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Tuesday, 20 October 2020

Enterprise Explains: Factoring

Every investment bank in Egypt wants to be a non-bank financial services player — and plenty want to start with factoring. The latest entrant is Prime Holding subsidiary Prime Fintech, whose Endorse arm is spinning up factoring, financial leasing and consumer finance offerings. Mervat Erian, Prime Fintech’s CEO, suggested factoring is a “much needed and very much underplayed” form of finance in Egypt. If you concede that the formal banking system has basically refused to extend real (traditional) finance to small businesses, we agree.

So we know lots of investment banks have NBFS arms that want to offer factoring. But what is factoring, exactly?

Think of it as the second-oldest profession. In the simplest possible terms? Let’s say y ou’re a business with uncollected receivables (invoices your clients haven’t paid yet). You sell those invoices at a discount to a third party — called a factor — who goes on to collect them instead of you. You get money today by clearing out your accounts receivable, and the factor makes a profit.

It’s usually a relatively expensive form of financing, but if the company wants to receive up to 80% of the value of the accounts receivables quickly, rather than waiting for the length of the credit terms to receive payment, factoring could be the way to go.

Who benefits the most? It’s particularly useful for companies that conduct a large portion of their sales through accounts receivables, who might experience cash flow shortfalls if their short-term debts exceed their sales revenue. By purchasing the customer’s debt, the factor provides the company with the working capital to continue trading. This is particularly valuable for rapidly growing companies that need plenty of access to cash. It also transfers the risk of default — the risk that the customer won’t pay the accounts receivables — to the factor.

And how does it work? A factor charges a factoring fee in exchange for quickly releasing funds to the company selling the receivables. This fee is a percentage of the receivables, with the rate depending on industry, the volume of receivables being collected, how long the receivables have been outstanding, and most importantly the creditworthiness of the customers paying the receivables. If the factor believes the risk of default is high, the fee charged to the company selling the receivables will be higher, while if the default risk is low, the factor fee will be lower too.

Going further:

  • YouTube econ channel Marketplace has an easy to digest explainer here.
  • This piece from the Wall Street Journal explains how small businesses can use factoring for cash flow.
  • What are the risks? Bloomberg has an overview.

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