[BLOG] Factoring: A robust funding option for small enterprises
Small businesses in most economies – developed and developing - are fund-strapped. Generally, commercial banks won’t touch them because they consider them high risk. As solution to this problem of accessing fund from traditional banks, many have proffered other funding options.
Emmanuel Ikhazobor, a renowned accountant and former interim administrator, Nigerian Stock Exchange (NSE), discussing this issue at BusinessDay’s organised Annual Capital Market Conference 2011, advised Over the Counter Trading (OTC), believing this funding approach would be very appropriate for SMEs who shun banks’ funds because of the high interest rates attached to them.
Additionally, according to him, this approach will allow for good governance, which “is currently absent in the sub-sector.”
But this option, according to experts, is associated with problems. They argue that although this arrangement has the merit of allowing smaller companies to be listed on the exchange, in practice, the two-tier system has generally not been successful. Many investors regard second tier companies with scepticism. For them, a Tier II label is like a badge of demerit - a Tier II listing connotes a public company that is not “good enough” to make it to the “big board.”
Hence, trading in Tier II stocks tend to be sparse, they argue. For them, this adversely affects both stock prices and liquidity (the two are linked); the potential of a Tier II listing is thus a mere inducement for small enterprises and potential investors.
Ikhazobor’s proposition is welcome but there is a caveat - experts have argued that it would be wrong to suggest that the mere act of creating the mechanism for an OTC market was a panacea for SME liquidity problems. For them, an OTC market requires brokerage firms willing to undertake the time and cost in its development, it requires a regulatory agency willing to adopt trading and disclosure rules, and it requires a sufficient number of companies on the OTC market to make the whole endeavour worthwhile.
They argue further that this will not happen overnight, that it will never happen without changes in statutes and other rules to allow small enterprises to more readily solicit capital from the public.
Another funding window small enterprises can explore is crowd funding .This is a funding window that the Nigerian fashion designer, who wants to key into the AGOA project by sewing 50,000 – 200, 000 boxers with ‘Adire’ fabric or some other garments, and shipping such products, on a regular basis, to meet orders in the US.
The ongoing Federal Government’s YouWiN project participants may find crowd funding an additional funding window that can speed up their transformation into the big enterprise club.
Only recently, the Small and Medium Enterprises Development Agency of Nigeria (SMEDAN) and the African Development Bank (AfDB) commenced fresh talks on provision of access to working capital for micro, small and medium enterprises (MSME) in Nigeria. The discussion, which took place in Abuja between the agency and a delegation from the continental development finance institution who were on a country visit to Nigeria, centred on the creation of a special pool of fund in the AfDB, specifically for MSME funding and promotion.
Factoring and small enterprises
Factoring is not a common form of finance for small enterprises in Nigeria. Most factoring done is granted by banks to companies in the oil and gas sector or large corporate clients. In other sectors, where the value chain is not as well understood, banks perceive higher risk in providing factoring finance to SMEs. But reports show that finance houses have been providing short-term working capital loans for SMEs, providing some factoring and purchase order financing. But the truth is factoring in small business sector has not taken strong root. There is need for small business operators to explore this attractive funding option.
We can take a cue from India whose case is similar to ours. The role of a factoring business is yet to gain ground in India, wherein SMEs struggle to get funding support from banks on concern of asset quality. At a little higher cost of funds, a factoring company can well be the liquidity generator to scoop the SME growth engine.
According to Sudeb Sarbadhikary, CEO, India Factoring - a Mumbai based standalone company, the business volume is increasing for factoring companies even as banks’ credit is contracting. SMEs generate the majority of country’s (around 75 percent) employment and they should keep growing with free fund flows.
“SMEs are promoter driven company with limited resources. The challenge is that money is blocked for 6-12 months leading to liquidity stress for them. In FY12, our business volume was at Rs 2,500 crore (N7,166.53), while we aim to take it to Rs 5,000 crore (N14, 333.06) in FY13. We have around 200 SME clients, which form around 90 percent of the total kitty. It was around 160 in the previous year,” he told moneycontrol.com in an exclusive interaction.
The year-on-year business growth is on a lower base as the company was started in December, 2009. There are around 10 factoring companies in India. Canbank Factors and SBI Global Factors are two of the oldest factoring companies in India. As of now, the total size of factoring business volume in India roughly stands at around Rs 17,000 crore (N48, 732.67) which according to Sarbadhikary, forms around 0.30 percent of the total banks’ credit in the country.
How it works
Small businesses sell their products to other big companies, which do not immediately release cash. Meanwhile, the former, with limited wherewithal, require more funds to expand their business. Banks are not so keen to extend credit to them beyond a point.
Here comes the role of a factoring company, which gives 80 percent of the assignment money upfront at an interest cost in the range of 14-15 percent per annum to the seller (chargeable on monthly basis). The factor will recover the money from the product buyer after a stipulated period. If the SME client does not repay interest, the factor will deduct it from the rest 20 percent at the time of final realisation.
Does it require any collateral?
“Banks want more collateral against loans. Factoring companies are relatively flexible. If we are satisfied with the quality of the debtors, we then are not hooked into collateral. In the last few years, we have seen SMEs are getting starved of traditional liquidity. In the recent time, a lot of new clients are approaching us,” the CEO said.
Increase in factoring demand
No doubt, it is banks’ drying up credit. In the wake of rising bad loans, banks have of late, become very selective about sanctioning SME loans. Other major trigger is the Factoring Bill enacted by the Parliament in January, 2012.
“Factoring bill brought in clarity of assignments. Earlier, we did not have any right to proceed legally against the buyers (on behalf of SMEs) in case of any default. Moreover, we could not expect our clients, who own smaller business entities to pay off the debt. The Bill now empowers us to have the same legal right,” Sarbadhikary said.
Following the Factoring Bill, the Reserve Bank of India recently issued guidelines creating a new non-banking finance category christened as NBFC-Factors. This has separated the class from other NBFCs, which have been facing a slew of regulatory issues.
Capital infusion and fund raising
Shareholders of India Factoring include Punjab National Bank (30 percent), Malta-based FIMBank (49 percent), Italy-based Banca IFIS (10 percent), Blend Financial (1 percent), and employees’ ESOP (10 percent).
We can extend the list of funding options for SMEs by going factoring business full blast. It is highly desired.
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