Businesses often face catch 22 situations especially when engaged in international trade. They book a sale of finished products or services for which they will have to wait a long period to receive the payment. Businesses need funds to purchase manufacturing supplies, deliver the promised products or services and to pay employees to perform the services. In this Catch-22 situation of managing debtor position vis-à-vis working capital requirement, businesses often face inordinate challenges.
This particular problem is heightened in international trade when a business books international sales. An international payment from foreign customers takes longer compared to what it takes in the case of payments from locals and sometimes foreign suppliers also demand sooner payments. At such times, export factoring can be a great financial tool that comes to the rescue. By applying this tool, cash flow issues can be alleviated easily. Further, with the help of this tool, the value of accounts receivables or trade invoices can be unlocked easily by businesses.
Let’s, therefore, dive into the meaning of export factoring and also understand its advantages for the export businesses.
Export Factoring: Meaning& Process
Export factoring means purchase, funding, management, and collection of short term account receivable based on goods and services provided to foreign buyers. Goods are delivered on open account credit terms without securing by any payment instrument such as a Letter of Credit. To ensure prevention of financial loss caused by buyers’ insolvency, export factoring can also be handled with insurance.
Factoring is a kind of financial transaction in the form of debtor financing in which a business sells its accounts receivable (i.e. debtors) to a third party (factor) at a discount. Unlike a bill discounting facility, factoring involves a continuous relationship between a factor and a seller, to finance and administer the receivables of the latter. Factoring companies pay cash against the credit sales of the client and obtain the right to receive future payments on those invoices from the debtors of the clients.
Factoring must not be confused with bank loan as it essentially differs in three main ways. In factoring the prominence is laid upon the value of the receivables and not on the firm’s creditworthiness. Secondly, in factoring the purchase is of an asset (the receivables) and not a loan. Thirdly, in factoring three parties are involved, unlike bank loans where there are just two parties involved in the stead.
In the factoring arrangement, the three parties involved comprise of - the seller, the debtor and the factor. The debtor owes the seller money for the purchase of services/goods. After the debtor has accepted the goods or services, the resulting obligation to pay the seller becomes a negotiable instrument to be sold. The third party in the factoring arrangement is the factor. The factor buys the invoices from the seller, at a discount to allow for the factor’s return and with a reserve that is a margin that the factor holds back till the receivable is settled by the debtor. Once payment is received on the invoice at its full face value, the factor forwards the reserve to the seller.
The diagrammatical representation mentioned below will give you a clear idea of export factoring process flow. Take a look at it.
Rising Popularity of Export Factoring
Traditionally, Letters of Credit (LOC) and bill discounting were considered to be the most popular forms of financing amongst the Indian trade community. Recently, domestic and international sellers have also found more benefits in going the factoring way. This is mainly because of two reasons-
Talking about export factoring, this tool has fast turned out to be a very effective tool of debtor management and cash management especially for mid size organizations who have deficient working capital arrangements and where they are selling to large companies and conglomerates. It bundles together credit protection, export working capital financing, foreign accounts receivables bookkeeping, and collection services- all in one product.
Advantages of Export Factoring
Immediate Cash Injection- Export factoring is the process of conversion of credit sale into cash without recourse to the exporter. The exporter sells their invoice receivables to the factors and immediately receives working capital. This immediate injection of cash helps the exporter to strengthen the company’s daily operations and allow a smooth flow of business.
Business Growth- The exporters increase their sales volume by offering open account terms to their importers, enabling the importers to place larger orders.
Reduced Risk- The factoring companies’ guarantees payment from the importers. In case the importer defaults on a payment due to bankruptcy or insolvency, the exporter does not have to bear the default.
Collection Management- The factoring companies handle the collection of payment from the importer, taking away the hassle of collection management from the exporters. The exporters do not have to worry themselves about the different time zones or language barriers.
Improves Cash Flow and Working Capital- The exporters are paid upfront by the factoring companies and therefore, they have access to capital for materials or to fund growth and investments.
Competitive Advantages- The export business is expanding tremendously and to keep pace with the fast-changing world, the exporters are required to sustain competition. An exporter that offers open account terms can have a competitive edge over others and win business in a competitive marketplace.
The demand for export factoring is rising as export contributes approximately 20% in India’s GDP. As per evaluation by the Indian Ministry of Commerce, 22 out of 30 export sectors witnessed positive growth. As export business is rapidly growing, exporters require steady working capital to sustain competition and enhance business growth too. And this is why the need for flexible credit tools like export factoring crops up.
Although the demand for export factoring in India is rising and despite the many advantages of export factoring, however, export factoring in India when compared globally, is growing at a very slow pace. Factors like lack of awareness, a perception of high-interest rates and cumbersome documentation processes, have prevented the growth of factoring services in India.
Globally, cash credit and overdraft facilities are not easily available and hence the finance happens through factoring. Also, their legal system is strong to back such a facility. However, in India, cash credit and overdraft facilities are more acceptable to the borrower. Debtors do not easily accept the assignment and are not ready to pay directly to factors. Even the banks have apprehension about factoring and consider it as a competitive product offering.
In the global scenario, the cost of funding is low and the exporters receive the amount at a low rate compared to what the Indian exporters avail. However, Indian exporters can now apply to export factoring services offered by reliable service providers to avoid paying additional interest charges demanded by banks.
There is a need to create awareness amongst exporters on the use of export factoring to enable them to sell on open account terms without risks associated with open account sales. Until and unless exporters understand the benefits of export factoring, they will continue to remain sceptic regarding the utility of this tool.
The role of factoring services in India is decisive for the Indian exporters as such would enable exporters to take quick andinformed decision, increase the organizations' liquidity flow and safeguard the business against the loss due to bad debts and many more advantages in favour of the export business.
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