INTERNATIONAL FACTORING A VIABLE FINANCING SOLUTION FOR FIRMS

Finances - Accounting INTERNATIONAL FACTORING A VIABLE FINANCING SOLUTION FOR FIRMS Assoc. Prof. Ph.D Giurc Vasilescu Laura University of Craiova Faculty of Economy and Business Administration, Craiova, Romania Abstract: The increased competition on the global market and the shortage of financial resources determined by the financial crisis imposed the international factoring as an alternative for financing for corporations and small and medium enterprises. International factoring eases much of the credit and collection burden created by international sales and financing is provided by means of advances against outstanding accounts receivable. Using of international factoring offers many advantages to both importers and exporters but in the same time presents some limits. Despite these, the international factoring has a great potential as methods of financing cross border transactions and the firms from all countries can beneficiate of this. JEL classification: G15, G32, O16 Key words: international factoring, financing, firm, advantages, limits, financial crisis Introduction The internationalization and globalization offer a lot of opportunities for the firms but in the same time generate many challenges, most of them being related to the financing resources and the risks involved by the international trade. Moreover, the financial crisis has already shown its negative effect on the global markets. It should be taken into consideration that the international transactions involve a high degree of uncertainty and more risks related to the firms financial situation, environment of the country the client is located or cultural barriers. One of the greatest problems facing exporters is the increasing insistence of importers to conduct the trade on open account terms. Further problems can arise if the importer delays payment beyond originally agreed terms or makes no payment at all because of financial failure. Besides, the increased competition on the global economy determine the companies to be more flexible, to be able to offer to the international clients better financing terms in order to maintain and develop their business. In these circumstances, companies have an attractive and valuable alternative which is: factoring (domestic and international). As consequence, around the world, factoring is a growing source of external financing for corporations and small and medium-size enterprises. In fact, factoring is a very common form of informal financial arrangement which suppose the sale of accounts receivable, at a discount, to a third party. The opportunities for the factoring industry increase accordingly with the 27

Revista Tinerilor Economi ti (The Young Economists Journal) development of the international trade. In fact, factoring's origins lie in the financing of trade, particularly international trade. Factoring as a fact of business life was underway in England prior to 1400 and it appears to be closely related to early merchant banking activities. Like all financial instruments, factoring evolved over centuries. The nineteenth century was a period of resurgence for factoring, but it was centered more in the US rather than Europe. Thus, in the United States factoring became the predominant form of financing working capital for the then high growth rate textile industry. Beginning in the 1970s, a number of countries began enacting legislation for cross-border trade activities, and once again the factoring industry was revived as an alternative financing tool. By the first decade of the twenty first century the basic public policy rationale for factoring remains that the product is well suited to the demands of innovative rapidly growing firms critical to economic growth. and it allows good business to provide a source of funds during the process of restructuring the firm so that it can survive and grow. In recognition for the importance of international factoring the UNIDROIT Convention from Ottawa (1988) settled up a lot of rules in the field of international factoring for harmonization these international transactions and makes the international assignment of receivables a more accessible form of finance. Another important event in the effort of unification of law regarding receivables financing was the United Nations Convention on the Assignment of Receivables in International Trade (UNCITRAL) adopted by the UN General Assembly on December 2001. The main objective of the Convention is to promote the movement of goods and services across national borders by facilitating increased access to lowercost credit, to removes legal obstacles to certain international financing practices, such as asset-based lending, factoring, forfeiting, securitization, refinancing and project financing; to facilitates the harmonization of domestic assignment laws by providing a substantive law regime governing priority between competing claims that States may adopt on an optional basis. International factoring - main features Factoring is a viable alternative to other external financing sources available for firms (banking loans, leasing, venture capital, etc.) by which a business can increase its cash-flow in order to fund expansions. Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange for immediate cash in order to finance continued business. Depending on the participants to the factoring operation, there are two types of factoring: - Domestic factoring at the basis of this operation there is not an international trade contract, it is done on the same country and there is a single factor, -International factoring appeared as a consequence of development of the domestic factoring and suppose the existence of an international trade contract; in the operation can be one or two factors (the import and the export one). International factoring may be defined as the sale of assignments of short-term (generally 120 days or less) accounts receivable arising from an international sale of 28

Finances - Accounting goods or services. Most of the basis characteristics of factoring refer to the domestic factoring as to the international factoring: the sale of accounts receivable, credit control, the acceptance of credit risk, collection of invoices, acceptance conditions. But taking into consideration the international size of the transactions, the international factoring is more complex than traditional domestic factoring since there are a number of parties, depending on how many countries there are in which the seller conducts business. There are two main forms of the international factoring (Molico and Wunder, 2004): - direct export or import factoring; - two factors system. In the direct export or import factoring there is a single factor in the importing or exporting country that administrates the factoring operations (figure 1). Factor (of import or export) Exporter (factoring client) Importer (Factoring debtor) Figure no. 1. Direct factoring The international factoring in the two factors system represent a cooperation between two factoring companies, one from the exporter country (named export factor) and the other one from the importer country (named import factor). Thus, there are four parties involved in the international transaction (figure 2): - the exporter (factoring client), - the export factor, - the import factor, - the importer (factoring debtor). The legal basis of this system with two factors is a contractual one, as follows: - there is a selling contract between the exporter and importer; - there is a factoring contract between the exporter and the export factor; - there is an Interfactor agreement between the export factor and the import factor. The operations in the case of two factors system are the followings: 1 - deliver the products/services with invoices and delivery documents; 2 - present copies of invoices and delivery documents; 3 - advance the money; 4 - transmit the invoices to the import factor which assume the unpayment risk of the debtor; 5 - collect the payments at maturity/ recuperate the amounts from the debtors; 6 - pay the invoices; 7 - transfer the amounts and ensure the protection against the unpayment risk of the debtors. 29

Revista Tinerilor Economi ti (The Young Economists Journal) Exporter (Factoring client) 1 Importer (Factoring debtor) 2 3 Export factor 4 7 6 5 Import factor Figure no. 2. International factoring - two factors system Source: Molico, T., Wunder, O., Factoringul, alternative moderna de finantare, Editura CECCAR, Bucuresti, 2004 There are basically three elements of service offered by international factoring companies: a) Managing the receivable, where an accounts receivable manager handles collections and provides reporting and bookkeeping services. Typically, the seller "assigns" orders to the factor and the buyer pays the import factor. The export factor guarantees the payment for the order (minus defects and other things that may go wrong that are beyond the factor's control). b) Furnishing credit protection on the receivable and establishing credit lines. Usually, if the order is not approved for factoring, the seller can still sell to the buyer, but collection is no longer guaranteed by the export factor. For approved orders, the factor collects the payment for the order and then pays the seller, minus the factor's fees, which can include an annual fee plus a commission on each sale. c) Lending against receivables. Interest rates vary and the most common loan is no greater than 90% of the value of the receivables. The seller must usually have a minimum of working capital and other qualifying criteria. One problem which can arise is finding the factors but this can be solved using the factoring networks. Thus, the international factoring business involves networks, which are similar to correspondents in the banking industry. There are two sources for global networks: Factors Chain International (FCI) and International Factors Group (IFG). Factors Chain International is a global network of leading factoring companies whose common aim is to facilitate international trade through factoring and related financial services. Since 1968 FCI has dedicated valuable resources in building the world's largest network of factoring companies. Currently the FCI network counts 247 factors in 66 countries, actively engaged in more than 80% of the world's cross-border factoring volume. When export factoring is carried out by members of FCI, the service involves the followings operations: The exporter signs a factoring contract assigning all agreed receivables to an export factor. The factor then becomes responsible for all aspects of the factoring operation. 30

31 Finances - Accounting The export factor chooses an FCI correspondent to serve as an import factor in the country where goods are to be shipped. The receivables are then reassigned to the import factor. At the same time, the import factor investigates the credit standing of the buyer of the exporter's goods and establishes lines of credit. This allows the buyer to place an order on open account terms without opening letters of credit. Once the goods have been shipped, the export factor may advance up to 80% of the invoice value to the exporter. Once the sale has taken place, the import factor collects the full invoice value at maturity and is responsible for the swift transmission of funds to the export factor that then pays the exporter the outstanding balance. If after 90 days past due date an approved invoice remains unpaid, the import factor will pay 100% of the invoice value under guarantee. The two factor system is supported by the existence of chains of correspondent factors. These where established for the purpose of facilitating the cooperation between import and export factors by the development of common rules and accounting procedures. There are members of factoring chains in most major trading nations. Some of them restrict their membership to one factor per country (closed chains), while others are open to the participation of multiple factors in the same country (Glinavos, 2002). Advantages and limits of international factoring International factoring eases much of the credit and collection burden created by international sales and financing is provided by means of advances against outstanding accounts receivable. Using of international factoring offers many advantages to both importers and exporters. International factoring provides the following benefits to exporters: - increased sales in foreign markets by offering competitive terms of sale; - protection against credit losses on foreign customers; - accelerated cash flow through faster collections; access to a flexible source of working capital; - avoid the delays often encountered when arranging letters of credit; - enhanced borrowing potential and an opportunity to make use of supplier discounts; - commissions paid to the factor are based on sales volume so costs fluctuate with actual sales, lowering operating costs during slow sales periods; - signs a single factoring contract, in its language with a factoring company; - benefit by a debtors expertise done on their domestic market by the import factor; - benefit by assistance offered by the import factor for solving the disputes with importers. Obviously, there are also advantages for importers. In summary, international factoring provides the following benefits to importers: purchase on convenient open account terms; no need to open Letter of Credit. Until quite recently the Letter of Credit was the most universally accepted method to control international trade. While this method had considerable merit when goods were moving slowly and at irregular intervals along shipping lanes, the Letter of Credit places a financial burden on

Revista Tinerilor Economi ti (The Young Economists Journal) importers, which in most cases is no longer tolerated; expanded purchasing power without blocking existing lines of credit; orders can be placed swiftly without incurring delays, negotiation charges, etc.; can pay the invoices to import factor in its own currency; do the business in its own language accordingly with the local commercial practices. On the other side, there are some limitations of international factoring. The main disadvantage of the system is the expense involved. The increased cost of employing two factors makes the arrangement unsuitable for transactions of low value. Also there is the possibility of delays in the transmission of funds and the duplication of some records is unavoidable. However, the use of chains of factors makes the transactions speedier through the use of a clearing system. International factoring generally does not work with foreign account receivables that have more than 180-day terms. Besides, it exists in countries with laws that support the buying and selling of receivables. Another disadvantage consists in the fact that international factoring may be cost prohibitive for exporters with tight profit margins. It is unsuitable for the new-toexport company as factors generally: - do not take on a client for a onetime deal; - require access to a certain volume of the exporter s yearly sales. Also, the political risks and commercial disputes are not covered and therefore need to be settled between the exporter and the buyer of the products. It is important to note that one implication of this is the fact that the factoring company will not meddle when the reasons for non-payment are commercial or technical disputes. Evolutions of the international factoring The international statistics (FCI, 2009) indicate that at the global level of factoring registered an increased turnover in the period 2004-2008, sign that these operations became more attractive for the companies and for the financing institutions (table nr.1). Table 1. Accumulative Factoring Turnover (for FCI members) - mil.euro 2004 2005 2006 2007 2008 Invoice Discounting 97,543 160,141 193,829 219,914 206,915 Recourse Factoring 89,808 116,626 139,978 168,683 167,860 Non-Recourse Factoring 191,467 232,683 247,818 237,585 243,413 Collections 15,549 13,120 12,604 13,934 25,940 Total Domestic Factoring 394,367 522,569 594,229 640,116 644,128 Export Factoring 32,405 42,073 59,302 68,424 88,244 Import Factoring 11,160 13,190 14,944 17,416 22,363 Export Invoice Discounting 13,997 21,716 24,179 32,430 33,801 Total International Factoring 57,562 76,979 98,425 118,271 144,408 Total Factoring 451,929 599,548 692,654 758,386 788,537 Source: Factors Chain International, FCI, Annual Review, 2009 32

Finances - Accounting Given the fact that the factor takes over non-payment risks in the case of external factoring and only in some cases for the internal one, determine the largest share from the total 82%, in 2008 for the domestic factoring. On structure, the non-recourse factoring represent 38% from the domestic factoring, followed by the invoice discounting (32%) and recourse factoring (26%) in 2008. The international factoring increased 2.5 times its turnover in the period 2004-2008 that demonstrates a major development of financing by this technique. The export factoring registered a fast increase and represent 61% from the international factoring in comparison with 15% registered by the import factoring in 2008. Regarding the geographical distribution of the factoring operations, the FCI reports indicate that the most developed factoring market is in Europe, holding 67% of the world volume, following by Asia-Pacific area with 20% and the Americas with 12% in the world volume (figure 3). 1000000 800000 600000 400000 Domestic factoring International factoring Total 200000 0 Europe Asia Americas Africa Australia Figure no. 3. Total factoring volume (2008) Source: Factors Chain International, FCI, Annual Review, 2009 The international factoring represent just 21% in Asia, 13% in Europe and 8% in Americas which indicate that the domestic factoring hold the most of the total factoring transactions in all world regions. Factoring has become well established in developing countries, in particular in those that are highly industrialized. In various Asian countries, the growth of factoring has been dramatic while in Latin America, financial institutions continue to join the industry. Similar growth has occurred in the Baltics and the Middle East. During the past years a strong increase was noticed of financings by factoring, especially in expanding economies in the Central and Eastern Europe. The financial crisis has effects on the factoring market too. Thus, in the actual global context, when financial crisis drills into the companies profits, the main risk for the factoring market is fund costs raise up to a level that invoice payers may consider prohibitive. Conclusions International factoring is a popular financial instrument whose main objective is to give security to exporters on the products and transactions they do in another country. In the context of present financial crisis, the international factoring is considered a method of obtaining finance and enhancing liquidity with great potential. 33

Revista Tinerilor Economi ti (The Young Economists Journal) The use of factors to provide prepayments for the sale of goods and services in an international context is necessary to increase the volume of international trade. International factoring is used by exporters who sell on open account or documents against acceptance terms and it eases much of the credit and collection burden created by international sales. By outsourcing the credit function, exporters can convert the high fixed cost of operating an international credit department into a variable expense. Also, international factoring gives both protection and financing to exporters regardless of the changes in the currency rates. Despite the advantages of the international factoring, this is still not used to a large extent. Some of the reasons regard the problems of creating assignments that are valid in more than one jurisdiction, the uncertainty of enforcing claims in foreign states and the lack of any clear priority rules to determine the rights of the third parties may account for the reluctant expansion of factoring in international trade (Glinavos, 2002). International factoring has a great potential as methods of financing cross border transactions. But in order to valorize this potential, should be done more efforts at the international level in the field of international factoring for harmonization these international transactions, for removal legal obstacles to these financing practices and making the international assignment of receivables a more accessible form of finance. In the future, the real challenge for factoring companies will be to maintain their flexibility so that they can react quickly to changing market circumstances, such is the financial crisis. REFERENCES 1. Bakker, M. R., Klapper, L., Udell, G. 2. Demirguc-Kunt, A., Maksimovic, V., The role of factoring in commercial finance and the case of Eastern Europe, World Bank working paper no. 3342, 2004 Firms as financial intermediaries: Evidence from trade reedit data, World Bank Policy Research WP, 2002 3. DG Enterprise Analysis of use of factoring, Final Report, Febr. 2003 4. Factors Chain Annual Review, 2009 International (FCI) 5. Giurca Vasilescu, L. Managementul financiar al corporatiilor, Ed. Universitaria, Craiova, 2008 6. Glinavos, I. An introduction to international factoring&project finance, MPRA paper nr 854, 01 Sept 2002 7. International Trade Trade finance guide, Export Factoring, 2007 Administration 8. Klapper, L. "The role of factoring for financing small and medium enterprises," Policy Research Working Paper Series 3593, The World Bank, 2005 9. Munteanu, I., Popovici, N., The development of factoring services in Romania. Analyses, evolutions, position in Europe, Annals of the University of Oradea, volume 3/2008 10. United Nations United Nations Convention on the Assignment of Receivables in International Trade, December 2001 34