Profile of firms
78. The use of assets to generate cash flow presents advantages for start-up companies, which have
limited credit history, but also for fast-growing and cash-strapped firms, which can respond more rapidly to
their short-term cash needs than through traditional debt channels.
79. ABL can serve in particular the needs of SMEs that are at a growth stage or that face seasonal
build-up of inventory or receivables, whose value can be hardly reflected into traditional loans that have
already been underwritten. In this regard, ABL allows for more flexibility than traditional lending in
accessing a credit line, whose limit can be expanded quickly, as the value of the underlying assets change.
For instance, in the case of a revolving credit facility secured by receivables, the outstanding loan amount
may fluctuate on a daily base, providing a significant degree of flexibility to the borrower to finance
evolving working capital needs.
80. The lender’s close monitoring of the secured assets’ value also implies that highly leveraged
firms, or firms that have experienced recent losses, can obtain cash flow more easily than it is generally the
case for conventional lending. This is because conventional lenders, which do not rely on specific assets to
support their loan and are not closely monitoring any underlying collateral, typically require borrowers to
maintain a conservative financial position over the loan terms (Smith & Howard, 2013). In this regard,
through ABL, companies with strong accounts receivables and a solid base of creditworthy customers can
overcome temporarily lending constraints or accelerate access to working capital. For this reason, ABL is
usually considered to be a transitional source of financing, to weather temporarily cash flow shortfalls,
when the firm does not qualify for traditional bank lending, or to take advantage of growth opportunities.
81. The broad range of assets that can be used to secure the loan (e.g. stocks or inventory, plant and
machinery, property, brands and intellectual property) implies that ABL can serve firms in many different
sectors, including manufacturing, retail and distribution, and other service industries.
82. Asset-based lending is also apt to fund businesses at times of transition and restructuring, such as
in the instance of mergers and acquisitions, management buy-ins and by-outs, when there is a need for
increased liquidity in a short time. Indeed, in the case of acquisition, it is possible to use the assets of the
company being acquired to finance the acquisition itself. This can be especially advantageous when the
value of receivables or inventory of the target firm is significant in relation to the price of acquisition (GE
Capital, 1999).
Enabling factors
83. ABL relies on a sophisticated and efficient legal system (Beck and Dermirguc-Kunt, 2006).
In
particular, the commercial law in security interests is crucial in determining the efficacy of the collateral in
the loan contract. As Berger and Udell (2006) highlight, key issues include clarity in the country’s
commercial law on how a collateral lien (i.e. the obligation or claim annexed to a property) can be
perfected, how collateral priority is determined, and how notification of a lien is made.
84. As a case in point, in the United States, the growth of the ABL market is favoured by Article 9 on
“Secured Transactions” of the Uniform Commercial Code (UCC), which includes blanket filings on
account receivables and inventory4
, and a well-developed electronic registration systems, which temporally
defines lien filings. On the other hand, asset-based lending is made especially difficult by commercial laws
that do not allow lenders to file a single lien on all existing and future accounts receivable and inventory,
but rather require that each single asset is identified by invoice and serial number as it is generated (Berger
and Udell, 2006).
85. The development of ABL also depends on specialised expertise by financiers, which need to
appraise industry-specific assets, within the framework of rapidly changing financial and economic
environments. Industry-specific knowledge is thus typically required and field examiners may spend
considerable time assessing the assets proposed by the borrower for securing the loan. In the case of trade
accounts receivables, for instance, this may include confirmations, testing of invoices, review of customer
agreements, and analysis of accounting reserves, among others (Banchaya and Anderson, 2010). The
professional appraisal by a reliable firm is generally a key element in the decision to lend (Clarke, 1996)
and, for this reason, the growth of specialised service firms can importantly support the development of
ABL markets.
3.2 Factoring
Modalities
86. Factoring is a supplier short-term financing mechanism, whereby a firm (‘seller’) receives cash
from a specialised institution (‘factor’), in exchange for its accounts receivable, which result from the sales
of goods or provision of services to customers (‘buyers’). In other terms, the factor buys the right to collect
a firm’s invoices from its customers, by paying the firm the face value of these invoices, less a discount.
The factor then proceeds to collect payment from the firm’s customers at the due date of the invoices. The
difference between the face value of invoices and the amount advanced by the factor constitute the “reserve
account”. This is paid to the seller when the receivables are paid to the factor, less interest and service fees.
Typically, the interest ranges from 1.5% to 3% over base rate and service fees range from 0.2% to 0.5% of
the turnover (Milenkovic-Kerkovic and Dencic-Mihajlov, 2012).
87. Factoring is thus a transactions funding technology, based on ‘hard’ data, similar to asset-based
lending, as the financing depends on the value of an underlying asset, rather than on the creditworthiness of
the firm. However, it is different from asset-based lending in the following aspects: i) it involves
exclusively the financing of accounts receivable, rather than a broader range of assets; ii) the underlying
asset is sold to the factor at a discount, rather than collateralised; iii) it is a bundle of three financial
services, i.e. a financing component, a credit component, and a collections component, as in most cases the
borrower outsources to the factor its credit and collection activities (Berger and Udell, 2006).
88. Factoring also differs from conventional bank lending and asset-based lending, in that it does not
generate debt on the firm’s balance sheet and there are no loans to repay. By selling accounts receivables to
a factor, the firm is able to rapidly convert accounts receivable into another asset, cash.
89. A key aspect of factoring is that the problem of asymmetric information between lender and
borrower is addressed by focusing on the quality of a third party, the borrower’s customer. It is the latter
that becomes the debtor and responds for its obligations directly to the factor, which entirely assumes the
credit risk and the collection of accounts.
90. Through factoring, thus, it is the factor which assumes the costs implied by collecting
information about buyers, which explains the specialisation of factors on specific industry segments, to
develop more accurate market knowledge and credit-risk assessment (Soufani, 2011). In the case of
“ordinary factoring”, when the firm sells its complete portfolio of receivables, these costs can be
significant, as the factor needs to collect credit information and calculate the credit risk for many buyers.
For this reason, ordinary factoring is most frequently observed in countries with a well-developed financial
infrastructure (i.e. credit bureaux, credit registries), which allows the factor to access information about
many buyers at a relatively low cost, while diversifying risk.
91. In the case of “reverse factoring”, the factor purchases accounts receivables only from selected
customers of the firm. In this way, the factor increases its risk exposure to one customer, but the costs of
acquiring information and assessing credit risk are lower and, typically, only high-quality receivables are
accepted. In this regard, reverse factoring can be especially suitable for financing receivables from
accredited firms that are more creditworthy than the seller, such as large firms or foreign groups. In other
terms, factoring may allow high-risk suppliers to transfer their credit risk to their highest-quality
customers. Indeed, a reverse factoring arrangement is typically engineered by a large customer that is
purchasing goods from a number of small suppliers. In this case, the factor agrees to finance any of the
receivables of the large firm generated by invoices from the small suppliers. The benefit for the large
customer is that, in exchange for working capital financing, the sellers may agree on more favourable sales
terms (Berger and Udell, 2006; Klapper, 2006).
92. Reverse factoring is a key component in Supply Chain Finance, a set of arrangements between
members of the supply chain, mainly in terms of financial intermediation. In this setting, reverse factoring
is a means for creditworthy buyers to facilitate favourable financing options for their suppliers, by
explicitly confirming deliveries and resulting payment obligations to a factor (Klapper, 2006; van der Vliet
et al., 2013).
93. Factoring can also take place across borders (‘export’ or ‘international’ factoring), reducing the
risk of international sales. By outsourcing the credit function to a factor, exporters can significantly reduce
the cost of collecting credits overseas, as well as the exchange rate risks. The ‘export factor’ identifies an
‘import factor’ in the foreign market and assigns this correspondent the receivables. It is the import factor
that, for a fee, investigates the credit standing of the buyers and establishes lines of credit with them. In
fact, export factoring presents advantages also for buyers, which do not need to open letters of credits and
sustain the related charges. The import factor collects the full invoice value at maturity and transfer funds
to the export factor, which then pays the exporter the outstanding balance (FCI, 2013a). As the evaluation
of the buyers’ credit standing is conducted by the import factor before agreeing to purchase the receivables,
the approval of the factoring arrangement can also provide the seller an important signal about the foreign
business partners (Klapper, 2006).
94. In this regard, factoring is also an instrument of trade finance, which is often a key tool for SME
international activity and comprises other diverse financing mechanisms, such as lending, issuing letters of
credit, export credit and insurance.
95. Although under factoring financing does not depend on the firm’s overall creditworthiness,
information about the seller may be used by the factor to determine the ‘advance rate’ of receivables, that
is, the share of their value advanced to the seller. This rate is typically based on historical dilution
experience and may be adjusted over time to take into account changes in specific receivables (Klapper,
2006).
96. The seller may incur additional costs, such as credit protection charges, in the case of “nonrecourse” factoring, whereby the factor assumes title of the accounts and most of the default risk, because
it does not have any claim (i.e. “recourse”) against the supplier if the accounts default. On the other hand,
in the case of “recourse” factoring, the factor has a claim against the seller for any account payment deficit.
However, even under “non-recourse” factoring, there is some risk sharing between the factor and the seller,
in the form of the “reserve account”, i.e. the difference between the actual value of the accounts and the
advance rate, which can be used by the factor to cover payment deficiencies. Across OECD countries,
“non-recourse” factoring is largely adopted, whereas in emerging markets most factoring is done on a
“recourse” basis, due to the greater difficulties the factor encounters in assessing the default risk of the
underlying accounts.
Profile of firms
97. As a source of working capital financing, factoring is of particular interest for high-risk and
informationally non-transparent firms, as well as firms with a solid base of customers but high investments
in intangible assets, which cannot be used to secure bank loans. This is because the factor primarily
evaluates the creditworthiness of the firm’s customers and the validity of invoices, rather than the firm’s
financial statements, its fixed collateralisable assets or credit history.
Hence, factoring may be especially
advantageous for a SME that has difficulties in accessing bank lending but supplies larger customers,
which are seen as more creditworthy than the firm itself. Milenkovic-Kerkovic and Dencic-Mihajlov
(2012) underline in particular the advantages of factoring for service firms, which tend to be payrollintensive, have usually little proper collateral that can be used to secure traditional bank loan, and may
have high investments in intangible assets, which are not always reflected in financial statements.
98. Factoring may also represent an instrument of choice to manage credit risk when the seller has a
very sparse specialised investment in its customers and the cost of monitoring them is high (Smith and
Schnucker, 1994). This can be the case also for customers located overseas, when export or international
factoring is used. Through factoring, the seller outsources the monitoring functions and may indeed
consider acceptance of invoices by the factor as a signal of its customers’ creditworthiness.
99. Factoring is also useful for firms that grow faster than their credit lines, as, similarly to assetbased finance, it provides greater flexibility than conventional loans. In fact, as each account receivable is
evaluated individually, in the event of increased sales, new receivables can be sold rapidly to a factor and
the advanced cash used to respond to new orders.
100. As the extension of working capital does not depend on the firm’s credit history, factoring can
also serve the needs of new and young companies. At the same time, however, start-ups with low turnover
may be little attractive to factors, as they are often too small, have an inadequate customer base and lack a
track record in sales and economic management (Soufani, 2001).
Enabling factors
101. On the regulatory side, factoring requires a legal environment that allows to sell or assign
accounts receivables and enforce the underlying contracts, such as norms that entitle the factor to take legal
recourse for recovering assigned receivables from the client’s customers. In this regard, a reference to
factoring in the law, or even a ‘Factoring Act’, which recognises it as a financial service, can clarify the
nature of the factoring transactions and the ruling in case of default of sellers or customers.
102. Factoring can be favoured by commercial laws that recognize it as a ‘sale and purchase’. In this
case, factors are not creditors, hence, in the event of the seller’s bankruptcy, the factored receivables are
not part of the bankruptcy estate. Rather, they are recognised as property of the factor on which other
creditors cannot advance claims (Klapper, 2006). On the other hand, in some countries, especially civil law
countries, factoring may encounter important legal restrictions, such as prohibition of transfer of future and
bulk receivables or obligatory notification of the debtor, which may limit transferability of receivables or
create additional costs (Milenkovic-Kerkovic and Dencic-Mihajlov, 2012).
103. However, since the underlying assets are removed from the firm’ s bankruptcy estate and owned
by the factor, rather than being pledged as collateral, factoring depends less on good collateral laws and
efficient judicial systems than traditional and asset-based lending (Berger and Udell, 2006). According to
Klapper (2006), this explains why this funding mechanism might play an especially important role for
SMEs in emerging markets, characterised by weak contract enforcement.
104. Nevertheless, the development of factoring can be constrained by other tax, legal and regulatory
aspects. With regard to tax treatment, factoring can be at disadvantage with respect to traditional debt
financing if interest on factoring is not deductible in the same way as interest payments to banks. Also,
VAT taxes may be applied on the entire transaction, rather than on service fees only, and stamp taxes may
be imposed on factored invoices.
105. A weak information infrastructure may discourage factoring, imposing excessive burdens on
factors for collecting information about customer’s creditworthiness and for assessing credit risk. Since the
factor needs to collect information and assess credit risk for all of the firm’s customers (or a selected
number of high quality buyers), the cost and time required strongly depend on the availability of a good
credit information infrastructure, for instance in the form of well-developed credit bureaux or registries.
3.3 Purchase Order Finance
Modalities
106. Purchase Order Finance (POF) is a highly targeted form of asset-based finance, intended to allow
a firm to fill a particular customer order, thus to seize the market opportunities that would be lost due lack
of financial resources to buy inputs and deliver the output.
107. POF funds the production stage of an SME’s activities, as it consist in a working capital advance
to cover part of the production of a good or service demanded by one or more specified customers. In more
details, through POF, the SME obtains a verified purchase order from a customer and estimates the direct
costs required to produce and to deliver the product, which may include labour, raw materials, packaging,
shipping, and insurance. The purchase order is submitted to a financier, which bases the credit decision on
whether the order is from a creditworthy customer or is backed by an irrevocable letter of credit from a
reliable bank and on whether the SME can produce and deliver the product according to the terms of the
contract. If the loan is approved, the financier advances a share of the total order value, typically paying the
approved costs directly to the suppliers. Once production and delivery are completed, the accounts
receivables from the customer are either assigned to the financier, as in the case of factoring, or the
payment is directed into an account under the financier’s control. Similar to factoring, when the financier
receives payment, it deducts the amount advanced and interest or fees, and remits the balance to the SME
(USAID, 2009).
108. As in the case of factoring, POF allows the SME to transfer the credit risk to a more creditworthy
customer, which is often a larger firm or a government agency. However, the advance rate is generally
lower than in the case of factoring, as POF implies higher costs and risks for the financier. In fact, this
mechanisms requires more intensive monitoring of the firm’s operation and the financier assumes the risk
in the case that the firm will not be able to meet the order, as well as the risk related to payment
deficiencies by the customers. As a consequence, interest rates and fees are typically higher than with other
forms of asset-based finance. Also, the financier can take guarantees and other collateral, such as inventory
and bills of exchange, to mitigate risk.
109. Furthermore, the PO lender may require that a factor intervenes in the transaction, if the payment
terms of the customer are beyond a certain threshold (i.e. 60 or 90 days). The factor buys the outstanding
invoices at a discount and thus provides immediate payment to the PO lender, and collects the full amount
of the invoices at a later time. As the factor adds its profit in the process, the overall costs of the operation
for the SME may be significantly higher.
110. Pre-export finance transactions are similar to POF operations, but are specifically applied to
export orders. They consist of the extension of financing against orders that have been placed and
confirmed by foreign buyers, after the lender has evaluated their creditworthiness. In addition to risks
implied by a traditional POF operation, the financier needs also to evaluate the political and legal risks
implied by the cross-border transaction, such as the risk of expropriation, sanctions, discriminatory change
of law or the impact of local insolvency law.
Profile of firms
111. POF can serve the needs of growing firms, with little access to working capital and poor cash
flow, which receive orders that are larger or more frequent than their current capacity to pay suppliers
upfront. In this regard, POF is generally not a replacement for conventional financing. Rather, as it
provides rapidly large amounts of new capital, it can be used alongside lending facilities to handle surging capital requirements brought on by accelerated growth or peak seasonal sales (Maselli, 2000; USAID,
2009)
112. At the same time, as the financier primarily considers the creditworthiness of the client who has
created the purchase order, it can also apply to new firms with little credit history and to high-risk and
informationally non-transparent firms, which would not qualify for conventional bank loans. As in the case
of factoring, the SME’s creditworthiness is typically enhanced by the link to a larger company placing the
purchase order. In this regard, POF can be an effective financing instrument for small firms participating in
supply chains, as part of the Supply Chain Finance arrangements.
113. As a financing mechanism that supports the production or distribution activity, the type of
businesses that qualify for POF are usually producers, distributors, wholesalers or resellers of
manufactured products.
Enabling factors
114. The development of credit risk assessment technologies has favoured the consolidation and
broader diffusion of POF. POF, factoring and trade finance, as we know them today, date back to the
Middle Ages, to the business practices of English factors in the 14th through the 17th centuries, as England
grew from an agrarian economy to a modern commercial economy. These practices evolved out of
experiences of banks in 13th century Italy, which were grounded in factoring practices of the Roman
Empire5
. Throughout centuries, POF was provided by financial intermediaries engaged in a relationship
model with customers, where the purchase order would act as sufficient collateral to finance the project
(Davidson, 1986). In recent decades, particularly since the 1990s, the advances in technological platforms
to assess risk facilitated the development of POF as an instrument to fund SMEs (van der Vliet et al.,
2013), without restricting this to the relationship lending business model.
3.4 Warehouse receipts
Modalities
115. Warehouse receipts (WHR) are an asset-based financing mechanism, whereby loans are secured
by commodities deposited at a certified warehouse. Under this arrangement, commodity producers and
traders deposit commodities at a warehouse, which offers secure storage and issues a receipt that certifies it
is in possession of a specified quantity of a commodity that meets specified standards. The receipt can then
be used by the depositor as collateral for a loan, whereby the lender places a lien on the commodity, so that
this cannot be sold before the loan is repaid (USAID, 2009).
116. As in the case of asset-based lending, the amount that the firm can borrow is typically a share
(50-80%) of the stored commodity value. The costs implied by the mechanisms for the borrower include
interest, taxes and storage fees.
117. WHR can be organised under different warehousing arrangements: a) private warehouses, where
manufacturing and warehousing take place under the same roof. It is thus the same manufacturer
(borrower) that can issue a warehouse receipt to be used as a collateral with the lender; b) public
warehouses, where a specialised operator stores commodities for third parties for a set fee and issues
receipts; and c) field warehouses, in which a collateral management or credit support company takes over
the warehouse of a depositor or a public warehouse by leasing the storage facility for a nominal fee, and
becomes responsible for controlling the commodities to be used as collateral (Höllinger et al., 2009).
118. Beside the warehouse operator, the WHR system engages specialised service providers, such as
those offering both depositors and lenders certification and inspection services, to ensure the warehouse
meets necessary standards for safe and secure storage. In addition, insurance companies generally provide
protection against commodity losses at the warehouse.
119. As the warehouses typically maintain records about producers’ performance, this system may
also work to build information on current and potential borrowers, which can be useful to financial
institutions over time, especially when other credit history information is lacking. Also, as the system is
based on consistent standards, their incorporation into receipts improves knowledge in the market,
reducing information asymmetry along the value chain about products’ quality and availability.
