EXTERNAL FINANCING FOR SMES: FACTORING
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.
Keywords
debt factoring internal or external
- Credit: J.O.
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