How to guarantee collections and payments

DOCS How to guarantee collections and payments 01 Introduction 02 Factoring 03 Confirming 04 Forfeiting 05 06 Credit insurance Conclusions and More information Barcelona Activa SAU SPM, 1998-2009

01. Introduction One of the keys for consolidation of a company is financing. Without funds, it is impossible for any project to get off the ground. It is, therefore, fundamental to make as rigorous a forecast as possible of the financial needs of your project, even though they can often be complex. The hardest thing to predict is the financial source of the business: collections from the customers. Any entrepreneur, especially in an SME, assumes that there will be risks when it comes to the financial resources. There may be cases of non-payment by customers and also of collections on credit. These situations pose a problem for the entrepreneur, since money is needed to substitute the collection of the customers, when collection has not been possible or has been delayed for longer than was anticipated. Government figures show that one in every four companies which goes bankrupt does so as a consequence of delays in the collections of its activities. To avoid this type of situation, the European Commission has approved a directive to combat arrears in commercial payments, which the Spanish Executive has incorporated into the normative of the country, (http://www.boe.es/g/es/bases_datos/doc.php?coleccion=iberlex&id=2004/21830), substantially toughening the interest on arrears and also reducing the term of non-payment claims. However, apart from the law, what other means do entrepreneurs have at their disposal to protect themselves from the insolvency of their customers? The financial system offers a manual of instruments which are detailed in this report: from the most common (factoring and confirming), to others which are less frequently used, but which can be useful in certain circumstances (forfeiting and credit insurance). 2 / 10

02. Factoring Definition Factoring is a financial instrument by means of which an entrepreneur (natural person or physical entity) transfers to a financial entity, all the rights derived from a sales operation and its corresponding collection. In order to facilitate this, a contract is drawn up between a company and a factor, which can be a company which manages this type of operation exclusively, or a bank, savings bank or credit cooperative which commercializes this type of product as a further line of business. The factoring entities take charge of collecting outstanding invoices, receipts, drafts, etc., which they pay into the account of the entrepreneur in return for a commission. In addition, and depending on the type of agreement signed, risk of non-payment by the debtor is also covered. The term of collection of factored operations is not usually more than six months (180 days), except when the debtor is a public administration, in which case this term can be extended, adapted to the period of collection. Methods There are two types of factoring: - With resources This is the type of operation where the factor does not cover any risk of non-payment on the part of the debtor. It only involves the management of collections from the portfolio of customers of the entrepreneur. - Companies which contract this kind of service have large companies and public administrations as customers, so the possibility of insolvency is low, and does not justify the payment of an extra commission for this service. - Without resources This is the most common type of operation, since the factor not only manages the collection of outstanding invoices but, in addition, covers the risk of non-payment on the part of the debtor in a state of insolvency, whether this be: De facto. When the debtor simply does not pay and offers no justification. De jure. When the debtor officially declares suspension of payments. It is essential to take into account, however, that there are other possible scenarios not covered by the factor in this type of factoring agreements, such as: - Non-payments derived from commercial disputes with the debtor. Sometimes, the buyer will refuse to pay the seller (the entrepreneur) because there is a previously stipulated contractual condition which the buyer does not agree with (price, quality of the product or service, term of delivery, etc.). 3 / 10

- Political risk. The factoring entity does not cover the risks of insolvency when the sales destination is a politically or economically unstable country, where changes in the state of the debtor can be produced making collection difficult. This type of service is appropriate for any business, from small companies to large corporations, which is concerned with covering itself for commercial risks and with not neglecting the inventory of its portfolio of customers. It is also essential for entrepreneurs who are in the growth stage. Benefits for the business owner The benefits of this type of accounts transfer to a financial entity are: - More time to devote to the activity of the company and less to worry about. The factoring entity takes care of all the necessary measures to ensure payment by the debtor, and to monitor collection from the entire portfolio of customers. - Saves money in both material and human resources. This tool permits externalization of the collections department which, depending on the number of customers, requires a regularly updated computer system and skilled personnel. - Reduction in activity of managerial staff in the supervision and direction of sales accounting. Factoring without resources, in addition, has the following advantages: - Security of collection, since the factor covers the risk of insolvency of the debtor, both de facto and de jure. Both situations allow the business owner to charge 100% of the total invoices that have been factored in a period of between 90 and 120 days following the due date. - Improvement in planning. The entrepreneur is able to make short and long term treasury plans thanks to protection in case of insolvency or non-payment on the part of debtors. - Financing and immediate liquidity. The factoring entity can advance to the business owner, the amount for the transferred outstanding invoices before the due date in exchange for the payment of a pre-established interest rate. This enables the entrepreneur to have access to funds in a more flexible way, which will increase as more sales are made. 4 / 10

Disadvantages for the business owner: - High costs. The interest rate applied is higher that the conventional commercial discount. - Long-term operations are excluded (more than 180 days), which affects certain types of product. - The factor cannot accept some of the documents (invoices, instalments, receipts, etc.) of the entrepreneur. - The business owner, as the customer of the factor, is dependent on the criteria of the factoring entity to evaluate the risk of the buyers. If the risk is considered excessively high, the factor will not agree to manage the collection. Cost - Consulting more than one financial institution is recommended, given that the costs of factoring operations can vary substantially between different institutions. 5 / 10

03. Confirming Definition A financial instrument which permits an entrepreneur (natural person or legal entity) to transfer to a financial institution, all the rights derived from an operation of purchase and corresponding payment to the suppliers. In order to do this, a contract is drawn up between a company and an entity dedicated exclusively to the management of this type of operation or a bank, savings bank or cooperative of credit which commercializes this product as a further line of business. The confirming entities are responsible, therefore, for covering the cost of outstanding payments, cheques, drafts, etc., in return for a commission. Unlike in the case of factoring, management is of payments and not collections. This method of accounts transfer is useful for companies who have a high number of suppliers and/or a complex system of payments. Likewise, it can be of interest to entrepreneurs who wish to extend the period of payment to suppliers, and improve the conditions of purchase. Moreover, for suppliers it is an alternative source of funding to loans and traditional credits, since the issuer of an invoice has the possibility of collecting it in advance. Once the invoice has been received, the entrepreneur informs the confirming entity of the conditions and amounts to be paid to the supplier. Next, the entity notifies the supplier of the existence of the invoice and indicates how much it will cost to advance payment to the due date and under which conditions. Advantages for the business owner The benefits of this kind of debt management on the part of a financial entity are the following: - Improves the relationship between entrepreneur and supplier. The image of the customer improves, because payments are always kept up to date and are guaranteed by a financial entity. - Increases capacity for negotiation with suppliers. Having immediate cash flow and paying when required to pay, helps you to attain better prices for products and services, permits you to demand quality, etc. - Saves money. Confirming helps to avoid the costs of payments cheques etc., and allows a reduction in the number of telephone calls made to suppliers to find out the state of invoices. In addition, it enables you to cut the numbers of administrative staff, since the quantity of documents generated is reduced. - Reduction of labour derived from incidents in the payment of receipts and the tracking of the same. Each supplier receives periodic notifications in writing, in which the invoice number, amount, due date, etc., are detailed. 6 / 10

- Helps you to plan ahead better, since it unifies the system and the flow of payments to the suppliers. The entrepreneur has more control over the treasury, since payments to creditors are made en bloc and a single charge for all operations is made at the due date. Disadvantages for the business owner - Higher costs in relation to other financial instruments. - Management is centralized in a single confirming entity. - Limitation in time control of the payments. Advantages for the supplier Confirming also has advantages for the suppliers: - Immediate financing. You can charge invoices for cash before the due date, less the discount of the corresponding financial costs (commission and interests). In this way, risk of non-payment is eliminated. This, effectively, represents a funding method which does not increase banking risk, and which enables you to avoid the usual lines of credit. - Simpler accounting. The advanced invoices in a confirming agreement can be considered as cash payment once the costs of financing have been deducted, so that these no longer appear on the balance liability. - Flexibility in control of the issued invoices. The confirming entity sends periodic notifications in writing in which the invoice number, amount, due date, etc., are detailed. - Avoidance of the payment of stamp duties, when these are not rebound to the customers. Collections are made by means of sales or transfers, so payment of the Tax of Documented Juridical Acts (IAJD) is not necessary. Disadvantages for the supplier - Obligation to work with a particular confirming entity. This limits your options of approaching another entity to raise financing. - Higher financial cost than other financial instruments. - You do not have the initiative in collection, since this has been transferred to your customers. 7 / 10

04. Forfeiting Definition A financial instrument by means of which an entity called a forfeiter buys an operation -whether in the form of an accepted bill of exchange, guaranteed promissory notes, letters of credit, etc., or any other form of payment- from an entrepreneur who is exporting. In other words, forfeiting is export factoring without resources. Factoring entities are responsible, therefore, for the purchase of bonds arising from the delivery of goods and services, which make up most export transactions. Being a resourceless operation, the forfeiter takes on all the risks and difficulties of the importer collection. To minimize risk and ensure a guarantee for collection of the transaction in case of problems, forfeiting bonds usually include a bank guarantee. On the other hand, exporters renounce their future rights in exchange for a cash payment to their account, for which they pay a fixed interest rate, an amount which is known as a discount. The period of transaction is longer than that of factored transactions. While the latter does not usually exceed six months, in the case of forfeiting the payment period is middle to long term, not less than 12 months and up to a maximum of 5 or 7 years. This instrument is normally employed for non-continual sales to the buyer or for large transactions of durable goods or capital equipment (machinery). The main currencies used in these transactions are those accepted in the European market. 8 / 10

05. Credit insurance Definition A financial instrument to cover commercial risks, where the factor is substituted by an insurer without management of collection nor the possibility of financing for the entrepreneur. In this case, the entrepreneur debtors do not analyse the situation according to their solvency, as in the case of factoring, but examine it from the point of view of an insurance company. This means that in order to cover an invoice, you not only assess the balance of the debtor company but also, the functioning of the sector, what ratios does it have compared with the average ratios of the sector, etc. Another difference with factoring is that there is no guarantee for risk of non-payment in its totality. Coverage is of between 80 and 90% of the amount of the invoice, but never 100%. In addition, the insurer, unlike the factor, does not manage collection, and does not offer the possibility of financing to the entrepreneur by advancing the money for the transferred outstanding invoices before the due date. Conversely, some insurers compensate for this reduction with the coverage of certain situations not covered by factoring, such as political risk. This characteristic makes credit insurance interesting for companies that export to countries which are somewhat unstable. 9 / 10

06. Conclusions and More information Conclusions Entrepreneurs and business owners in general have at their disposal a series of financial cushions to combat the arrears of their customers, and manage the treasury of their business. However, before taking advantage of any of these financial instruments, it is essential that you analyse in detail their characteristics and suitability to the needs of your company. You should also analyse the cost, and consult various different entities in order to get an idea of the costs involved in carrying out this kind of transactions. More information - Banco de España List of financial credit institutions: http://www.bde.es/noticias/dot/tarefc.htm Written by the Barcelonanetactiva team from the following sources of information: - Santandreu, Eliseu, Marc i Pol; Confirming, Factoring y Renting. Ediciones Gestión 2000, 1998 - Banco Atlántico, S.A.; Manual Técnico de Factoring Proveedores (Euros). Ed: Noviembre, 2000 - Abanfin.com: Other financing instruments: http://www.abanfin.com/modules.php?name=manuales&fid=ff0adaa - Wikipedia: "The factoring contract": http://es.wikipedia.org/wiki/contrato_de_factoraje - Wikipedia: "Confirming": http://es.wikipedia.org/wiki/confirming Barcelona Activa SAU SPM, 1998-2009 - Last Update: 16/09/2009 Barcelona Activa SAU SPM will ensure that this information and the data contained in the reports are accurate and faithful. These reports are published to provide general information. Barcelona Activa SAU SPM will not accept under any circumstance any responsibility for losses, damages or theft, or for any other business decisions based on data or pieces of information that can be extracted from this report. 10 / 10