How should Factoring Service be Launched?

How should Factoring Service be Launched? S P Singh Factoring is basically the purchase of book debts of client companies. Apart from financing investments in book debts, the factoring company offers individualized service packages covering credit screening, ledger keeping and collection, and provision for doubtful debts and write offs. In the context of the government policy of strengthening money and capital markets, a study group of the Reserve Bank of India is considering how to launch factoring service in India. S P Singh considers two approaches to launching factoring service. One is the conventional approach of letting banks, which are providing cash credit for book debts, promote factoring as an extension of their activities. The other the market approach of enabling independent companies compete on improving upon the current average collection period and percentage of write offs. Singh recommends the market approach to launching factoring service. Efficient factoring, requires a culture of price banking, aggressive selling and low unit cost operations a culture unfamiliar to public sector banks and financial institutions. S P Singh has served on several committees of the Reserve Bank of India. He is Senior Professor at the National Institute of Bank Management, Pune. Since the beginning of the 80s, the Government of India has been actively promoting the development of money and capital markets so as to benefit both the suppliers and the users of funds. Steps being pursued include: developing financial agencies, improving the range of financial instruments and services, and increasing the volume of financial transactions. Behind these steps is a desire also to catch up with the growing market orientation in banking in the developed world, which focuses on converting social needs into business opportunities. In the context of this overall policy, the Working Group appointed by the Reserve Bank of India, popularly called the Vagul Committee, has recommended that banks should develop factoring services and that private non-bank financial institutions providing factoring services should be encouraged. Following up on this recommendation, the Reserve Bank of India has appointed a Study Group to look into how the factoring service should be developed in India. Two approaches can be taken to launching this service the conventional banking approach and the market approach. The choice between these approaches would make a difference to overall operational efficiency. Delay in collection of debts is becoming a serious national problem and efforts to popularize bill discounting have not succeeded. Through the seventies decade, sales of 1,720 large and medium-sized companies grew at a simple annual rate of 12.7 per cent and inventories at 11.6 per cent, while book debts grew at 21.3 per cent (Hunt et aj] 1984, p 24ff). If factoring service is to improve the turnover of book debts, it should be launched using the market approach. After outlining what the service is, I discuss the implications of organizing the service using each of the approaches. Factoring Traditionally, factoring has meant buying of book debts for cash. Today, it is not merely invoice

discounting or credit insurance. Apart from credit and collection, a wide variety of choices are offered to industrial companies: with or without recourse to customer company on default by paying company, only post-maturity or pre-maturity date debts as well, and, with funding or without funding service by the factoring agency. The development of factoring in the Western world shows that despite a comprehensive bundle of services, factoring is confined to industries with credit and collection problems. Also, there is no country in the world where a major part of credit and collection work has been turned over to factoring companies. Credit and Collection. Credit and collection are specialized functions, although handled routinely within the company, usually by separate sections in the finance department. The credit service involves gathering of information on potential and existing customers, screening them for credit purposes, rating customers on their creditworthiness and the formulation of credit policy, such as credit period, the rebate for prompt payment and penalties for delays, and finally, actual decisions on whom to sell, and on credit lines to be given to individual customers. Collection involves recovering the amounts due, once the goods have been accepted by the buyers. It includes such services as sending invoices, reminders, urgent telegraphic communications, legal notices, legal action, making provisions for doubtful debts, and finally writing off bad debts. Four clusters of activities can be identified: credit screening ledger keeping and collection provision for doubtful debts, write-offs funding or financing of investment in book debts. Normally, industrial companies can handle these functions by themselves reasonably efficiently. But conditions do arise affecting these functions adversely. This was true of many industries in the United States, especially cotton textiles, during the Great Depression and generally during the inter-war period. Once credit and collection functions become inefficient, they can set in motion a downward slide for the entire company. The downward spiral would proceed as follows. Credit would get extended to customers of substandard creditworthiness Average collection period would rise Collection of older book debts would become difficult Higher provisions would be required for doubtful debts and finally large amounts would have to be written off. The greatest damage is caused by delays in cash realization and increasing the investment of funds in book debts, resulting in heavy borrowing and interest burden. If funds are not forthcoming, operations would come to a grinding halt. Origin of Factoring The attraction of subcontracting credit and collection to recycle working capital funds is high. It is out of this attraction that factoring services emerged as a new financial service in the United States during the inter-war period. It became particularly popular with textile and other industries that were in serious difficulties. Partly because of unfavourable conditions in the external environment, and partly because of their own inability to set up efficient and specialized credit and collection departments, companies subcontracted their credit and collection functions to factoring agencies. Importance of Factoring in India With growing industrialization, collecting receivables is becoming a problem, as large amounts are getting locked up in book debts. The problem is largely one of delays in collection and significantly not defaults. Statistics show that funds locked up in book debts have been rising much faster than either growth in sales revenue or inventories. The problem can become more serious as the economy turns into a buyers' market. Borrowing from the banks at high rates of interest is adding to costs at a time when competitiveness is becoming increasingly important. The problem of collecting receivables has other dimensions. One is the effect on small units as large and medium-sized companies delay payments especially to captive small units. Although the Vaghul Committee envisaged the factoring service mainly from the point of view of small units, efficient factoring can have a more important 24 Vikalpa

role in India. Some industries like textiles and paper where the market is down have a serious problem of collection as well as funding of receivables. Another dimension to the collection problem is the emergence of government and semigovernment agencies as dominant buyers of goods and services. They are slow in making payments. The result is a transfer of a sizable part of private commercial sector credit to government and semigovernment agencies. Launching Factoring Service Would factoring help improve funds management and cost? Although bill finance is available from banks at a concessional rate of interest, it has not become popular. For, bills too are not paid on time. Government agencies do not accept bills. Almost every industrial company borrows against book debts from banks. This facility is liberally available and is well-utilized. Unlike in Western countries, credit and collection are not well-developed functions in most of the companies in India. The average collection period is very high. Besides, unlike in the United States or United Kingdom, India does not have a Prompt Payment Act, or other legislative backing for prompt payment as in Japan. I wonder also whether we have the will to abide by such legislation if there were one. Under these conditions, it is not easy to launch the factoring service in India. Apart from uncertainty about legislation that would require governmenal agencies to pay in time, it is difficult to foresee how far the better-managed companies would patronize factoring agencies. If efficient factoring service agencies can cut the average collection period to a half of what it is today, Indian industry can improve its margins by as much as one per cent of the sales turnover. Cutting the collection period to a half is not an unreasonable goal; our collection period is more than double that of Western countries. Much would depend upon whether the service is launched so as to make its success dependent upon such economic efficiency or not. On the one hand, we are faced with an uncertain demand, cost and pricing of factoring services. On the other hand, there is the possibility that an effective factoring service can significantly improve efficiency. To launch the service, it would be necessary to estimate the demand for factoring. Demand for Factoring Service Assuming that one-third of commercial bank lending is financing book debts in the business sector, a rough estimate of the investment in book debts at present is Rs 10,000 crore. Data on company finance published by the Reserve Bank of India show that sales revenues have been growing at about 12 to 13 per cent per annum over the last 15 years. Rate of growth of book debts can be assumed to be the same or somewhat higher. In the nineties, therefore, the volume of book debts would double every four to five years. Therefore, even if factoring can halve the average collection period, it will have a big potential market. An optimistic estimate is that if aggressive marketing and favourable conditions can be ensured, factoring business may start off at a turnover level of Rs 200 crore in the first year and increase to between Rs 5,000 and Rs 6,000 crore in five years. Factors that would determine the size of the market are: legislative support such as a Prompt Payment Act, exemptions from stamp duty for factoring agencies just as banks are now exempt from stamp duty for assignment of book debts to them government's willingness to accept financial discipline whether factoring service would be competitive enough to stand on its own economic merits or would simply subserve the banking and financial system whether a limited number of factoring agencies will fully exploit economies of scale, working on high volumes and low margins, or a large number of factoring agencies would be satisfied with a highcost small volume situation the attractiveness of the price at which the service is offered vis-a-vis the current alternative of bank finance available to individual companies. If the price is lower than what the banks.charge for cash credit limits against book debts, the chances are high that the business world would patronize the new service in a big way. If all the factors above favour factoring service, then not only will optimistic estimates of demand be realized, but a growth rate of 15 to 20 per cent in Vol. 13, No. 3, July-September 1988 25

subsequent years can be considered realistic. On the other hand, if conditions are unfavourable, a demand at the end of five years may be only around Rs 2,000 crore, with a much lower subsequent growth rate of between five and ten per cent. Much would depend upon how the factoring service itself is launched. Looking at Indian realities, two approaches can be envisaged: the conventional and the market approach. I outline them below. Conventional Approach This approach to launching the service would take a supply orientation and pursue the social need to help those in difficulty, such as small units and sick industries. It would be devoid of competition. We would encourage existing banks, or groups of banks, financial institutions or a consortium to promote subsidiaries for offering factoring services perhaps with a built-in subsidy element. Pressures to help those industries and companies in difficulty would mount. The factoring service would be treated as an extension of traditional banking. The banking culture would be transferred to factoring, perhaps with a marginal infusion of people from outside. The conventional approach would provide only a limited coverage, a modest rate of growth, high costs, low volume and low profits. I have not estimated the cost of factoring service under the conventional approach, as it may in practice be viewed as a joint service with the other services of the present banking system. The cost estimates in this approach would depend on the need for allocation of costs of the system as a whole to factoring. Market Approach The market approach to launching factoring service would basically be a private sector or independent activity, take a demand orientation, and involve aggressive selling and achieving extensive coverage. It would be characterized by a culture of youth with professional education from management institutes. Competitive pressures would arise in this approach to achieve low cost, low margin, high volume, and high profits. It would develop specialized services to selected industries. I discuss next the possible cost and pricing for the market approach. The elements of cost in factoring are outlined in Box 1. 26

These estimates are annualized rates. For a 60 day period, they would work out to 2.53 to 2.70 per cent of the turnover of the factoring company. Our estimates are more or less in line with the actuals prevailing in the U K (Brandenberg, 1987, p 100). With this cost structure and a 10 per cent margin on turnover, the factoring companies can offer their services at rates ranging from 16.72 per cent to 17.82 per cent. Compare this rate of the factoring company with the not-so-popular bill discounts for which the current rate is 15 per cent, and the popular cash credit for which the rate is 16.5 per cent. In view of the costs of credit and collection saved and the improved services offered, the industrial companies may be willing to patronize the factoring companies at rates 0.5 to 1.5 per cent points above the cash credit rate, that is, 17 to 18 per cent. This upper limit corresponds closely to our estimates of cost of 'factoring, including a reasonable margin. Let us, for illustration, consider a factoring company that offers a competitive package of services including credit screening, collection, write-off and funding to a client company. At 14.0 per cent cost of funds, 0.4 per cent as overheads, 0.5 per cent as screening cost, 0.4 per cent as the collection cost, and 0.3 per cent as the write-off cost, all on annualized basis, its costs add up to 15.6 per cent. That means, it could quote 2.86 per cent, assuming an average collection period of 60 days, and a profit margin of 10 per cent on turnover. To fetch business in a competitive market, it could quote a price as low as 2.60 per cent, which would cover all its cost but provide no margin. In some cases, it may be satisfied with a margin of just 0.05 and quote 2.65 per cent. In other cases, it may negotiate a price higher than 2.86 per cent. The cash credit rate, credit and collection costs for the client company set an overall upper limit for the factoring company's services. In the final count, its profits would depend on how quickly it collects and whether it collects almost everything. It is specialization and efficiency in these two areas that would determine the success of the factoring company. Our illustrative factoring company would not have done very badly in terms of return on equity. If it is assumed that the company has 10 per cent equity, 70 per cent long-term and 20 per cent short-term funds, its before-tax return on equity can be around 15 to 20 per cent to begin with. If it improves collection upon the 60-day period assumed and also writes off percentage, it can show a really impressive performance to its shareholders. Choice In my view, the Indian situation is ripe for adopting the market approach to launching the factoring service. In an increasingly buyers' market, what the factoring agency should primarily look forward to are high profits through efficiency in costs and shorter average collection periods. Although it will be easier to launch the service in the conventional approach, I am convinced that it would not only restrict the long-term potential of factoring but that it would also close the door on an opportunity to develop a new and viable service in the economy. The primary reason for my conviction is the culture required for an efficient factoring service Vol. 13, No. 3, July-September 1988 27

compared with the culture of the public sector banks and financial institutions. The factoring service is price banking, the values on the right hand side of the decimal point of the cost of service are where competition would work and the profits earned. The public sector banking culture is not oriented to these values of cost reduction and price banking. It is somewhat insensitive to the needs of customers. Its processes of decision making are not entirely commercial. There is a high chance that the conventional approach would turn out to be an expensive and subsidized way of factoring in the long-run. Internationally, selling of financial services has moved away from the background of traditional banking to a new philosophy characterized by specialization, new manpower, new skills, new technology, deregulation, disintermediation, price competition, low margins, very high volumes, and huge profits. Factoring, as a new service can help modernize our financial services sector, in howsoever small a way. It is important not to develop additional weaknesses in our banking in launching the new service. tional approach of launching the factoring service, treating it as a natural extension of traditional banking done by traditionally developed manpower, would achieve desired results. The bankers in India are not used to sharply negotiated price deals within narrowly set margins. They would not be able to develop and sell specialized credit and collection services at competitive price and do what the corporate sector has not been able to do in-house. Specialized private or semi-private independent agencies are most likely to introduce efficient systems and practices in credit and collection, reduce the average collection period and write-off percentages and contribute to general economic efficiency, besides earning good returns on their own equity. References Brandenberg, M (1987). "Why don't they Use Factoring?" Accountancy, January. Conditions for Launching Conditions will have to be created where a few factoring companies, say a maximum of six to nine, will operate autonomously under dynamic leadership. These companies would need one or two years to find their own niches within the price limits broadly set by the cash credit alternative. A typical company would have to invest in fixed or semi-fixed costs such as an infrastructure of offices, spread over 30 to 40 business centres supported by computers. It will have to build strong and specialized credit and collection departments to handle a large number of cases and absorb its high fixed expenses at a low unit cost and, therefore, offer competitive prices. For, in the market approach, it will have to prove itself in a narrow band set by difference between its costs and the maximum possible price. Conclusion Major reasons for slow collection in India are the built-in lethargy in market practices, the culture in general, and lack of expertise in credit and collection. There is consensus that this is harming business as a whole. It is doubtful whether the conven- 28 Vikalpa