Small or medium size enterprises (SMEs) may face many problems and market challenges in their efforts to develop and grow. With the many difficulties faced by the small business sector, the unique financial problems that overshadow the barriers hindering the small firm’s survival and growth pertain to credit rationing and finance gaps. The notion that SMEs experience disadvantages in their relationship with the capital market, i.e. the existence of credit rationing and also Finance gaps in their relationship with banking institutions have been popular for decades. The existence of this problem normally directs many businesses to seek different alternatives of finance for their operations. As sales grow, the major initial source of external financing is likely to be trade credits and to some extent stringently regulated bank loans. Many small or medium sized enterprises (SMEs) may confront problems when attempting to gain access to external funding because of the natural difficulties which financial institutions face in producing consistently reliable risk assessment processes. Particular problems for firms may be experienced in the management of working capital. In an attempt to alleviate such problems many firms have sought to pledge and finance an important element in their working capital, that of accounts receivable; a process known as factoring. There has been a rapid growth in the use of factoring and invoice discounting with an average annual rate of growth in excess of 20%. This is estimated to contribute around 6% in additional finance to SMEs compared to 6.5% provided through venture capital.
Many firms do not require immediate cash payment for their merchandise, which gives rise to trade credit; an area most likely to absorb unnecessary cash from the business. Firms normally seek bank credit in the form of short-term loans and overdraft facilities; however, many report problems in terms of access to external finance, delayed payment and the management of working capital and cash flow control. It is the underlying causes of these difficulties and the most appropriate strategies for their alleviation that is the subject of vigorous debate. Firms attempting to finance smaller projects through debt finance may confront a ‘debt gap if they have insufficient access to collateral. The financial expertise of management and the burden of security would tend to be greater for younger and smaller businesses.
Market volatility and delayed payment compromises working capital control in smaller and younger firms.
What is Invoice Factoring ?
Factoring is a financial transaction whereby a business sells
its accounts receivable to a third party (called a factor) at a
discount. Factoring makes it possible for a business to
convert a readily substantial portion of its accounts
receivable into cash.
How Invoice Factoring works?
Factoring involves a process where a specialized firm assumes the responsibility of the administration and collection of the account receivables for its clients. It can be considered as a form of short-term commercial financing based on the selling of trade debts at a discount, or for a prescribed fee plus interest. The mechanism of factoring involves the interaction of three types of firms or economic agents, the client firm, the customer firm, and the Factor. The client firm provides its customers with goods or services for payments on terms ranging in periods between 30-90 days. The firm is typically a supplier of a good or service, and its credit accounts are classified as accounts receivable. The customer firm, is the one that buys goods and services from the supplier and therefore has the obligation to make the financial payments within a stipulated period. The third economic agent is the factoring firm; it provides the client firm with specific functions, namely, it substitute cash for accounts receivable, hence placing the client’s extension of credit on a self-liquidating basis as if it was selling for cash (i.e. provision of finance for working capital). It assumes the credit risk for the accepted accounts and thus takes full responsibility for the solvency of such customers to the extent of the accepted or approved amounts (i.e. provision of credit management). It also checks the credit and collects the accounts (i.e. sales accounting services).
Is Factoring a Solution?
Access to finance and financial control present problems to many SMEs. Younger and smaller firms and those requiring significant capital outlays may be more prone to access and management problems. Factoring and invoice discounting would appear to offer some solution to the problems of access to and management of working capital. From the supply side it might be expected that these firms could constitute a significant market for the sale of factoring and invoice discounting services.
Accounts receivables are the most values assets for any company. It is one of the mode for increasing sales and expanding business. The payment is done of the 80% of the invoice value. The 20% of the value is kept as reserved and is paid after deducting the fee once the amount on the invoice is due.
The practice of accounts receivable factoring is most suitable for small and medium business owners. Due to accounts receivable factoring small and medium business owners are able to generate cash and avoid the debt trap. It also helps in representing string financial status and avoids interest on any loans if otherwise taken.
Increase your working capital
Accounts receivable factoring also results in increased working capital as receivables are conditional on customer’s creditworthiness and not the business owners. It helps to avoid loan repayment, transferring business equity, engaging the assets, and also avoid yearly loan review process. For a small business owner accounts receivable factoring represents gaining working capital without overtaking any debt or loan. It is also a mode to increase sales without any repayment tensions for any loans etc. Thus business is able to meet demands and the circle keeps on auto-rotating as accounts receivable factoring increases sales and increased sales asks for more money to complete more orders.
Flexible Funding and Cash flow relief
Accounts receivable factoring also provides relief from non-paying clients or slow paying clients. It generates more sales due to increased orders. It also offers flexible funding program to help heighten the sales graph and take vendor discounts due to availability of cash.
This practice of accounts receivable factoring generates cash to fund the payrolls and taxes due. The funds thus generated also help to increase the inventory or buy new equipments, tools, etc to flourish the business.
The availability of cash helps small business owners to negotiate for discounts from their vendors and suppliers. It also helps to reduce book keeping, depositing checks, monitoring collection process, and preparing reports for collections. Brokers or agencies also provide their services for accounts receivable factoring. They help the business owners to manage their collections, payments, generating more cash and managing their cash inflow process.
The existence of cash flow problems and cash shortages will almost certainly lead to substantial financial difficulty and financial management problems that force firms to request bank credit in the form of loans or overdraft facilities. The factoring firms often claim that they are the ideal financing option for cash strapped businesses. Therefore, it is useful to explore if there is an association between the existence of financial difficulties and factoring use.