On Financing Receivables

(On 22nd July 2014 RBI vide its Press Release No. 2014-2015 /157 sought feedback on the Draft Guidelines for setting up of and operating a Trade Receivables Discounting System (TReDS). In course of drafting out my responses, I had perforce to think through the existing receivable financing system followed by banks in India. This note is an outcome of that thinking through process)

1.             Introduction

Financing receivables is a well-established credit offering and an excellent example of real life classic “win-win-win” non-zero sum game.

• The seller wins by getting cash upfront against receivables so that it’s liquidity improves and it  can continue its operations.
• The buyer wins since it gets time to make payment. It can process and sell the goods and make a profit before it has to make any payment for the goods / services received. Moreover, it is virtually cost less credit (under some specific circumstances).
• The Bank wins, since it can profitably deploy its funds on short-term self-liquidating transactions.

Receivables arise when a seller makes the sale on deferred payment terms. That is, when the title of goods gets transferred to the buyer, but the buyer does not make the payment immediately but after some time. By understanding the nuances of receivable financing banks can not only add value to the supply chain but also make profits in the process.

Now sales could mean either sales of goods and / or of services. That is, receivables arise both due to sales of goods (raw materials, machinery,  food stuffs etc.) or services (processing charges, labour supply, advertising fees, lawyer’s fees etc.). Banks have historically been averse to financing receivables arising out of sale of services since it is difficult for them to distinguish genuine sales of services from “accommodation” transactions. This is apparent from the fact that most bank’s operating procedures insisting on “evidence of movement of goods” as part of the required documentation for advancing money against receivables. With 66% of India’s National Income now arising from the services sector, it is high time this bias was addressed by designing suitable procedures for financing receivables which arise from sale of services and there is no movement of goods. In the absence of this, effectively, 66% of the Indian economy is deprived of the benefit of access to credit from institutional sources. From the bank’s point of view, they are missing out on a very large market segment!

2.             Types of Receivable Financing

2.1        Against Letters of Credit

Under this methodology the buyer arranges for issuance of Letter of Credit through its bank in favour of either the seller or the seller’s bank. The theory, practice and procedures under this method is widely understood and well established and would not be discussed further in this note. Apart from drawing the attention of the reader that LCs for payments arising from sales of services is still a rarity.

2.2        Against Acceptance of Bills of Exchange

Under this method, sellers draws up a (Sight / Usance) Bill of Exchange (BOE) and sends it to the buyer. The buyer thereafter accepts the BOE by signing on it. The seller is known as the “drawer” and the buyer the “drawee” of the BOE. Any holder “in due course” of the BOE can demand payment from drawee on due date of the BOE. In case the BOE is “with recourse” to the drawee, the holder can also demand payment from the drawer.

BOE are typically sent along with the invoice (with face value of BOE being equal to the invoice value) and documents evidencing title of goods (lorry receipts, bill of lading etc.) by the seller to the drawer either directly or through a bank. Acceptance by drawee can be for the full value of the BOE or for a lesser value. The main reason for drawees to accept the BOE for lesser value (than the face value of the BOE) is generally because of quality / quantity issues with the goods supplied.

The law, theory and practice of BOE is well established and understood. One major impediment in using BOE is the relatively high stamp duties applicable on them and the associated time and effort in getting the stamping done. 

Using technology where BOE are dematerialized to enable their drawing, acceptance, transfer or noting / protesting be done electronically would go a long way in boosting their use. This could also enable collection of stamp duty centrally thereby reducing costs in implementing this cess. The benefit of lower costs can be passed on by reducing rates of stamp duty.

2.3        Against Invoices

Invoice Discounting is a much discussed credit product and also offered by various banks. However, this product has various weak points and can be quite risky if not offered with care and with suitable mitigants to handle which very specific procedures / processes would be required. 

I.                    But can Invoices be Discounted?

For any instrument to be eligible to be discounted, it should fulfill certain basic conditions, such as:

• It should have a due date of payment.
• The commitment of the entity to make the payment should be unequivocally established.
• The Bank (who is doing the discounting) should be able to legally establish itself as the entity to whom the payment is due.

Unfortunately, an invoice, per se, does not fulfill any of these conditions and so cannot be (legally speaking) “discounted”! 

An invoice is just an intimation by the seller (who makes out the invoice) to the buyer that he has supplied various goods / services (as per details given in the invoice) for which a certain specific payment is due to be made by the buyer to the seller (less any advance payment already received or discount offered in case of early payment ).

Therefore invoices  cannot be discounted; only negotiable instruments (eg. A Bill of Exchange or a Post Dated Cheque or a post dated Promissory Note) can be legally discounted.  

II.                  The pitfalls in “Invoice Discounting” 

• How is the usance period of payment to be decided? Would it be (i) as per market practice, (ii) as per informal understanding between buyer and seller, or (iii) based on a formal Sale Agreement between Seller and Buyer where the payment terms is specified. In case there is a formal Sale Agreement, has it been sighted / examined by the Bank?
• What happens if the goods are returned by the buyer after acceptance of invoice and after it has been “discounted” by a bank? That is, there is no more any commitment by the buyer to make the payment!
• What happens if after acceptance of invoice and its subsequent “discounting” by an intermediary bank, the buyer checks for quality and quantity and finds some discrepancies / defects and takes a view that it would make payment for a lesser amount (invoice value less deduction for shortage / breakages / lack of quality)?
• How are the invoice payments to be monitored if payment by buyer is on open account? That is, payment is not made on invoice by invoice basis, but monthly a round figure is paid. That is, in cases where the buyer and seller have a separate mechanism for reconciliation of payments.
• Buyer exercises its right of set off. That is, there are certain payments due to buyer from the seller for transactions not related to the invoice and of which the Bank is not aware. After the bank has “discounted” an invoice, the buyer deducts a certain amount (by exercising its right of set off) and then makes payment of the balance amount only.

III.                What are the Mitigants (If any)?

a) Finance against invoices should invariably be done only as an “advance” (not “discount”) against the invoice after deducting a margin. The margin can vary depending on experience with the seller and specific buyers.

b)    The advance amount can be made after deduction of interest upfront for the period of advance. This is what gives the transaction the flavor of “discounting” while not actually being so!

c)   The documentation  with the seller (on whose behalf the financing is being done) should specify, inter alia:

• Period / Tenor of advance
• Rate of interest for the advance.
• Interest would be deducted upfront for specified tenor.
• Penal interest applicable in case amount is not settled on due date.
• All payments due from buyer would be routed through the bank making the advance.
• The seller undertakes to make full payment on due date in case payment is not received from buyer on due date.

d)      In all cases a quarterly / half yearly confirmation from buyer should be obtained of net dues by buyer to seller which should be reconciled / cross checked with outstanding invoices financed. This would mitigate risk of there being any transactions in the reverse direction between seller and buyer.

e)   A basic credit assessment of the buyer should be done covering inter alia payment track record and market standing. In case the buyer is situated in a country other than where the seller (on whose behave the advance is being made) operates, there should be adequate country limits available.

f)       Financing against invoices is most efficient when the bank has a relationship with the buyer who has various small suppliers from whom the buyer avails credit. Now for the bank to assess and monitor each supplier might be cumbersome and expensive. So against some kind of comfort from the buyer it advances payments to the seller against each invoice. That is the bank finances the sellers while predicating credit risk on buyer. The kinds of comfort in practice, include:

• A written commitment / mandate from buyer enabling the Bank to debit the due amount from buyer’s account (say, 30, 60, 80, 120, 180 days) after date of invoice / date of receipt of goods by the buyer. This is an ideal case since entire credit risk is on buyer. In such cases, the main operating account of the buyer is maintained with the financing bank.
• A written commitment / undertaking from buyer that in case the seller defaults, further payments by buyer to seller for future supplies (ie invoices generated subsequent to default) would not be released without the Bank’s “No Objection”.
• An acknowledgement by the buyer that all payments due to seller would be routed through the Bank duly supported by an irrevocable assignment of receivables by the seller in favour of the Bank.

2.4         Against Book Debts

Another widely used method of lending against receivables is against comfort of outstanding book debts of the seller. The seller periodically (typically monthly) provides its bank a list (or summary) of outstanding book debts. The bank in turn makes a certain amount of funds available to the seller in proportion to the outstanding book debts (value of eligible book debts less margin). 

Eligibility criterion of book debts against which finance may be advanced is typically age of book debt (say book debts less than 90 days) and buyer (receivables from specific buyers only). 

The margin could be decided based on (a) profit margins of the seller (the value of receivables include the cost of goods / services supplied plus the sellers profit margin), (b) age of receivables (say margin of 25% for receivables less than 90 days, 40% on receivables more than 90 days but upto 180 days and no finance against receivables more than 180 days old), or (c) credit standing of buyer (say, 20% on receivables from Hindustan Lever, but 40% on receivables from other buyers) etc.

To protect itself further the financer could also insist that the seller assigns the right to collect the receivables on its behalf either through a specific assignment agreement or a specific Power of Attorney which to further fortify itself the financer could register with the buyer. 

It is important to periodically assess the quality and realisability of the book-debts. This can be done through either auditing (receivable audit) of the seller’s books of accounts and / or  cross checking with the buyers against whose names the receivables are listed.

Periodic cross checks with the buyer also helps in determining if any amounts are due to buyer from seller against which right of set-off can be exercised.

3.             Some Concluding Remarks

• In the lending business, competing solely on the basis of pricing is a straight race to the bottom. There would be so many lenders chasing the really good credit risks, that such borrowers can demand (and get) such fine rates that lending to them can become unremunerative unless the relationship generates other kinds of remunerative business opportunities.

• On the other hand, lending to higher credit risks without understanding the nature and designing suitable mitigants (appraisal, monitoring, and recovery) might make taking the risk unremunerative in view of the fact that banks are highly leveraged institutions and any credit gone bad delivers a double whammy, (i) loss of income (interest not being services) and simultaneously (ii) loss of principle on account of making provisions against the bank’s equity capital!  

• Proposed TReDS should seek migration of initially the receivable financing against BOE, then of invoice based financing, and lastly the book debt financing. Eventually domestic LC based receivable financing could also be sought to be migrated on to this platform. 

• Successful implementation of the TReDS would enable:

·         Faster monetization of receivables, that is, easier availability of credit.

·         Lowering of costs (both operational as well as risk premium).

·    Building up of database which would enable credit risk (arising from payment of receivables) be treated as a stochastic process (on the lines of Credit Cards) further reducing the costs, effort and time required for making detailed appraisal /  monitoring / recovery.