Factoring is a transaction where an entity, like a Micro, Small, and Medium Enterprise (MSME), sells or mortgages its receivables to a third party or a factor to avail funds. This factor can either be a financial intermediary like a bank, a non-banking financial corporation (NBFC), or alternate lenders. The easiest method to generate stable working capital is to use receivables as an asset, and factoring is an effective way to do so.
Although the RBI's Factoring Regulation Bill was enacted in 2011, the RBI was authorized to allow NBFCs to remain in factoring business only if it was their principal operation. However, this restriction was eased in the Amendment Bill of 2021, allowing more non-bank lenders to enter the domain while expanding the avenues of working capital credit to small businesses. The bill came at a time when the MSME sector was facing a severe cash crunch due to the pandemic, providing a much-needed respite for them. Besides this, factoring also paves the way for other benefits for MSMEs.
Check out our finance guide here if you wish to learn more about factoring and its key components.
Technological innovations, widespread internet penetration, and tools like e-invoicing and Goods and Services Tax Identification Number (GSTIN) have become pillars to support MSMEs. Tech-based factoring services are efficient and speed up documentation, decision-making, and transaction processes. Providing real-time information through AI and blockchain technology also provides factors with a realistic picture of an MSME's credit profile while assisting in the ease of doing business.
Technology-based solutions empower MSMEs to reduce their financing costs and improve business efficiency in a transaction. Working capital for both buyers and sellers is getting optimized with the provisioning of short-term credit.
Factoring is a powerful alternate finance option, and collateral-free financing is a critical facet that separates it from the traditional financing model. Because factoring entails selling an outstanding payment for a fee, even companies with little to no asset collateral can avail of its benefits. In addition, there is no requirement to submit a monthly working capital statement like in working capital overdrafts or cash credits. This is a gamechanger for small businesses that otherwise would not have been eligible for a loan from a traditional banking institution. The lack of collateral also means reduced bureaucracy and paperwork.
The RBI's Factoring Regulation (Amendment) Bill and the subsequent plan to mandate companies with a turnover of over INR 250 crore annually to register on the Trade Receivables Discounting System (TReDS) will play a significant role in ensuring that MSMEs secure funds quickly. It will also lower interest costs and improve cash management. This is expected to enable almost 9,000 NBFCs to participate in the factoring market.
The massive shift toward financial inclusion will aid Indian MSMEs in utilizing working capital to expand their businesses, cater to excess demand, explore new markets, and diversify their product offerings. Such steps would establish Indian MSMEs as integral components of the global value chain and enable them to work on an equal footing with their international counterparts.
Factoring players also provide a plethora of ancillary services such as insurance packages, forex advisory, and shipment tracking tools, among others. It can also unlock the blocked working capital funds and solve the delayed bill collection problem that plagues most small-sized firms. This service reduces the time, effort, and money involved in bookkeeping and is a regulated, easy, and safe way to keep businesses functional without worrying about funding.
Although the government has introduced major changes to ease factoring in India, much more must be done to regularize the country's trade finance sector, in general. With more government support and a robust legal structure, factoring can be a great ally for MSMEs. And if successfully implemented, it can lead to a significant economic revival for both the MSME sector and the economy.
The article was first published on smeworldasia.