If bankers are reluctant to provide working capital loans to cash-strapped MSMEs, what is in it for them to fund MSMEs through factoring? If it is fatter fees, commissions or larger discounts, then factoring is a costly proposal for them. Also, when the banking industry is short on capital to lend, financing to MSMEs through either factoring or working capital loans will be limited.
Assistant professor, finance, Indian School of Business, HyderabadEnd-July, Parliament passed the Factoring Regulation (Amendment) Bill 2020, which is expected to ease working capital financing for MSMEs by allowing more banks and NBFCs to enter the factoring business.
Factoring allows companies to sell their receivables to a bank or NBFC at some discount and get upfront payment, rather than wait for customers to pay it off. The bank or NBFC will directly collect the receivables from customers at a later date. Discount would reflect the quality of customers as well collection time.
But, importantly, factoring converts illiquid receivables sitting on a company’s balance sheet into liquid cash. MSMEs in India typically face substantial delays in realising their invoices. This not only hampers their capacity to pay their suppliers or bankers, but also forces many to scramble for last-minute, exorbitant financing options to avoid getting classified as an NPA account.
Also, from the MSMEs’ perspective, factoring has a significant advantage over working capital loans in that it makes balance sheets less leveraged. When it factors the receivables, it transforms its illiquid asset into a liquid asset — cash. If it borrows against receivables, its debt and, consequently, debt-equity ratio go up, hurting its term loans or credit ratings.
Over the last couple of years, bigger firms have deleveraged and repaid debts, while MSMEs have become more leveraged. Factoring could be helpful from the perspective of cashcstrapped, leveraged MSMEs. Presently, only NBFCs whose substantial revenue comes from factoring can provide such services. The amended Bill will now allow any bank or NBFC to provide factoring services.
Utilising RBI’s Trade Receivables Discounting System (TReDS), it could also create a vibrant market. But is it a good proposition for NBFCs? First, from a banker’s perspective, buying receivables isn’t much different economically from providing a working capital loan collateralised by those receivables. Both options require a bank or an NBFC to invest substantial capital upfront. Further, the quality of a bank’s balance sheet ultimately depends upon the quality of the receivables. So, the risk involved in both types of funding is similar.
Perhaps factoring has an advantage as collection of receivables could be better by NBFCs. But NBFCs can always provide — for a fee — collection services to MSMEs to recover dues after providing working capital loan against the receivables.
If bankers are reluctant to provide working capital loans to cash-strapped MSMEs, what is in it for them to fund MSMEs through factoring? If it is fatter fees, commissions or larger discounts, then factoring is a costly proposal for them. Also, when the banking industry is short on capital to lend, financing to MSMEs through either factoring or working capital loans will be limited. Hence, factoring does not fundamentally relieve MSMEs from their dependence on banking health.
Finally, the aggregate banking capital stuck in financing working capital against capital expenditure is similar even under the factoring option. In India, 65% of bank lending is for working capital, only 35% for capital expenditure. Integration of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (Sarfaesi) Act and, perhaps, the Insolvency and Bankruptcy Code (IBC) could enhance the collection rates for NBFCs.
But the need of the hour is to think of solutions that allow banks to focus more on capital expenditure loans, and less on working capital loans. GoI can institutionalise a ‘net-off’ scheme to be implemented via a central clearing house for depositing only net payables after adjusting its receivables. These deposits can then be made to make payments to MSMEs in net receivable positions. This can substantially reduce the banking capital stuck in funding working capital.
Incentives could also be provided to larger manufacturers to speed up payments to smaller suppliers, thereby transferring some liquidity from their balance sheet to smaller firms. These could be in the form of tax rebate or interest subvention on loans obtained by larger companies for this specific purpose.
So, instead of using banking capital, we should aim to use surplus liquidity within the corporate sector to fund cash-strapped MSMEs.