Factoring & bill discounting: Meeting working capital needs

Bangladeshi businessmen often face short-term cash crisis before and after producing certain goods, especially until the payment for sales and exports is made. There are mechanisms to resolve the problem but they are yet to be properly functional. Factoring and bill discounting are such financing products.
Practically, manufacturers and traders need short-term sources of financing to run day-to-day operations of business. When their finished products are produced for customers, the latter may take up to few months to pay in view of liquidity situation and as per terms of sales. As a result, manufacturers or traders face difficulties in purchasing raw materials and other inputs to keep the operations running. In such a situation, they have the scope to use bill discounting and factoring to tackle the cash crunch.
The two are identical financial instruments that are used to provide capital to businesses, mostly to small and medium enterprises (SMEs), to be derived from invoices raised. Both are short-term trade financing products, banking on future receivables through sales or transfer of the rights before due date.
Bill discounting can be defined as advance selling of a bill to an intermediary before it is due to be paid. Factoring involves a third party, which is placed between the buyer and the supplier. The third party, i.e. is the factor, purchases a company's unpaid invoices at a discounted rate.
In both the methods, interest and fee are calculated based on risks of non-payment, so a funder would look at creditworthiness and trading history of the customer. The originator is liable if the buyer doesn't pay and the factor take over liability of non-payment. In bill discounting, if the buyer fails to pay, the liability goes to the drawer. In 'non-recourse' factoring, the factor bears the loss of bad debts.
While dealing with bill receivables, the original company that owns the bill receivables will continue its obligations to chase payment and fulfil the upkeep of the sales ledger. The customer will still pay the company directly, not the discounting party. Typically, a factor will pay up to 95 per cent of approved invoices.
Difference between factoring and bill discounting is the way the services are undertaken. In factoring, a factor undertakes service, based on quality of the debtor, past record and credit worthiness, whereas the credit worthiness of the drawer with the banker is a major concern for the bill discounting facility.
Some companies might not let their customers know that they are using financial services as it might make negotiating a good deal with suppliers more difficult. So, confidentiality is an important reason for choosing invoice discounting.
Bill discounting is often called 'confidential invoice discounting'. The buyers won't know the use of financing facility although in Bangladesh, the bill discounters notify the billing company about transactions and ask for guaranteed payment to the particular bank account.
Factoring, on the other hand, means the invoice finance providers will deal directly with the customers. Thus the buyers know the sellers are using invoice finance.
Factors may be independent organisations or subsidiaries of major banks or financial institutions. Factors closely examine the applicant company, assessing financial stability of the company, its history, and, most importantly, quality of the company's credit customers. Most of the financial institutions are providing discount of invoice to their customers.
Factoring and bill discounting are financial service covering financing and collection of accounts receivables in domestic as well as in international trade. Factor gets credit control services included as part of invoice factoring, but it's not included with bill discounting.
Factoring is usually a service agreement as well as financing arrangement. Bill discounting is purely a financial arrangement of a short-term nature.
Some business owners love having credit control services, because it frees up their time and late payments are less likely. Others prefer dealing with customers themselves. A choice between factoring and discounting depends on business size and turnover.
In our country, the SMEs look for alternatives to conventional short-term business loans to avoid lengthy approval process and strict credit requirements.
Both factoring and bill discounting help entrepreneurs to avail short-term credit. This option enables business owners to meet immediate working capital needs or improve cash flow by availing credit based on account receivables.
Unfortunately, there are limited services of factoring due to lack of law and policy. The bill discounting does not require any special law but it has not been widely used as financial products due to lack of awareness among both financial institutions and customers.
The Bangladesh Bank has allowed domestic factoring but only a few banks and financial institutions are offering domestic factoring and in most cases, they ask for collateral whereas this trade financing mechanism is sufficient for security. The concept of bill discount and factoring is to ensure financing without additional security. The central bank is in the process of drafting rules for international factoring and expected to complete it soon.
There are differences between two banking products especially for bill of import and export trade. Bill discounting is allowed under offshore banking by authorised dealer (AD) branches of banks for export and import bills and factors may be a scheduled bank or any specialised company.
The advantage of factoring is that factors are responsible for recovery of export bill and very suitable for developing country like Bangladesh as stock lot, demand for discount on invoice and refusal of payment against export are major problems for the country.

MS Siddiqui is a legal economist.
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