The Use of “Reverse Factoring” For SME Financing

The World Bank 1818 H Street, NW Washington, DC 20433 (202) 473-8738 [email protected]

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

Trade Credit Receivable

– the extension of

Accounts

– is an important source of financing in emerging markets

•

Demirguc-Kunt & Maksimovic (2001), Fisman & Love (2002)

•

Van Horen (2004), Fisman & Raturi (2003), McMillan & Woodruff (1999)



Trade Credit is Often Extended by

and Medium Sized Firms (SMEs) Small

•

For instance, 81.1% of small Mexican firms offer supplier credit: Firms that Grant Some Type of Financing to Clients Total Small Medium Large AAA 75.6 81.1 73.1 73.3 57.1

Central Bank of Mexico, “Credit Market Survey”, 2004.

Export 72.6

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How can a firm convert its (illiquid) Accounts Receivable into Short-Term Financing?

"I don’t lend against Assets, I lend against Collateral“ -- CEO of Heller Financial

 •

Receivable Loans The collateralization of receivables

•

Requires good collateral law allowing “floating liens”, electronic credit bureaus and registries, strong bankruptcy laws, and efficient judicial implementation



Factoring (“Receivables Management”)

•

The sale of receivables

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WHAT IS FACTORING??

Step 1 : “Tiny Textiles (TT)”, an SME, sells 1 million in raw material to its customer “Massive Manufacturer (MM)”, a large multinational exporter. TT (in a competitive gesture) offers MM 30-days trade credit; TT records the sale as 1 million in accounts receivable.

Step 2: TT needs working capital to produce more inventory.

TT’s only available assets to use for collateral are its accounts receivable from MM. The factor purchases TT’s accounts receivable (TT “assigns” its accounts receivable from MM to the factor.) TT receives today 80% of the face value of the accounts receivable (800,000.) Step 3: In 30 days, the factor receives the full payment from MM, and TT receives the remaining 20% less interest (on the 80%) and service fees.

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“Ordinary” Factoring



TT sells all its receivables -- from various customers (MM, AA, ZZ, etc.) -- to a factor.



Requires the factor to collect timely and comprehensive credit information and calculate the credit risk for MM, AA, ZZ, etc.

TT MM AA ZZ 5

“Reverse” Factoring



The lender pools and purchases accounts receivables payable by only MM from many suppliers (including TT)



The lender only needs to collect credit information and calculate the credit risk for MM (a large, very transparent, internationally accredited firm)



Since the credit risk is reduced, lenders in developing countries can absorb the credit risk and offer factoring “without recourse”

TT MM AA ZZ UU MM AA ZZ YY MM AA ZZ 6

Advantages of Reverse Factoring for SMEs



Reverse factoring allows firms to transfer the credit risk of their borrowing to only their most creditworthy customers and does not require credit information on a pool of customers.



The credit risk is equal to the default risk of the high-quality customer and not the risky SME. For the (high-risk) Seller: Short-term (and cheaper) working capital financing For the (creditworthy) Customer: The ability to negotiate better terms with suppliers, lower cash management costs For the Factor: Low information costs and credit risk (and securitizations)

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Challenges in Emerging Markets



Taxes (stamp tax, VAT, etc.)



Burdensome and costly regulation of NBFIs



Weak legal environment

•

Factoring Act

•

Electronic securities and signature Laws



Inadequate technology infrastructure

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Example: The Nafin Product in Mexico



Uses an electronic platform to provide on line factoring services, which allows cheaper, quicker and safer transactions



Nafin has extended over US$ 9 billion in financing (~US$600,000 monthly); over 1.2 million transactions – 98% to SMEs.



Depends on strong technological infrastructure and good electronic security and signature laws



Provides factoring, contract financing, training and technical assistance to suppliers

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Nafin Factoring Product

Day 1 Day 10

S

receives a purchase order from

B

, due in 40 days

Supplier S, Buyer B

and sign to allow factoring Day 50

S

makes a delivery to 30 days

B

,

Factoring

and

B

posts a

documentos negociables

on its Nafin website, payable to

S

in

S

uses the Nafin website to factor its recevables from

B

with

F

(at an average interest of bank rate + 5%) and receives today the full amount of the

documentos negociables

, less interest Day 80

B

repays

F

directly the full amount of the

documentos negociables

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Nafin Purchase Order Financing

Purchase order financing

Day 1 Day 10

S

receives a purchase order from

B

, due in 40 days

S

days

Day 50

delivers the order and posts a

documentos negociables

website, payable to

Factoring S

on its Nafin

B

in 30

B S

credit from Nafin, equal to 50% of the purchase order (at an + 7%) Nafin factors the receivables from

B

as payment: Nafin deducts an amount equal to the used portion of the line of credit plus interest (bank rate + 7%) and

S

receives the difference less interest (at an average factoring interest rate of bank rate + 5%)

Day 80

B

repays Nafin directly the full amount of the

documentos negociables

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Lessons Learned

 Most suppliers have no other source of financing.

 The success of the Nafin program shows how the use of electronic channels can reduce costs and increase access to SME financing.

 Banks can lend at lower margins  Penetrate rural areas  Requires supporting laws and regulations  Reverse Factoring can be an important source of financing in countries with weak secured lending laws, inefficient bankruptcy systems, and imperfect records of upholding seniority claims.

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