Modern trade thrives on credit. Sellers and service providers offer goods and services to customers before full corresponding value is received, allowing for a fast and seamless pace of commerce. This "buy now, pay later" arrangement, tends to be present in most companies across different sizes and revenue brackets. A creditor–debtor relationship crystallizes soon after a credit transaction has been triggered; reflected as account receivables on the books of the seller. However, the seller or service provider is often burdened with these trade receivables for an indefinite time and cannot determine the pace at which receivables are transformed into ready, accessible funds. This naturally will have an impact on liquidity and operational health of the business as prolonged debts typically do not aid business success. This fairly common scenario has thus far inhibited economic development, and recently resulted in a strong push towards setting up legal and regulatory frameworks in Nigeria to transform account receivables (debts) into liquid cash through a mechanism known as factoring.
What is factoring?
Factoring is the sale of account receivables to a third-party (factor) at a discount. It is similar to the relationship between a borrower and a lender in that the lender advances money to the borrower on terms. However, the difference with factoring is that the relationship is tripartite. The seller of goods or services, sells (assigns) its trade receivables (invoices) to the factor, who buys the receivables at a discount. The factor then proceeds against the seller's debtor to recover the invoice. The factor's profit is the discount on the receivables. It is important to state that factoring is not a loan, does not create a debit in the balance sheet of the company and is not categorised as a new debt.
Consider the following hypothetical fact pattern: Company A regularly supplies iron rods to Company B on credit. Company B usually pays A's invoices within 60 days of receipt of the rods. Company A is however having liquidity concerns and cannot wait 60 days to receive payment. Company A therefore sells its account receivables (the invoice) to Company C (the factor) at a 10% discount. Company C's profit is the discount on the invoice.
Factoring may be with recourse or without recourse. Where it is with recourse, the factor has the right to proceed against the seller of goods or services for the debt if the debtor fails to pay out the invoice. Where it is without recourse, the factor can only recover from the debtor and absorbs any loss arising from the debtor's failure to pay out the invoice. Where appropriate frameworks are in place, factoring could take place not only domestically, but also service cross-border trade across international borders.
There is already a form of factoring operational in Nigeria, known as reverse factoring. Here, banks play an intervening role between a company and its suppliers and commit to pay the company's invoices to its suppliers at a fast-tracked pace in consideration of a discount.
Why do we need factoring for business to thrive in Nigeria?
Many if not most companies will at one time or another struggle with liquidity challenges due to delayed payments for goods sold or services rendered. These challenges could result in added financial strain by way of unplanned borrowing, restructuring etc. The solution lies in factoring.
While factoring may be misconstrued as a last resort for distressed companies, it is actually a flexible financial mechanism available to any business, irrespective of its credit situation. Factoring reduces the time within which the company can realise its receivables.
Factoring will play a significant role in the future of trade, receivables, and supply chain finance, as it offers an added secure and convenient means for financing and securing transactions.
Upsides of factoring
- Factoring improves and guarantees liquidity for businesses at all levels, both big and small.
- Factoring will take away the monopoly of banks on finance solutions.
- Factoring will help the Nigerian economy grow due to provision of working capital to businesses.
- Factoring will aid international trade and help Nigerian businesses in cross-border transactions within the African Continental Free Trade Areas.
- Factoring aids credit protection against customer defaults and bankruptcies.
- Factoring births opportunities for investments.
Downsides of factoring
Factoring is theoretically susceptible to fraud, as invoices can be forged – just like with any financial instrument or document. However, there are ways to significantly reduce or eradicate the potential for fraud through technology. This will be addressed in a subsequent article. Another downside, which is more or less negated by the immediacy of invoice payment by the factor, is the discounting of the invoice, thereby reducing profit to the seller. There are also concerns of contingent liability on the seller or service provider. Where the debtor defaults in paying the factor, the seller or service provider is liable to pay the debt where the invoices are factored with recourse.
Legal and regulatory framework
Much has already been done towards setting up the legal and regulatory framework for factoring in Nigeria. On November 29, 2017, the Nigerian Factoring Working Group (NFWG) was commissioned by the African Export Import Bank (AFREXIM), Nigerian Export Import Bank (NEXIM), and Factor Chain International (FCI). The mandate of the NFWG is to facilitate the passage of the Factoring Assignments (Establishment, Etc.) Bill (The Bill) into law and ensure the creation of an enabling environment that will encourage the growth and development of factoring in Nigeria. It is expected that once the law is passed, the Central Bank of Nigeria will also issue a policy to allow banking and non-banking institutions engage in factoring services. This will open the floodgates for investments in this area, as new companies will be incorporated in Nigeria to offer factoring services.
To realize the commercial promise of factoring in Nigeria, enabling legislation is paramount. To this end, representatives of AFREXIM, NEXIM, and FCI, including the Managing Partner of Perchstone & Graeys, Mr. Osaro Eghobamien, SAN, on Monday, January 27, 2020, were at the Nigerian Senate to make a presentation on the Bill. The Bill purports to provide an enabling legal framework for the establishment of factoring companies in Nigeria, restate the common law position on factoring, lay down the mechanism for dispute resolution, and create safeguards against fraud, amongst other laudable objectives.
Notwithstanding the challenges that must be overcome before factoring is mainstreamed, it remains an undeniably potent tool for economic development in Nigeria. With the current push for setting up appropriate legal and regulatory frameworks, we should see some positive changes to the liquidity challenges of businesses in Nigeria in no distant time.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.