Trade Receivables Financing: Tale of 3 Modalities

Dayita Kanodia | Finserv@vinodkothari.com

Trade receivables form an important part of working capital, and given the increasing trend toward the provision of buyers’ credit, occupying an ever-increasing part thereof. Traditionally, it is funded by usual modes of working capital funding. However, businesses have been searching for alternative modes of receivables financing. 

This article discusses and compares three prominent alternative modes of working capital finance, namely – Factoring, Bill discounting and Loan against invoice.

1. Factoring

Mechanism

Factoring involves selling a company’s accounts receivable to a third party, known as a factor, at a discount. The factor then assumes the responsibility of collecting the receivables from the company’s customers. Factoring can be done on a recourse or non-recourse basis. In recourse factoring, the company retains the risk of bad debts, while in non-recourse factoring, the factor assumes this risk.

Legal Framework in India

The Factoring Regulation Act, 2011 governs the factoring business in India. This Act aims to regulate factoring services, provide for the registration of factors, and protect the interests of small businesses. 

Benefits

• Immediate Cash Flow: Factoring provides immediate access to cash, improving liquidity and enabling businesses to meet their short-term obligations.
• Outsourced Collection: The factor handles the collection process, saving the company time and resources.
• Credit Risk Management: In non-recourse factoring, the factor bears the risk of non-payment, protecting the business from bad debts.

Drawbacks

• Cost: Factoring can be expensive, with fees often higher than traditional financing options.
• Customer Relations: Some customers may prefer dealing directly with the business rather than a third party for payments.

2. Bill Discounting

Mechanism

Bill discounting, also known as invoice discounting, involves selling a bill of exchange to a financial institution at a discount. The financial institution advances the cash to the company, typically a percentage of the bill value, and collects the full amount from the customer when the invoice is due.

Legal Framework in India

Bill discounting is primarily governed by the Negotiable Instruments Act, 1881. This Act defines and regulates bills of exchange, promissory notes, and cheques:

• Negotiable Instruments: Bills of exchange are considered negotiable instruments, meaning they can be transferred from one party to another.
• Endorsement and Delivery: The process of discounting involves the endorsement and delivery of the bill to the financial institution.

Benefits

• Quick Access to Funds: Like factoring, bill discounting provides quick access to cash.
• Retention of Control: The company retains control over its sales ledger and customer relationships, as the customer is usually unaware of the discounting arrangement.
• Flexibility: Bill discounting can be used as needed, allowing businesses to finance specific invoices rather than their entire receivables portfolio.

Drawbacks

• Credit Risk: The business retains the risk of non-payment by the customer.
• Cost: While typically less expensive than factoring, bill discounting still incurs fees and interest costs.

3. Loan Against Invoice

Mechanism

A loan against invoice involves using outstanding invoices as collateral to secure a loan from a financial institution. The lender provides a loan based on a percentage of the invoice value, and the company repays the loan once the customer settles the invoice.

Legal Framework in India

Loans against invoices are like any other secured loan and are therefore governed by the RBI Regulations applicable to the financial institution. 

Benefits

• Collateral Utilization: Businesses can leverage their receivables to secure financing, which can be particularly useful for companies with limited tangible assets.
• Maintained Customer Relations: The business continues to handle its customer interactions, maintaining its relationships.
• Flexible Financing: Loans against invoices can be tailored to the specific financing needs of the business, offering flexibility in terms of loan amount and duration.

Drawbacks

• Credit Risk: The business is responsible for repaying the loan regardless of whether the customer pays the invoice.

Refinancing by financial institutions

Receivables acquired as a part of the factoring business.

As discussed above, a financial institution registered as a factor with RBI can purchase the accounts receivables of a business and advance money against it. However, the question which arises is whether this financial institution who has accepted the receivables can subsequently transfer the same to another financial institution ? 

Under the Transfer of Loan Exposure Directions of RBI (‘TLE Directions’), receivables acquired as a part of factoring business can be transferred to another financial institution. 

MHP Requirements

The TLE Directions mandate a Minimum Holding Period (MHP) requirement during which loans should stay in the books of the originating financial institution. The MHP requirements for loan tenors of 2 years and less is 3 months. Considering trade receivables have a very short tenor, it will not be possible for factors to fulfill the MHP requirements. 

Accordingly, the TLE Directions provide an exemption from the MHP requirements for receivables acquired as a part of factoring business. 

Para 39 of the TLE Directions provide that, 

“Provided further that the transfer of receivables, acquired as part of ‘factoring business’ as defined under the Factoring Regulation Act, 2011, will be exempted from the above specified MHP requirement subject to fulfilment of following conditions:

1. The residual maturity of such receivables, at the time of transfer, should not be more than 90 days, and
2. As specified under clauses 10 and 35 of these directions, the transferee conducts proper credit appraisal of the drawee of the bill, before acquiring such receivables”

Can bills discounted be subsequently transferred by the financial institution ?

Financial institutions which had discounted bills of exchange for their customers may subsequently transfer the same. However this transfer will be effected under the Negotiable Instruments Act, and will not fall within the purview of the TLE Directions. 

Loan against Invoice

Loan against invoice is similar to any secured loan advanced by a financial institution and will therefore be governed by the TLE Directions in a similar manner. 

Are trade receivables discounted/purchased from the borrowers eligible for securitisation ?

In terms of para 6 of the Securitisation of Standard Assets Directions (‘SSA Directions’), trade receivables with tenor upto 12 months purchased by lenders from their borrowers will be eligible for securitisation provided the drawee of the bill has fully repaid the entire amount of last two loans/receivables within 90 days of the due date.

Loan against invoice will be securitised in the same manner as that of any secured loan. 

Conclusion

Trade receivables financing in India, through methods such as factoring, bill discounting, and loans against invoices, offers businesses valuable tools to manage cash flow and liquidity. The regulatory frameworks provided by the Factoring Regulation Act, 2011, the Negotiable Instruments Act, 1881, and RBI guidelines ensure a structured and secure environment for these financial transactions. Further, lenders after advancing cash to businesses against invoices can transfer or even securitise the same.