The Factoring Regulation (Amendment) Bill, 2021 — An Explainer

Yesterday, the Parliament passed an important legislation called The Factoring Regulation (Amendment) Bill, 2021. The bill is aimed at improving the liquidity and finances of the MSME sector.

How? By increasing the number of entities (lenders, NBFCs etc.) who offer factoring services to small businesses. The bill also aims to reduce some of the operational difficulties faced by factoring business earlier.

A few things first. Factoring is a transaction where a company (like MSMEs) ‘sells’ its receivables (dues owed by its clients) to a third party called a ‘factor’ (like a bank or NBFC). It does so to get immediate funds from the factor so that it can meet its working capital needs and not wait for its clients (and their tedious dispositions) to pay up.

This is a very dynamic process of debt financing which businesses all around the world depend on to operate without capital strings. Factoring is also closely related (and yet different) to another practice called “invoice discounting”, which we had captured earlier in another deep dive.

Today, we discuss how the present amendment has changed that factors do business in India and how effective it could be in rescuing a cash-strapped MSME sector.

Factoring Facts

The current bill was introduced in September 2020 to amend the Factoring Regulation Act, 2011. A Parliamentary Standing Committee headed by Jayant Sinha recommended a few changes, the most important among which was to allow extra classes of NBFCs to undertake factoring enterprises.

Well, those recommendations have been heard, and then some. According to the Finance Minister, the bill will pave the way for the number of factoring NBFCs to increase from seven currently to more than 9,000 post enactment.

The two most important issues faced by the MSME sector today are lack of credit and delayed payments, both of which affect their working capital needs. Despite having a decade-old regulatory framework, factoring hasn’t taken a major lift in India so far.

The reasons for that could be quite a few. For instance, the procedures or documentation involved were a little cumbersome. In addition, the culture of asset-based credit endorsement in India has led to banks depending more on the collateral or strong financials of the borrower rather than depending on the strength of the transaction.

Both of these drawbacks have been mitigated to some extent by this amendment, in theory, by changing the definition of factoring businesses (and security interests) and doing away with time-bound registration requirements.

The MSME Factorial

At the core of businesses like factoring lies the idea of insuring one’s credit, meaning indemnifying one’s accounts receivable against default. But credit insurance packages indemnify only losses, not non-payment of dues.

With factoring, a company (or assignor) essentially farms out its dues-related obligations (collection, control of sales ledger, assignment of debt etc.) to the factor. The point is for MSMEs to conduct businesses without the lack of receivables handicapping their finances or operation. In return, the factors take over the MSMEs’ book debts and earn from the debtors via interest and commission charges.

A similar process to factoring is invoice discounting. This is where a company or business sells its bills (instead of debts) to a third party (lender, NBFC etc.) before the bill’s maturity date at a discount. It is another way for them to get financed. But here the lender has lesser control over the company’s finances.

The factoring credit contributes only 2.6% to the total formal MSME credit in India (against 11.2% in China). As per the Standing Committee’s report, only 10% of the total receivable market is covered under the formal “bill discounting mechanism” in the financial system. The underutilisation of these businesses, therefore, is quite evident.

MSMEs, by virtue of their contribution to GDP and sizable share in exports, are central to the growth machinery. However, their operational efficiency gets heavily impacted with delayed payments.

RBI data shows that the average debtor days of MSMEs is above 210 and working capital cycle is above 300 days (as per 2017–18 numbers). This in turn leads to high inventory turnover ratio which coupled with narrow bandwidth available from the creditors today make their businesses extremely tough to conduct.

Globally, factoring businesses have performed quite handsomely, especially in Europe which accounts for two-thirds of the world’s factoring market. They bring in cost and operational efficiency by reducing processing charges and other expenditures which burden the assignor companies. The global factoring market is estimated to reach $9.2trn by 2025.

The Factors & Multiples At Hand

Having showcased all their benefits, it still remains to be seen how factoring businesses amplify the scale and success of MSMEs in India. Opening up the sector to non-NBFC factors and other entities is definitely expected to increase the supply of funds available to small businesses.

With more players in the market follows more competition which is likely to boost credit access for businesses and ensure timely payment against their receivables.

A growing need for alternative financing for MSMEs is anticipated in line with the winds of “democratised finance” across the country and the world at large. With UPI and GST helping accelerate formalisation and digitisation of MSMEs, this amendment could cement those gains further by giving impetus to the short-term financing needs of MSMEs through factoring and related credit facilities.

The RBI has been entrusted with making regulations to enforce the Act. One area which it could improve on is by mandating higher standards of data collection and sharing on the TReDS (Trade Receivables Discounting System) platform. The TReDS is a purely voluntary platform at present which could benefit immensely from integration with GST data.

By enabling automatic upload of GST invoices onto the TReDS platform, a real-time data sharing portal could be created that will allow buyers and sellers to have a single window access to invoices. GST information could add an additional layer of authenticity which would encourage financiers and factoring enterprises to shift to the platform and create an efficient working capital cycle for MSMEs.

(Originally published July 31st 2021 in transfin.in)