credit risk decision on business partners coming from foreign countries. 376

5 Table 1 Attributes of factoring and credit financing Factoring Credit Asset based lending Asset based lending/creditworthiness lending Performing cash flow Well performing cash flow Most important are receivables towards debtors, who are financially strong and have good payment moral Indebtedness does not rise Drawing any time(when receivable is isuued) Only certain receivables are accepted for assignment (depends on creditworthiness of subdebtors -customers) Amount of money depends on amount of receivables No additional collateral needed (except blank Promissory note ) Source. Author s own work Hard or tangible assets real estate, equipment, machinery, company s equity Indebtedness rise Drawing in specified periods (14 days, 1 month, etc.) All receivables are accepted as pledge Amount of money is restricted by credit limit set by bank Collateral needed Real estate pledge, business share + promissory note 3. Czech factoring market Factoring market in Czech Republic has long term tradition. Market has experienced fast and strong growth in past ten years. Volume of assigned receivables and trend is strictly bound to general economic well being. The 2012 development directly or with small delay do copy the economic growth and total output of Czech economy. Market consist of small as well as large provided serving hundreds of clients. Dominant role play daughter companies of biggest Czech banks, where share of bank connected factors counts for 98% of Czech factoring market. Market shares in factoring more or less copy shares of mother Banks in the Czech Republic banking scene. Big factor has wide products scale and service in factoring industry, small factor could not really compete with big ones, as portion of potential client s stems from the Banks portfolio. Bank is more easy to acquire large portfolio of prospective factoring customers that the small financial players. 377

6 Graph 1 Development of Czech factoring market turnover in past 12 years - in Billion EURO Source: Czech factoring association, 2012 figures estimated on 1-8/2012 results Hypothesis Paper predict banks are to switch credit working capital facility to factoring financing in cases, where construction companies have lack of cash flow and financial standing company is not enabling bank to credit the construction company. Factoring can go on with management and financing of receivables, even if bank does not want to credit company any more. Asset clean up, where factoring cost less in terms of risk weighted assets cost, is for bank institution a good alternative. Alternative risk transfer enables way of how to supply company with money under less risk and lower total transaction costs for bank. Factoring management and financing of receivables is proper for enterprises with sufficient piecework contract repletion, when there are enough receivables to be used in factoring transaction. 4. Risk weighted assets and alternative risk transfer Alternative risk transfer consists of credit risk transfer from lender on to co-lenders, guarantors or sub-lenders. In fact bank partly or completely shift the exposure and the risk on third party in crediting procedure. Insurance companies as guarantors, creditworthy business partner as a sub-debtor or financially strong mother companies could help in rating procedure and this way facilitate the lending process.(vlasák, 2012) Factoring financing purports the risk transfer from lender to debtors. Company supplies to portfolio of debtors, who are creditworthy for bank. Factoring risk is stipulated in the probability risk of debtor s portfolio in the first place, financial health of supplier is not the most important, but can not be omitted. Default risk of portfolio is way lower than risk of one sole lender.(vlasák, 2012) 5. Case study switch of credit exposition into factoring financing Bank is to solve situation, where constructor is credited by bank. Working capital facility in form of short term 1 year revolving, that amounts 5 million Czech crowns. Constructor has lack of cash flow, what bank sees as a big threat in terms of principal repayment at maturity. Alternative risk transfer is here to help, consists of credit risk transfer from lender on to colenders, guarantors or sub-lenders. In fact bank partly or completely shift the exposure and the 378

7 risk on third party in crediting procedure. Insurance companies as guarantors, creditworthy business partner as a sub-debtor or financially strong mother companies could help in rating procedure and this way facilitate the lending process.(vlasák, 2012). In case factoring financing is available in bank, revolving facility is to be switched into factoring facility. Insolvency threat by construction company is high, when bank is to demand payback of principal at maturity. Gradual repayment is more feasible, as tension on cash flow is not so high. Demand for full amount repayment at maturity would lead to quick insolvency or bankruptcy. Continual step by step repayment facilitates further life of company and lowering current credit exposition of bank. Constructor is to apply for factoring financing, where transaction consists of creditworthy sublenders and piecework contracts, usually with month invoicing period. As first receivables are to assign, construction s company draws down 80 % of invoice. This 80 % is used one half for cash flow needs, and the other half goes to repayment of loan principal. First invoice amounts 1,2 million CZK, 80 % advance payment amounts for 1 million CZK. Out of this one million CZK, 500 thousand goes for principal repayment, the other half of advance payment to construction s company for cash needs. Invoicing goes further every month, continual principal repayment on dates set by Bank. The rest constructor use for cash flow needs. Table 2 Continual switch overview of credit line into factoring financing Switch of credit into factoring I.2012 IV.2012 VII.2012 X.2012 XII.2012 Cash for receivables ,5 Indebtness/ Engagement of creditor -5-4,5-3 -2,5-2 Contract invoicing 0 1,2 3,6 6 3 Source: Graph 2 Depicting of credit line switch into factoring financing Source: How to deal with new capital adequacy rules Clean up is a control method of correcting the portfolios in terms of financial accouting if all loans are correctly filed. It is one of the ways to meet the target - control, whether all 379

8 facilities are correctly entered into core systems. Extra collateralization doesn t have to be properly spelled and therefore enumeration of risk weighed assets could be higher, then they in fact are. Clean up is really important mainly for longer maturities and high exposures, where exact indemnity could save bank high portion of risk assets cost. Banks have the option to add extra capital to raise core Tier 1 ratio. Only few names out of European Banking branch did this scenario, having respect to bad Unicredit experience. Capital raise is most expensive out of all measures and does not yield confident merit. Rising capital quote means cut current profits and dividends, what shareholders do not expect definitely and do not want. Banks in crisis are more likely to make negative restatements to total assets, as they are ready to sell assets and booster capital to assets ratio (Junarsin 2011). High risky, no or very low collateralized facilities are biggest threat in risk weighted assets calculation. Bank could easily sell outstanding receivables stemming from worse portfolio. Assets sale could be done either separately, in package of few loans or complete portfolio. When you sell complete portfolio of loans to customers, other competitors are more willing to buy. Entire portfolio earns you quickly high amount of new customers, as the customers are the dominant cash generator for banks. Shorten the long money is way to have portfolios with better expectation of potential loss. The longer period bank grants money, the less probable the estimation of default is. When there is an option and the client is able to repay the loan in a shorter time, this could be on of the ways to cut the risk costs. Let thing the banker has certain amount of loan granted to medium size company. Year on year figures shows worsening rating. With very low rating, incomes for bank, as it has to hold more capital and cash relevant equivalents, sloped down. The banker has to find a solution, one out of many could be meeting to client. Banker says, your financials are not very positive, we would like to take your building into pledge to be better secured in order to be able to carry with banking business. If the client says yes, banker is happy as his business carries on, credit facility is better collateralized and banks spares portion of risk weighted assets cost. Change of risk weighting model is a tricky measure. You play a game and in the middle you see, that you will probably lose, so change the rules. Bank proposes the new risk model, which regulator approves. Change of model is not easy and is not the quickest solution, but brings primarily lookout to close future. Bankers admit, that more convincing procedure would be to use the former model and cut the risky assets to meet the 9% Tier 1 ratio as of June 2012 (Vaughan 2011). Cash coverage, or pledge on standing account bear no risk cost at all. Lending institution would be easy to cover the default just by transferring the money from one account just to another in one Bank. Most of the bank s clients are not cash rich and do use this collateral very rarely. By doing so, lending in the bank would not have much sense. Businesses do use banking financing mainly due to lack of cash. Solution in corporate finance - Alternative risk transfer Alternative risk transfer (ART) is complement to already mentioned procedure. ART Consists of credit risk transfer from lender on to co-lenders, guarantors or sub-lenders. In fact bank partly or completely shift the exposure and the risk on third party in crediting procedure. 380

9 Insurance companies as guarantors, creditworthy business partner as a sub-debtor or financially strong mother companies could help in rating procedure and this way facilitate the lending process. Typically trade finance and documentary business facilities are convenient for alternative risk transfer. Exporter does not have proper financial stability to cover the loan installments, therefore credit insurance company steps into business and guarantees the loan repayment. Letter of credit enables to cut the risk cost, as liable is not only supplier, but also the business partner, let us say, his bank. Bank guarantee in form bid bond could save large proportion of risky assets. Probability, when business wins the tender and does not conduct the work, is really low. Factoring financing purports the risk transfer from lender to debtors. Company supplies to portfolio of debtors, who are creditworthy for bank. Factoring risk is stipulated in the probability risk of debtor s portfolio in the first place, financial health of supplier is not the most important, but can not be omitted. Default risk of portfolio is way lower than risk of one sole lender. In case whole portfolio or certain debtors are not legible in terms of risk, insurance comes in place. Credit insurance company is to bear part of risk, consisted of potential debtor s insolvency or payment refusal. Factoring transaction with insurance company as a guarantor ensures high sureness about future incomes stemming from business. Factoring with insurance brings not only earnings, but also vastly cuts risk weighted assets costs for transaction. Alternative risk transfer products in trade finance, bank guarantees or factoring enables Bank to supply their clients with competitive product, that is better risk managed than conventional credit financing. In addition, alternative risk transfer facilities extend the available credit limits set by bank. Summary and Conlusion Study investigates on management and financing o receivables of construction companies. Present crisis showed, how complex and long the post crisis period is. Mainly in construction industry was hit most by the crisis itself and its subsequent impact. Small and medium size constructors are to deal with lower risk acceptance from banks. As a result, financial institutions demand back financing, which was credited in past years. Switching of credit lines into factoring of receivables proved to be beneficial for both sides of credit agreement. Alternative risk transfer spread the overall risk of constructor onto its valuable business partners. Constructor has suitable contracts, where receivables towards creditworthy customers can be used for assignment in factoring financing. Factoring helps in continual transit of credit line into receivables financing. Demanding principal repayment at maturity would cause quick insolvency, mainly for small and medium business constructors, who are strongly dependant on external financing and tenders from dominant construction companies. Paper proved successful gradual repayment of credit principal facilitated by synchronous drawn down of factoring financing. Factoring facility brings suitable solution for short term fluctuation in cash flow and creditworthy stability of small and medium size business. Short term maturity of receivables 381

10 financing is aiming at speedy improvement of constructor s cash flow and overall financial stability. In case factoring does not help, work out enforcement comes in place with all its consequences. Factoring as form of receivables financing is rarely used in constructions industry. Research proved limited suitability of factoring for complex construction projects, in contrast to enabling small and medium size business survive in tough market conditions in construction industry. Case study showed smooth switch over from cash flow onto asset based lending. Sources: [1] BANKS, Erik. Alternative risk transfer: Integrated risk Management through insurance, reinsurance and the capital markets. 2nd printing. John Wiley & Sons Ltd., West Sussex, England, ISBN [2] KIMBER, Andrew. Credit Risk: from transaction to portfolio management. 2nd printing. Elsevier Butterworth Heinemann, Oxford, ISBN [3] CULP, L. Christopher. Structured Finance and Insurance The art of managing capital and risk. 3 rd printing. John Wiley & Sons, Inc, New Jersey, ISBN [4] VLASÁK, Václav. Risk weighted assets in contemporary international finance, Proceedings of 3 rd International Joint Conference on Business Strategies on Global Markets, Trends in International Business 2012, June 28, 2012, University of Economics, Prague: Oeconomica Publishing House, ISBN [5] KRÁTKÝ, Zdeněk. The Financial analysis of the construction company, Diploma Thesis, Brzno: Masaryk University, [cit ]. Dostuponé z: [6] VAUGHAN, Liam. Financial Alchemy Foils Capital Rules as Banks Redefine Risk, Bloomberg Businessweek. [online]. [cit ]. Dostupné z: < published [ ] [7] BAKKER, R.H.Maire, Financing small and medium size enterprises with Factoring: Global growth in factoring and its potential in Easter Europe. [online]. [cit ]. A joint publication of the World Bank s Private and Financial Sector Development Department and the Development Economics Research Group, The World Bank, Poland, Warsaw office, Edition I, Warsaw 2004, ISBN Dostupné z: [8] BEST INVOICE FAKCTORING. The History of factoring. [online]. [cit ]. Dostupné z: < published [ ] [9] CEEC Research, KPMG Czech Republic, Ipsos Tambor. Quarterly Analysis of Czech Construction industry 1/2011. [online]. [cit ]. Dostupné z: published [ ] [10] BREALEY, Richard. Basel II: The route ahead or cul-de-sac. Journal of Applied Corporate Finance. 18 (4), p ISSN [11] JUNARSIN, Eddy. Capital ratios and risk taking of commercial banks in financial crisis period. European Journal of Social Sciences. Volume 21, Number 1 (2011), [online] [cit ]. ISSN

11 [12] MĚŠEC.CZ. Czech Factoring Association. Volunteer association of 8 Factoring companies in Czech Republic. [online]. Dostuponé z: Ing. Václav Vlasák Doktorand Vysoká škola ekonomická v Praze Nám. W. Churchilla 4, Praha 3 vlasak.vaclav@centrum.cz 383