Financial technology (fintech) is widely used to describe the use of innovative technologies to deliver financial services.
The rise of fintech is visibly changing the way that businesses, especially small and medium-sized enterprises (SMEs), now source and access capital or financing.
In the past, banks dominated the game via traditional debt financing when it came to SME scaling.
However, thanks to fintech solutions such as crowdfunding and other peer-to-peer (P2P) platforms, SMEs now have access to alternative intermediaries who are often willing to extend financing to them faster and on even more flexible terms than banks.
Factoring, which involves the use of creditworthy receivables to procure working capital and credit management services, is one example of these new and cost-effective financing alternatives now available to SMEs.
These are often provided through specialist P2P-like platforms known as invoice trading platforms, electronic invoice marketplaces, or receivables exchanges.
In Africa, where many people still do not have personal bank accounts, factoring is quickly becoming one of the main financing alternatives for entrepreneurs and SMEs.
SMEs – the key to economic growth in developing economies
Without access to capital, many small companies are not able to maintain operations, let alone expand and create new jobs.
With timely, affordable, and adequate access to finance, SMEs are better positioned to survive, grow, and expand their operations beyond national borders and into international markets.
This, in turn, enables them to have a greater impact on the national economy through job creation, tax contributions, and export duties.
Their smaller and informal organisational structures often mean they are more agile than their larger corporate counterparts, enabling them to grow faster and adapt to changing economic circumstances such as those experienced during the COVID-19 pandemic, which plunged many developing countries into a state of economic crisis.
Estimates indicate that SMEs account for around 60% of all jobs in Africa and contribute to over 50% of the continent’s GDP.
Given their potential to make immense contributions to economies, governments across Africa are increasingly focusing on ways to ensure that SMEs have affordable and adequate access to finance.
Direct monetary intervention via grant schemes, subsidised loans and guarantee schemes, is currently the most common measure adopted by governments in Africa to improve access to finance for their SMEs.
However, many African governments are also realizing that they can improve access to private forms of equity for SMEs by establishing laws and adopting fiscal incentives that promote more flexible financing alternatives.
Many of these alternatives exist outside of the traditional financial system made up of banks and capital markets.
Given how risk-averse traditional financial institutions are, the latter makes a far better ‘fit’ for African SME start-ups, many of whom also fall outside of the traditional monetary system because of their perceived credit risk factors.
Factoring as a solution for African SMEs
Of these, factoring has been consistently put forward as a viable and cost-effective alternative that African countries can use to boost credit penetration for MSMEs.
As a result, there has been an increasing call on African countries to adopt laws governing factoring transactions between SMEs and financial institutions, as well as introduce fiscal incentives that reduce costs for factoring transactions.
‘Open account’ or the extension of credit is a common trade practice in Africa, especially amongst SMEs that are suppliers.
Under this trade practice, goods or services are often supplied to trade customers under extended payment terms, usually between 30 and 120 days.
Open account enables SMEs suppliers to be competitive and increase sales.
However, it does have its challenges, including liquidity problems – until the invoice is eventually settled by the customer, the supplier SME will have pressing working capital needs to meet such as paying salaries, rent, and its own suppliers.
To cope with this discrepancy, the receivables (as represented by the invoice to the customer) could be assigned by the SME to a non-bank financial institution called a factor at a discount and for immediate cash.
The factor could also provide other credit management services to the SME, like receivables collection, bookkeeping, or credit risk protection, in connection with the assigned receivables.
Such an arrangement sums up factoring.
The pros and cons of factoring
The hallmark of factoring is that it helps businesses quickly convert their receivables into cash, while also giving them access to credit management services that are typically unavailable under other forms of financing.
Factoring is particularly tailored to serve SMEs that deliver goods or services to other creditworthy businesses on open account.
Compared to traditional debt financing from banks, factoring is more advantageous for the following reasons:
- it is faster to process and requires less paperwork,
- it does not require collateral from the supplier SME, or create additional debt obligations on the books of the supplier SME (via interest payments), and
- it comes with credit management services that ease the burden of open account.
One of the major downsides to factoring, however, is that the service and discount fees charged by factoring services can be costly.
Nonetheless, considering the time value of money and the convenience of accessing financing through factoring, many African start-ups deem it a cost worth paying.
Factoring can also support open account transactions in both domestic and international trade.
International factoring was particularly developed out of a need to promote a more secure and flexible alternative to traditional methods of trade financing, such as letters of credit.
Untapping the benefits of factoring via regulatory intervention
Data from FCI, the world’s largest network of factors, shows that Africa has consistently accounted for roughly 1% of the global factoring turnover over the past decade.
Apart from South Africa, which accounts for over 80% of Africa’s market, only a few other countries including Morocco, Egypt, Tunisia, and Mauritius, have thriving factoring markets.
The poor development of factoring in Africa has been attributed to the absence of factoring laws, the lack of tax incentives and unfavourable regulatory regimes for non-banks.
Other obstacles include the general lack of awareness and the underdevelopment of credit risk insurance and credit information systems in most African countries.
Encouragingly, however, with support from institutions such as the FCI, African Development Bank (AfDB), the African Export-Import Bank (Afreximbank) and the European Bank for Reconstruction and Development, other African countries are pursuing a host of legal, tax and regulatory interventions to promote factoring as a financing alternative for SMEs.
Taking things a step further: Invoice trading platforms
While the COVID-19 crisis spelt economic challenges for many countries, it also created opportunities for disruptive fintech solutions, such as factoring, to achieve wider adoption.
In countries like the United Kingdom, where there is a growing shift away from manual to digital platforms, factoring platforms are either operated by factors themselves or by intermediaries that play the role of ‘matchmaker,’ pairing businesses that want to factor their invoices with factoring firms.
The latter platform is called an invoice trading platform.
Since invoice trading platforms aggregate numerous participants simultaneously, they are better suited for driving large-scale adoption and utilization.
Invoice trading platforms often employ reverse factoring to manage credit risk.
Reverse factoring, also called supply chain finance (SCF), is buyer-led as it is the buyer or customer (usually a high-credit quality buyer) that requests the factor to settle his payables in advance in favour of the supplier.
The buyer will then pay the factor when the receivables mature for collection.
It is, however, the supplier that bears the factoring cost as this is deducted from the nominal value of the assigned receivables.
Invoice trading platforms can also be purely private- (in which the platform is administered by a private company) or public-sector-led (whereby a government institution administers the platform) or a mixture of both.
The latter is known as a public-private partnership (PPP).
Penetration of invoice trading platforms in Africa
Despite the usefulness of invoice trading platforms in promoting factoring as a financing alternative for SMEs, they remain largely untapped in Africa.
While a few factors do exist in countries like Nigeria and South Africa, invoice trading platforms remain conspicuously absent.
The time is right for policymakers and regulators in Africa to pursue invoice trading platforms, whether on a purely private-sector-led or PPP basis, to promote factoring as a financing alternative for SMEs.
For economies of scale purposes, such projects could be implemented on a regional basis via trading blocs such as the Economic Community of West African States (ECOWAS) and East African Community (EAC).
The success of a cross-border intra-African digital payment solution known as the Pan-African Payments and Settlement System (PAPSS), developed by Afreximbank, is evidence that invoice trading platforms can be scaled to a regional level.
Factoring as a viable financing alternative
Factoring in its various forms appears to offer a viable financing alternative to traditional lenders that can help to plug the SME financing gap in Africa, which currently stands at over US$ 331 billion per year.
Apart from implementing the legal, tax, and regulatory frameworks needed to support the growth of factoring, governments in Africa should also explore fintech solutions such as invoice trading platforms to accelerate more wide-scale adoption.
To make these platforms even more attractive, governments could institute guarantee schemes to cover instances where factors cannot recover debts from buyers.