Account Receivable Financing, Traditional Financial Institution vs Platform?
Receiving cash in exchange for invoices to be paid or account receivable is nothing new, the concept has been around for a long time. In fact, it is believed to date back to ancient Rome, when agents from traditional financial institution, called ‘factors’, managed the sale and delivery of merchants’ and producers’ goods. Over time, as industrial and economic conditions changed, the role of the factor, evolved to become what it is today—providing cash to businesses in exchange for their receivables.
Currently, traditional financial institution offers two types of funding related to account receivable. The first one – factoring, is a true sell of account receivables against cash. The invoices are not owned any more by the seller but are owned by the factor. The second form – invoice financing, is an asset-based loan with account receivables as collateral. The invoices stay on the balance sheet of the seller and in case of his bankruptcy it can be accessed by creditors.
In Asia, account receivable financing through traditional financial institution has long been considered a financing option for SMEs and mid-cap businesses. Banks, however, have become more reluctant to extend such services since the last economic recession. These financial products tend to involve more manual work and costs more for banks than other financial products like traditional business term loans.
As such, small and medium businesses have had to seek alternative forms of financing. During the last decade, platforms have emerged to help bridge this gap. These platforms are managed by financial technology (‘fintech’) companies. According to Fintech Weekly, fintech companies aim to provide “financial services by making use of software and modern technology”. They have a strong focus on customer experience and accessibility.
Below are the major ways in which traditional financial institution account receivable financing differs from the solutions offered by platforms.
1. Financing constraints
Traditional financial institution support invoice financing and factoring facilities from their own balance sheets. They make decisions based on their assessment of the risk versus the reward—much like the way a business owner measures the worth of an investment by calculating potential returns.
On one hand, to prevent banks from undertaking excessive risk by extending too much credit, regulators have always implemented capital requirements to constrain lending and financing. Capital requirements dictate how much liquidity banks must hold relative to their assets. They help ensure that banks have sufficient capital to continue honouring withdrawals even when they are under economical stress.
While these capital requirements help decrease the risk of default, they result in higher constraints and less flexibility in financing terms. Since the financial crisis of 2007-2008, these requirements have become more stringent to reduce the systemic risk of economic collapse.
The rising costs of Anti-Money Laundering (AML) and Know Your Customer (KYC) compliance have also put a strain on banks’ profits. KYC procedures help financial institutions verify a potential customer’s identity. An AML program is aimed at preventing financial crimes, and includes KYC procedures, internal controls and audits, and risk assessment and monitoring.
To make sure that account receivable financing agreements are a sustainable business, banks impose restrictions to guarantee that the bank receives a minimum return. For example, to obtain the minimum amount of fees to cover the cost of the loan, banks finance the full sales ledger for a specified lock-in timeframe.
In contrast, platforms have funds coming from investors. These investors may be individual or institutional—depending on the platform’s licence—and may provide funds either through directly investing in an invoice or by joining a pool of investors within the platform.
In other words, platforms do not fund account receivable financing agreements on their balance sheet. As they specialise in a specific type of financing product, they also have lower AML and KYC costs and no capital requirements imposed by regulators as they are not generally under banking regulation.
As a result, platforms are able to offer more flexibility with regards to funding the sales ledger. For example, they typically allow selective factoring, which means a business may choose specific invoices to exchange for funds, instead of their full sales ledger.
Traditional financial institutions’ invoice financing product scalability is restricted by the creditworthiness and the size of the seller. The bank will advance the loan to the seller with invoices as a collateral, thus they need to assess the risk profile of the seller and put the loan limit on this assessment. Sellers are usually smaller than the buyer thus limiting the size of the facility to the seller’s credit profile.
On the other hand, platforms’ facilities don’t suffer the same scalability constraints because the risks don’t lay on the seller but on the buyer’s ability to pay the invoice. The platform and its investor become the owners of the invoice and the buyer will then pay at maturity. As a result, the platform will focus more on the commercial relationship and the buyer’s creditworthiness and size, substantially increasing the potential limit of the credit facility.
3. Application process
With traditional financial institution, the application process may be lengthy and complicated, requiring many printed documents and multiple background checks. Legacy systems and entrenched business practices force traditional financial institutions and their clients to follow antiquated, slow and at time frustrating procedures at onboarding.
On the other hand, the application process for financing facilities on platforms can usually be done online with digital documentation. While the degree of due diligence carried out by platforms is as thorough as the one carried out by traditional institutions, the user experience is greatly improved.
4. Processing time
Given the extent of banks’ due diligence, as well as the requirements and regulations they need to comply with, they tend to take longer time to assess applications. It can take weeks to receive a bank’s decision and then even longer to receive the funds.
Platforms avoid this uncertainty by offering an online registration and onboarding. After completion of the onboarding, once the client and the transaction have been approved, funds are then immediately released.
Given their access to a larger pool of capital and different sources of profit, banks are sometimes able to offer lower interest rates compared to factoring platforms, but it does not necessarily mean that they are charging less overall.
Interest rates differ greatly between factoring platforms, depending on the country where they operate and their target clients. When considering that platforms will seldom ask for collateral and will not force sellers to discount the whole sales ledger, they offer an advantageous solution compared to bank’s offering. Moreover, fees are generally more transparent, there are no set-up or ancillary costs, there are no hidden costs. Considering there are also no maintenance fees, no exit fees and no early termination fees, platforms are extremely competitive compared to traditional financial institutions.
Choosing a financing service for your business
When determining the form of funding that best suits a business, it’s important to undertake a thorough research to understand the different options available, as well as their advantages and disadvantages. It is also very important to correctly assess the current situation and what are the immediate priorities.