EXTERNAL FINANCING FOR SMES: FACTORING - The Thesis

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EXTERNAL FINANCING FOR SMES: FACTORING



picture showing someone working on an invoice.


Several works have confirmed the insufficiency of internal resources used by SMEs in financing their operations. Publications by Vasilescu (2010), BDRC Continental SME Finance Monitor (2013) and several works have underscored not only the inability of SMEs to rely on only internal resources, but also the availability of an array of external financing products for funding the development and growth of SMEs.

Some works have therefore sought to assess the use of external finance by SMEs. Mulaga (2013), analyzing the use of external financing by SMEs in Malawi concludes that firm size significantly determines the use of external financing or not. This view is however contrary to that of Beck et al. (2008). The latter, in assessing whether, why and how banks are financing SME around the world, point out that the lending environment is more important than firm size in shaping bank financing to SMEs. To support this further, Beck, co-authoring a separate work with Demirguc-Kunt (2006) reports that there is a strong economic effect of financial and institutional development on easing SME’s financing constraints and on increasing their access to formal sources of external finance. The co-authors therefore seek to shift the focus away from size-oriented policies to policies that improve the playing field between firms of different sizes. Mulaga however goes on to propose the roll-out of special financing schemes which target firms with different sizes.

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In effect, even though Vasilescu (2010) asserts the undeniable fact that external finance has traditionally been dominated by bank loans and overdrafts, there is evidently a strong indication about the development of alternative and appropriate external financing technologies which will respond to dynamic needs of business, especially SMEs as they grow.

Factoring is a financial transaction and a type of debtor finance in which a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount. A business will sometimes factor its receivable assets to meet its present and immediate cash needs.

 Factoring as a fact of business life was underway in England prior to 1400 and appears to be closely related to early merchant banking. In the nineteenth century, it became the predominant form of financing working capital for the high growth rates of the United States’ textile industry. 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. It is now a viable alternative to other external financing sources available for firms (Laura, 2013). In their recommendations following an assessment of the challenges faced by SMEs in obtaining credit in Ghana, Ackah and Vuvor (2011) propose that banks in Ghana should consider Factoring to enable SMEs ‘breath some air’ when it comes to managing accounts receivables.

Available literature on factoring could be classified into two broad themes. One presents a detailed analysis of the factoring mechanism while the other probes specific issues on factoring. A large chunk of the literature, especially with respect to literature which investigates key concepts under factoring, covers regions other than Africa.
Due to the special nature of the factoring transaction, and the fact that it is still yet to be widely employed in some regions of the world, several studies have sought to explain how it works, throwing more light on its merits.   Berry (1999), like Klapper  (2005), Mbatha (2011) and Spasic et al (2010), underscore the fact that unlike traditional forms of working capital financing, factoring involves the outright purchase of accounts receivables by the factor, rather than the outright collateralization of a loan. Since bank loans and overdrafts are dominant features of external financing (Vascileu, 2010), factoring enables SMEs avoid the problem posed by the unavailability of collateral. This advantage invariably feeds into Mbatha’s (2011) finding that a major advantage of Reverse Factoring was that it could be done without recourse. In effect, SMEs are therefore not obliged to put forward some form of fixed assets or personal guarantees just to obtain sufficient short term working capital financing.

While several authors explain the nature or mechanisms of the factoring contracts, Spasic et al sought to highlight the common characteristics which exist among the various forms of factoring agreements. These characteristics concern the subject matter of the factoring agreement, the conclusion, the effect, the termination, obligations of the parties, among others. Turcu, like Spasic et al, makes it clear that factoring is not ‘subdued to laws of specific component civil law institutions’, but rather regulated by the UNIDROIT (Institute for International Standard Civil Law) Convention of 1988. Additionally, the United Nation’s Convention concerning Debts Transfer in International Trade (UNICTRAL), is mentioned by Turcu as ‘one of the best efforts at standardizing the legislation regarding debts financing’ This is because it tackles some ‘omitted subjects’ per the UNIDROIT Conventions. These omissions concern the validity of foreign debt transfer and the vital problem of priorities in the debtor’s insolvency. In fact, the UNICTRAL according to Turcu, is superior to UNIDROIT except for the unexpected situations forseen by the latter. She argues that since the UNICTRAL has been recently adopted, it is yet to be widely applied.

But despite its immense benefits, ‘ordinary factoring’ has proven to be insufficient in some cases. Chen and Liang (2012) focused on the inability of factoring to solve the chain-debt problem which is prevalent in the China context. Through the review of relevant works on factoring and its development in China, the co-authors present a remodeled factoring technology -the Account Receivable Right Trading (ARRT) - to tackle this particular financing problem faced by China SMEs. The model involves the issue of right certificate, transfer of right certificate, and repurchase of right certificate. The right of account receivable is transferred by a trading certificate rather than in cash, and the trading is based on not only the credit quality of account receivable but also the value of the collateral, which is an additional guarantee. This eliminates ‘the traditional factoring’s confinement to creditworthy large companies. Additionally, the right certificates could be used as collateral in applying for loans or equally sold to another organization to cater for cash requirements. Additional research is however required on a suitable price mechanism for the ARRT as well as an appraisal and precaution system to manage related risks.

In a similar fashion, although employing a different method, i.e. a sample of factoring turnover as a percentage of Gross Domestic Product (GDP) of 48 countries, Berry (1999) points out another challenge with utilizing factoring. This resides in the reluctance of factoring organizations to take on the business of customers of SME firms because the former is not judged to be a ‘quality’ customer. The historical credit information of the firm is therefore central in enabling the factoring organization to arrive at a decision. Berry concludes that although factoring is in theory a form of finance, it is not available to all. Klapper (2005) suggests that the problem of informational opacity may be addressed by employing Reverse Factoring even though this will have to be the case for receivables from high-quality buyers.

To assess the risks and rewards associated with Reverse Factoring (without recourse), Mbatha (2011), uses a sample of heads of procurement of government institutions and chief investment officers of Development Finance Institutions (DFIs) in South Africa, as well as managers of 80 SMEs which supply government institutions and blue-chip firms. The findings showed that although reverse factoring could be highly appropriate, poor information on SMEs, weak Information Communication Technology (ICT) infrastructure and skepticism on the part of banking institutions hindered progress in this direction. Also important in Mbatha’s finding is the fact that reverse factoring could be extended to SMEs involved in government tenders, the construction industry, as well as those which are export-oriented.

Some other literature centered on the kind of business environment (either external or internal) within which factoring was a workable alternative. In a bid to test what country-level characteristics are associated with a greater use of factoring, Turcu tests the hypothesis ‘that there is a relation between  and factoring local macroeconomic and business environment variables’. Turcus came out with findings that factoring thrived in countries with better availability of credit information and weaker contract enforcement. It provided an example of how ‘reverse’ factoring was successful in overcoming barriers of access to credit information and weak contract enforcement in the Nacional Financiera (Nafin) Development Bank, Mexico. Through the creation of an online market infrastructure to facilitate on-line factoring services to SME suppliers.

Delving deeper, this time into the internal environmental features which prompt the use of factoring, Hartmann-Wendels and Stoter (2012) found that high risk firms which possess a dire need for short-term financing but face a restricted access to bank credit are more likely to resort to factoring (i.e. full-service factoring for that matter). Again, larger firms will generally go in for in-house factoring while smaller firms prefer full-service factoring. Hartmann-Wendels and Stoter also provide a unique twist from previous research by comparing full-service factoring to in-house factoring.

In hindsight, it is clear that even though factoring offers several immense advantages, it certainly has its limits in providing an alternative to existing traditional bank loans and overdrafts. With every country possessing a unique business environment, the Ghanaian economy equally presents varying features which could support or hinder the effective roll-out of factoring.

Keywords
debt factoring internal or external
is debt factoring internal or external


- Credit: J.O.

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