Ref. Ares(2014)78096-15/01/2014 PROJECT TITLE: ANALYSIS OF USE OF FACTORING DG ENTERPRISE ACCESS TO FINANCE UNIT ETD/00/503408 FINAL REPORT GREATER LONDON ENTERPRISE LTD
CONTENTS PAGE NO. 1.Background to the Study 1 1.1 Introduction 1 1.2 Access to Finance by SMEs 1 1.3 The Role of Factoring 4 2.Executive Summary & Recommendations 7 3.Study Objectives and Methodology 11 3.1 Primary Study Objectives 11 3.2 Study Methodology and Approach 11 3.2.1 Desk Research 12 3.2.2 Supply Side Survey - European Factoring Industry 12 3.2.3 Demand Side Survey European SME Associations 15 4.How Relevant is Factoring for SMEs? 17 4.1 What is Factoring? 17 4.2 Definition of Factoring Process and Products 18 4.2.1 Recourse and Non-Recourse Factoring 19 4.2.2 Invoice Discounting 20 4.2.3 Other Factoring Related Products 21 4.3 What is the Incidence of Factoring by SMEs? 22 5 HOW ACCESSIBLE IS FACTORING TO SMES? 29 5.1 How do Factors Assess Risk? 29 5.2 Security and Collateral 33 5.3 Legal Framework for Factoring 33
5.4 Factoring for all Business Sectors? 35 5.5 Factoring for all Types of Business? 40 5.5.1 Size of Business by Turnover 40 5.5.2 Legal Form of Business 41 5.5.3 Trading History 42 5.6 Costs of Factoring Finance 42 5.7 Cost of Factoring services 44 5.8 Image and Product Understanding 46 6.Structure of European Factoring Markets 49 6.1 Factoring Products and Relative Importance 49 6.2 Number of Factoring Companies 49 6.3 Market Concentration 50 6.4 Structure of Ownership of Factoring Companies 52 6.5 Government Influence on Factoring 54 7.Size of European Factoring Markets 55 7.1 Volume of Aggregated Factoring Turnover 55 7.2 Factoring Relative to GDP 56 7.3 Factoring Relative to Cashflow Financing 58 7.4 Volume of Factoring Turnover Disaggregated by Product 58 7.5 Volume of Factored Turnover Domestic / International 59 7.6 Volume of Domestic Factoring by Product 63 7.7 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
Annex 3: Annex 4: Annex 5: Demand Side Sample Survey Questionnaire Demand Survey Respondent Organisations Contacts Economic and Factoring Statistics
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. - 1 -
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 2001-2 -
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 7-14 15-29 30-44 45-59 60-74 75-89 >89 Austria 31 20 30 27 8 3 4 2 Belgium 52 2 16 22 21 24 7 5 Denmark 30 11 41 37 4 1 1 1 Finland 26 18 51 22 5 1 1 1 France 58 7 8 17 13 26 14 10 Germany 31 21 34 26 8 4 2 2 Greece 83 4 4 11 6 9 16 46 Ireland 56 4 7 23 23 21 9 10 Italy 78 4 2 9 8 21 18 35 Luxembourg 47 9 15 27 9 14 7 6 Netherlands 43 6 22 29 18 16 3 3 Portugal 70 2 3 20 14 21 14 26 Spain 71 4 5 15 12 17 18 28 Sweden 36 4 23 56 9 4 1 0 UK 41 11 18 27 19 12 4 2 EU Average 50 11 18 22 11 13 8 13 Grant Thornton European Business Survey, 2002 1 See Commission Staff Working Paper, Enterprises Access to Finance, CEC 2001. - 3 -
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. - 4 -
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 2001. 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. - 5 -
Figure 1.2 Aggregate Volumes of Factoring by Member States (Million Euro) 140,000 120,000 100,000 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. - 6 -
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. - 7 -
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 1998-2000 (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 -
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. - 9 -
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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. - 11 -
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. 3.2.2 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, - 12 -
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 2. - 13 -
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. - 14 -
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. - 15 -
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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. - 17 -
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. - 18 -
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. - 19 -
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. 4.2.2 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. - 20 -
Thefactoreleasesupto 3. theinvoicevalue 80%of 7.Thefactoreleasesthe remaining20%totheclient Analysis of Use of Factoring ETD/00/503408 Final Report (February 2003) Figure 4.2 Process of Invoice Discounting 2. The client sends copy invoices (or sales ledger details) to the factor THE FACTOR THE CLIENT 6. The client pays the proceeds from the customer into a nominated trust account held to the discounter s order 1. The client sends their invoice to the customer 4. The client chases the customer directly 5. The client receives payment directly from the customer TRUST ACCOUNT THE CUSTOMER The process of invoice discounting follows almost exactly that of factoring as referred to in the previous section. However, as a confidential service, under invoice discounting the Client chases payment from the Customer directly where this payment is made to a nominated Trust Account held under control by the Factor. As demonstrated, invoice discounting is much more about access to finance, rather than factoring which is more about access to finance with professional services. This is reflected in the typical size of clients that are suitable for each service with invoice discounting more appropriate to medium and larger clients with resources enough to run a professional credit management function, and factoring, conversely, more appropriate to smaller firms. 4.2.3 OTHER FACTORING RELATED PRODUCTS The definitions given in 4.2.1 and 4.2.2 were used as base definitions in carrying out this study research thus ensuring a common understanding by study survey recipients across the EU. On the whole they were understood without uestion. However, two alternative, but related and similar products were also mentioned as being used some Member States: - 21 -
Discounted Bills of Exchange A bill of exchange is an unconditional order in writing addressed by one person (the supplier) to another (the buyer). It is signed by the person giving it (the supplier) reuiring the person to whom it is addressed (the buyer) to pay on demand (or perhaps at a fixed or determinable future time) a sum of money to a specified person. Once signed by both parties the bill is classified as having been accepted. Accepted bills may then be sold to another party for a discount so that they can collect it for a profit. This is exactly the same process as factoring, except that bills of exchange are used as the legal asset rather than the more common use of an invoice. Bill discounting is the common form of factoring in France where it estimated the some 80% of all trade is on bills of exchange (traites). In France the factoring industry offer a service including raising the bills and subseuently discounting the accepted bill. Confirming - This is a type of finance where a financial body confirm orders placed by buyer to the seller i.e. funding the purchase ledger rather than the sales ledger. The financial body guarantees payment to the seller whilst offering credit to the buyer. The system was originally used to provide comfort to exporters. It was further developed in the United Kingdom in the 1960 s by factoring companies to provide another service to their clients to enable them to expand. It was usually provided on the occasion when a factoring client received a large order it could not fund the factor provided funding and recovers it funds from the resultant factored debt. This system of helping clients was reduced when banks bought into factoring companies but it is still operated by some of the smaller independent factors in the UK and is offered as a service in Spain. Neither Bills of Exchange nor Confirming are substitutes for factoring. In the case of the former, it is simply factoring using bills rather than invoices as assets. In the case of the latter, Confirming is used for the financing purchases, rather than sales. 4.3 WHAT IS THE INCIDENCE OF FACTORING BY SMES? It is argued that factoring is a highly appropriate source of working capital finance for smaller businesses. The following rationale in support of this supposition is generally uoted: The cost of funds are competitive against alternative, typically bank overdraft, product charges; - 22 -
The availability of funds through factors is higher to smaller growing businesses than traditional sources (i.e. bank overdrafts) because factors consider the sales invoice as a secure asset, whereas banks typically look for fixed assets as security; Clients know and can plan for the actual value of charges made by factors, whereas, bank overdraft charges can be variable; Factors are able to process and pay against invoices considerably more uickly than the time taken to renegotiate any overdraft extension; and The credit management services offered by factors often provide an economic solution to smaller businesses who either do not have the relevant skills internally, or the opportunity cost of undertaking these functions are prohibitive. Conversely to some of the above rationale, factoring is generally not perceived to be of value to larger businesses for the following reasons: Above a certain size, businesses may be motivated and able to pay for the reuisite credit management skills; and Above a certain size, businesses may well be able to source comparatively cheaper sources of finance, through perhaps a stronger negotiation position with their bankers, or having more control of managing trade credits, or perhaps their increased ability to raise capital through external sources (including increasingly the use of corporate derivatives). In the supply side survey we asked factoring industry respondents to provide details of their client profile, through banding their clients by turnover. The results achieved are shown over: - 23 -
Table 4.1: Factoring Clients by Size of Client Turnover (Euro) Annual Client Turnover (Euro) 0-500,000 500,001-2,000,000 2,000,001-5,000,001 - >15,000,000 Total 5,000,000 15,000,000 Clients % Total Clients Clients % Total Clients Clients % Total Clients Clients % Total Clients Clients % Total Clients Clients % Total Clients Austria 100 20% 200 40% 150 30% 50 10% - 0% 500 100% Belgium - 85% - 10% - 3% - 1% - 1% - 100% Denmark 200 10% 400 20% 600 30% 600 30% 200 10% 2000 100% Finland - 5% - 15% - 22% - 23% - 35% - 100% France 50-75% 22-45% 3-5% 21,600 100% Ireland 20% 70% 10% 100% UK 11,600 40% 6,380 22% 7,830 27% 2,030 7% 1,160 4% 29,000 100% Source: GLE Study Survey Questionnaire 2002-24 -
A headline summary of Table 4.1 is shown in Table 4.1a. Table 4.1a Summary of Factoring Clients by Size of Client Turnover Client Turnover Less than 15mn Euro Client Turnover More than 15mn Euro Client with turnover to 2mn Client with turnover to 5mn Client with turnover to 15mn Clients with turnover >15mn Austria 60% 90% 100% 0% Belgium 95% 98% 99% 1% Denmark 30% 60% 90% 10% Finland 20% 42% 65% 35% France 63% 95% 95% 5% Ireland 20% 90% 90% 10% UK 62% 89% 96% 4% Average 50% 81% 91% 9% GLE Study Survey Questionnaire 2002-25 -
There are a number of observations to make from Tables 4.1 and 4.1a. Perhaps the most important is that, reasons aside, an average of 50% of factor clients have annual turnovers of less than Euro 2mn. This increases to 81% of factor clients with annual turnovers of less than Euro 5mn, and 91% of factor clients with annual turnovers of less than Euro 15mn. On average, only 9% of factor clients have turnovers greater than Euro 15mn reduced to only 4% if Finland, showing a disproportionately high number of clients, was removed. So, certainly in terms of performance, factoring is certainly catering for smaller businesses typically with annual turnovers of less than Euro 5mn. Four survey respondents indicated total numbers of actual factor clients by turnover bandwidths. This makes particularly interesting reading, and offers some rudimentary insight into the future potential for expansion of factoring services. We take the UK as an example: There are a reported 29,000 business clients using factoring services; The UK statistical service reports a total business stock of 1.664mn registered businesses in 2001, of which it is reasonable to estimate 90% of these are SMEs, which extrapolates as around 1.5mn; Extrapolating further from this, only 2% of UK registered SMEs currently use factoring services; The EU Access to Finance 2001 report predicts that 50% of UK SMEs use overdrafts, which translates as 750,000 businesses; Therefore, if factoring is seen as an alternative to overdrafts, and whilst not all firms will use, or be appropriate to using factoring services, there would seem a large potential gap to fill between the current 29,000 factoring clients, and the estimated 750,000 SMEs using overdraft facilities. When also considering that Austria only boasts a total of 500 factoring clients, and Denmark 2000 clients, it would seem reasonable to assume that there exists a large potential for growth in factoring business across the EU. The above reflections are based on a supply side industry view. What about the demand side small businesses themselves? In our demand side survey of European SME Representative Associations the overwhelming opinion was that factoring is a useful and useable source of finance for all SMEs. - 26 -
A total of 62.5% of demand side survey respondents believe that factoring represents a cheaper and/or at least similar cost option than alternative sources of finance (indicated as bank loans and overdrafts). - 27 -
However, the same respondents confirmed that in most instances whilst SMEs may be aware of factoring, it is hardly ever used. This raises the interesting uestion that if both the supply and demand side forces both recognise that factoring is relevant to SMEs, and that the costs of factoring are comparative to alternative sources of finance, why then is there a relatively low take up of factoring by SMEs? This uestion is explored below where the issues of access to factoring are considered. - 28 -
5 HOW ACCESSIBLE IS FACTORING TO SMES? In Chapter 4 issues related the relevance and incidence of factoring to SMEs were discussed. In this Chapter the focus is on issues related to the accessibility of factoring by SMEs. 5.1 HOW DO FACTORS ASSESS RISK? ICT innovations enabled banks to improve and change their risk assessment procedures dramatically. The development of a so-called rating culture will lead to more risk-sensitive pricing, focusing on enterprises individual risk. The process of introducing the regulatory banking framework, the so-called Basel II process, put the spotlight on these changes and accelerated the transition. A factor approach to client risk assessment is markedly different to that of bank lending. Banks lend money to clients, and whilst they may well take a debenture over the company with respect to their loan, they do not own the debt in the sense of being able to control the debt. Therefore, banks are primarily concerned about the ability of the client to make productive use of the debt to ensure a sufficient enough return to service the debt. In mitigation of repayment default by the client, banks usually seek to take collateral. Factors on the other hand do not lend money to clients. Factors take assignment over a client invoices or in effect purchase a clients debts for a discount. As explained in the previous chapter, under this arrangement, factors make a pre-payment to the client of an agreed percentage of the value of the assigned invoice. The remaining balance (less the pre-payment and fees) of the assigned invoice is paid to the client when the invoice is paid to the factor by the customer (or at an agreed specified future date). Unlike banks, under this arrangement, the factor effectively owns the invoiced debt and has full legal recourse to pursue this invoiced debt in the case of non-payment by the customer. Therefore, as a first point, factors typically have no need to, so do not, seek collateral, additional to the assignment of the invoice, as security from their clients. As an exception, some factors do seek security against fraudulent practice by the client. This issue of security and collateral is discussed in Section 5.2 below. - 29 -
So, what are factors interested in ensuring when assessing client risk? Primarily, factors assess prospective clients with respect to: The factorability of the clients product / business; The uality, strength and performance of the sales ledger; The profile and credit worthiness of the clients main debtors; The uality and integrity of sales invoices; and The uality, clarity and consistency of client administration and documentation. In making judgements on the above considerations, it is normal for a factor, giving consideration of a facility to a prospective client, to carry out a survey of the business. Sometimes this survey is known as an initial audit, or an initial investigation, or perhaps due diligence. All survey reports would involve a visit to the clients premises, normally for up to one day and survey reports normally are completed within two working days for presentation to senior management of the factor. The senior management team then makes a ualitative judgement on whether or not to take on the prospect as a client. Whilst every factor will have their own internal survey report format and considerations, a typical survey audit would address issues as outlined in Table 5.1. Should a factor choose to offer a facility to a prospective client, as mentioned above, it is not usual for the factor to seek security, additional to the factoring agreement, from the client with regard to protecting the factor against business failure. However, it is more common for the factor to seek personal guarantees from the directors of the client business to protect the factor against any fraudulent practice on the part of the client. - 30 -
Table 5.1: Checklist of Factor Risk Assessment Procedures AREA OF INVESTIGATION The Constitutional Set Up of the Client presentation of the headline information on incorporation of the client KEY INDICATORS (INCLUSIVE) Business Details (name, address, trading style etc) List of Directors and shareholders Details of Auditors, Bankers and Charge Holders Sales Ledger Analysis building a picture of the size and uality of the sales ledger, including the uality of associated documentation. Product Analysis confirming the extent to which the product is sell and forget confirming the factors ability to legally enforce the assigned debt. Check on Debtor Statements (are they reconciled; agree with ageing) Profile of debtor business Analysis of debtor profile (normally for top 10-20 debtors) Quality of sales ledger documentation Ledger analysis relative size of debtors, payment terms, bad debts Average invoice value Average credit note value Credit notes as percentage of turnover Average remittance advice value Average debtor balance Average debt turn Nature of the business; Assessment of warranties, guarantees, returnable containers, schedule delivery, long term contracts, retrospective discounts, constructive delivery, product insurance, free issue material - 31 -
Invoicing and Sales Order Process confirming the trail of documentation is appropriate and clear from enuiry-orderinvoice. Also, investigating the reasons behind disputed invoices. Financial Analysis and Statements a general picture of the financial structure of the client business and confirmation of solvency. Suppliers and Creditors confirmation of payment terms and performance of the client with its creditors. Invoicing process and documentation uality - orders in writing, proof of delivery, acknowledgements, self billing, payment terms, layout clarity of invoice information Sales order process and documentation uality system of handling sales enuiries through to invoicing Analysis of disputed invoices Analysis of remittance advice s Analysis of turnover Analysis of financial facilities and conditions thereof Current balance Cash book balance Value of unprocessed cheues Analysis of contracts with major suppliers and supplier payments Confirmation of any legal proceedings taken or threatened Confirmation of any judgement debts Payment terms - 32 -
5.2 SECURITY AND COLLATERAL Building from the previous section is the uestion of the impact of the factor approach to security and collateral on accessibility of factoring by SMEs. Banks usually ask for collateral security for their lending, which reflects their conservative approach to risk. The availability of collateral is an essential condition in securing access to loans for healthy businesses. Banks will generally reuire either real estate or other tangible assets as collateral or a guarantee from a person or an institution. Innovation in overcoming this conservative approach has seen impressive growth of leasing services and general asset based financing whereby the bank can more effectively service the SME through financing other than traditional loans or overdraft facilities. Similarly for factoring, which is a form of asset based financing, here the factor owns the debt legally, rather than takes a charge on the debt to be redeemed only in a receivership situation i.e. each invoice should be a legally enforceable debt in its own right. This issue is important with respect to the issue of fixed verses floating charges. Specifically, the difference between bank lending and factoring where in the latter case, instead of the company providing security in the form of a charge over book debts, it assigns those debts to the factor. Thus banks may prefer to offer working capital through factoring, rather than through traditional overdrafts secured by a fixed or floating charge on the book debts. This realisation is possibly reflected in the observations made later in this report, noting that banks are increasingly entering the factoring market. So, unlike banks, factors are not concerned with taking security additional to the book debts. 5.3 LEGAL FRAMEWORK FOR FACTORING The availability of factoring, and its cost, are directly related to the risk the factor bears. Accordingly the legal framework with regard to the transfer of ownership of a debt and the rights of a creditor in cases of default are most important considerations. - 33 -
It is beyond the scope of this study to undertake a full cost-benefit analysis of the legal framework for each Member State. However, there are certain issues related to the prevailing legal framework governing the assignation of receivables and enforcement of collection thereof, which could affect the accessibility of SMEs in certain countries to factoring services. Firstly, there is the issue of the mechanics of legally transferring the ownership of a debt - how long does it take, what is involved, and what does it cost?. The laws under which ownership of debt can be transferred are specific to each individual country circumstance and no common theme across countries is identifiable. However, the physical process for assigning debts differs in each country. For example, in most countries, the euitable assignment of debts is automatically covered in the factoring agreement between the factor and the client. Whereas, in the Netherlands, the factor must take a documented list of all invoices to be factored that day to a court of law to be stamped by an officer of the court. This clearly has a differential impact on relative efficiency of the process. Further there is a uestion concerning the strength of the factor s legal position in cases of default? Again, with laws and processes specific to each Member State it is not possible to define a common theme across all countries. However, we can make an observation with regard to the relative penalties for debt defaulters across Europe. For example, in the UK it is not uncommon for cheues to be returned unpaid with little or no impact on the credit rating for the offending party. Whereas in France, if a debtor negates on payment of a Bill it is reported to the Bank of France who act also as a credit rating body. Therefore the act of a single default in France could well affect, as a matter of course, the future credit rating of the debtor. Whilst the legal process is different in each Member State and there will therefore be cost and risk differentials between Member States on balance, it is not thought that the impact of this will significantly affect access to factoring by SMEs in one Member State over another. - 34 -