How should small businesses view factoring when managing receivables?

A shortage of the working capital needed to run any business day-to-day is a challenge for many businesses. To help micro, small and medium enterprises (MSMEs) improve their access to working capital by making it easier to monetise their receivables, the Indian government recently passed a  Factoring Regulation (Amendment) Bill.

In a nutshell, the amendment lowers the threshold for non-banking financial companies (NBFCs) to take part in the factoring business. In a factoring arrangement, an NBFC buys the right to collect on an MSME’s unpaid invoice, paying the MSME the value of that invoice while charging it a fee based on percentage of the invoice value.

This arrangement gives an MSME facing late payments from its clients speedier access to funds. The resulting boost to its working capital means it can be better positioned to grow, by investing in equipment, or often to meet basic day-to-day expenses like salaries and utilities. 

The health of such businesses are vital to the global economy. In India, for instance, MSMEs are responsible for 45% of manufacturing output, over 40% of exports, around 30% of gross domestic product, and employ  60 million people. 

But there are drawbacks to factoring as well that MSMs need to consider. While factoring can be a useful way to access funds, compared to bank loans, their charges are significant.

Even more fundamentally, improving a business’ ability to access this kind of funding may not necessarily be helpful to them in the long run. As we detail in our book, Let The Cash Flow, RIABU holds the view that a supplier's payment terms are negotiable, but once an agreement has been reached, it needs to be binary. This means that a business commits to providing the requested goods and services on time and to specifications, and its client commits to paying for these goods and services by the agreed date.

Services such as factoring may fill the working capital gap, but reliance on such arrangements could also lead small businesses to postpone the essential step of putting in place a rigorous system based on early, consistent and clear communication with their clients, with the goal of ensuring they are first in line to get paid.

Implementing and fine-tuning such a system, which we term the Virtuous Revenue Cycle, takes time, because it often requires a mindset shift within a business. While services like factoring may sometimes help in the short term, it is important to keep the long-term health of a company’s working capital in mind and start investing time in getting the fundamentals right.