Factoring Business in India: Beyond Banking

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1 CORPORATE LAW RESEARCH GROUP Factoring Business in India: Beyond Banking CORPORATE IN-FOCUS A Note on Banking Business in India Note: This research report is a product of the research conducted at Corporate Law Research Group (CLRG), Faculty of Law, Dr. Shakuntala Misra National Rehabilitation University, Lucknow and does not correspond to the views of any other author, reporter or columnist. This research paper is intended towards academic uses only and does not offer professional advice or opinion.

2 1.] Factoring business- A brief Corporate Perspective Factoring is a transaction in which a business sells its accounts receivable, or invoices, to a third party commercial financial company, also known as a factor. This is done so that the business may receive cash more quickly than it would by waiting 30 to 60 days for a customer payment. Factoring is sometimes called accounts receivable financing. The origin of factoring goes back to the 14th century in England. Earlier factoring was limited to textile and garment industries but later spread across various industries and markets. Though Europe provides largest volumes globally, factoring in Asia has been growing rapidly in the last few years. The purpose factoring is to assign the account receivables to be able to: Instantly convert receivables into cash, that enables the companies to have funds to finance the day to day operations of the company, Helps in efficient collection of receivables and protection against bad debts, Outsourcing sales ledger administration and, Availing credit protection for receivables. In India, however, in the absence of legal framework regulating factoring for so long, it has played a limited role in business financing. India s factoring business in 2012 was around 3500 million Euros in domestic and 3650 million Euros in total as compared to a total of 21,32,231 million Euros worldwide. The Indian factoring volume has grown approx 38% from However, India s factoring stands at mere 0.17% vis-a-via worldwide factoring volume. Some of the challenges the factoring companies in India faced were: No specific law for the assignment of debt, No recovery forums available to the factoring NBFCs viz.drt or SARFAESI Act, Lack of access to information on the basis of credit worthiness and Assignment of debt involves heavy stamp duty cost. Some of these issues were addressed while the factoring regulation was coming into effect in There is a very slight difference between factoring and bill discounting. Bill discounting unlike factoring is always in recourse to a client whereas, factoring can be and can also be done without a client even. There are different types of factoring such as full factoring (without recourse factoring), recourse factoring, maturity factoring, advance factoring, invoice discounting, bulk factoring, agency and export factoring.

3 2.] Issues In-focus Over the years, the Indian economy has gone phases of transformation. After witnessing the Hindu rate of growth for the first three decades of post independence, the Indian economy got its first push with the first economic phase reform in 1980s while the second major push came in 1991, following liberalisation of the economy, which helped it to move towards a sustainable higher growth trajectory. India made a radical break in 1991 from its previous policies of inward orientation and started a process of opening up to foreign and trade investments. 01. Like the other emerging market economies of the world, the Indian economy is also facing certain challenges such as high inflation, less growth, slowing down of investment, current account deficit is above sustainable levels, high fiscal deficit, and exchange rate under pressure. While global slowdown is an important factor, domestic factors are no less important. An important point to note is that in the recent period growth has become broad-based, in many states of India, poverty has declined but financial inclusion has become a major concern. Going forward,there are some ongoing challenges likeproviding world class infra-structure for rapidly growing economy, particularly in power and telecom sectors, and macro- economic management involving fiscal reform and monetary policy in the context of the open economy. 02. In the years to come, it is expected that millions of people in India may move out of the agricultural sectors and jobs will have to be provided to them. Therefore, India needs to increase its manufacturing capacities, though in the recent past the growth of the manufacturing sector has outpaced the overall growth rate of the economy, at just 16% of the GDP, therefore the contribution of the manufacturing sector is below its potential. The National Manufacturing Policy announced by the government of India proposes to increase sectoral share of Manufacturing in GDP to 25% over a decade. 03. Notwithstanding the growth in number of branches opened by banks, still Indian banking sector has to reach the desired level of banking penetration and inclusion as observed in the most advanced and emerging economies. Regionally, north-eastern, eastern and central regions are more excluded in terms of banking penetration. The assessment and comparison with other economies brings need imparting dynamism in expanding the commercial banking system in terms of its size and number; need to focus on consolidation; need to relax barriers entering to improve the competition; and need for enhancing operational efficiency.

4 3.] Strategies In-focus 01. While the concept of factoring may be new to the business owners, factoring as means of financing has been there for centuries depending upon the availability of traditional bank financing there seems to be resurgence interest in factoring business. It is a way by how the businesses generate cash by selling out their receivables to the third party called factor. The advantage of this to business is that it gets cash from the sale immediately and need not to wait for the receivables to be collected. Factoring is different from bank financing as it solely looks to the accounts receivable as a security, whereas in addition to accounts receivable, bank financing considers other assets as collateral. The other assets typically considered by the banks are inventory, real property and equipments. Importantly, factoring is a sale of financial assets. 02. The life blood of any organisation is its cash flow therefore, it stands that irregular flow of finance can spell potential disaster to a company that fails to implement the systems and processes of necessary to maintain healthy flow of funds. Alternatively, many of them resort to debt or equity to generate necessary flow of funds. Considering small business contributes more than one third of the nation s GDP, 15% of the export market, it is clearly economically unviable for the SME sector to carry the responsibility of slow payers. In response, many SME operators are taking a leaf out of the UK market, and adopting alternative cash flow management measures to avoid the significant pitfalls of fund shortages. 03. Business growth requires a solid foundation and it is built on powerful risk management. Fortunately for SMEs, industries have been developed to manage the risks. These industries have developed processes, software and procedures that are accessible to all. 04. Many factoring facilities impose minimum balances. If sales cycle is lumpy, the situation may end up where paying fee/interest despite having no outstanding accounts payable. Set-up costs, handling fees, interest rate, relationship costs, all have to be considered as a whole. In closing, the use of factoring to obtain the cash needed to accommodate a firm s immediate cash needs to be allowed by the firm to maintain a smaller ongoing cash balance. By reducing the size of its cash balances, more money is made available for the firm s growth. It is useful to have a lot of accounts receivable with different credit terms to manage. However, proper care has to be taken at the nature of the business and the total costs that a factoring relationship can incur to determine if it is right for the business.

5 4.] Regulation In-focus 01. In order to revive the business and render liquidity specially to the small and medium enterprise, in the last session of Parliament the finance minister has tabled a pilot bill to bring the factors business in India under regulation. While the intention would have been to stimulate the growth of factoring business in India, but looking close to the bill does not enumerate so. It is a regulation bill, but the need is to promote factoring and not so much to regulate. 01. The Regulation of Factor (assignment of receivables) Bills, 2011, given the fact that several other important bills have taken years to ascend into the statute book, factoring bill has really been commendably quick to progress. Factoring business was a mushrooming business which needed to be regulated. Factoring is an idea that the RBI has been meaning to promote over decades, and there has not been any substantial pick up in factoring volumes over the years. It is exactly the model that RBI used while passing the Securitisation Act- with the idea to promote securitisation, under this act. 02. The government s efforts at promoting factoring date back to 1988 when the RBI appointed Kalyan sundaram Committee. RBI allowed banks to enter factoring by notification in However, some of the banks did respond by starting factoring companies- SBI factors, Canbank factors etc. were started. Factoring volumes in India have not been significant enough, and unlike other facets of NBFC activity, factoring business has not drawn foreign players to any appreciable extent, except recently when some foreign banks have begun factoring services. 03. While factoring might have picked up much, receivables financing has continued to grow with growth of the NBFC sector. As a part of asset-based financing toady NBFC sector views receivables as a part of tangible assets. Discounting is common as a mode of salesaid financing several software and hardware vendors provide the facility to instalment or deferred payments to their clients and in turn sell the receivables to finance companies.

6 All Rights Reserved CLRG Report Prepared at: Corporate Law Research Group Published on: 09 February 2015 (Monday) RESEARCH & ANALYSIS TEAM Chairman Research Advisor Research Coordinator Mr. Shail Shakya, Group Chairman, CLRG Mr. Prashant Singh, Senior Associate (Research), CLRG Ms. Vishakha Gupta, Senior Associate, CLRG Mr. PSS Bhargava, Senior Associate, CLRG Research Associates Ms. Shivali Misra, Associate, CLRG Mr. Sarvesh Sen, Associate, CLRG Ms. Saumya Prajapati, Associate, CLRG Ms. Nainshi Srivastava, Associate, CLRG Ms. Isha kabra, Associate, CLRG Ms. Kudrat Agrawal, Associate, CLRG Mr. Shubham Tripathi, Associate, CLRG Mr. Kartikeya Tiwari, Associate, CLRG For Queries: Website: