By Shantanu Bairagi
“Incomprehensible jargon is the hallmark of a profession” Kingman Brewster, Jr.: Most of the time, this holds true for us finance folks, but let that not deter you from paying attention, especially if you are the founder, promoter or CFO of a startup/MSME.
In India, MSMEs account for over 63 million units, contributing significantly to the economy. These businesses play a crucial role in driving economic growth, accounting for 6.11% of the manufacturing GDP and 24.63% of the GDP from services. However, one of the biggest challenges they face is access to adequate financing. While traditional lenders, i.e. banks and NBFCs offer very limited funding options, the situation gets exacerbated with customers stretching payment terms. These issues disrupt working capital, affecting the overall growth of the businesses.
A solution gaining traction in the financial world is Receivables Securitization. This process can provide MSMEs with quick access to liquidity and reduce the strain of credit risk. But how exactly does receivables securitization work, and how does it differ from other financing methods like invoice financing? Let’s comprehend that.
What is Receivables Securitization?
Receivables securitization is a financial process where businesses bundle their trade receivables—amounts owed to them by customers—into a pool. This pool is then sold to a third party, which finances the purchase by issuing securities that are sold to investors in the financial markets. The main goal of this process is to convert these receivables into liquid funds that can be used for business operations, expansion, or other capital needs.
In essence, receivables securitization allows MSMEs to unlock the value tied up in outstanding payments and gain access to funds quickly. These funds can be used for a variety of purposes, such as reducing debt, originating more assets, or meeting capital requirements.
How Does Receivables Securitization Differ from Regular Invoice Financing?
Bill or invoice discounting is a fairly common term that most of us understand well. At first glance, receivables securitization may seem similar to invoice financing, as both involve obtaining funds against outstanding receivables. However, there are key differences between the two:
- How Funds Are Obtained:
Receivables Securitization: In this method, MSMEs sell a pool of trade receivables to a third party. The third party then issues securities in the financial markets to finance the purchase.
Invoice Financing: This is usually a bilateral facility between the financer and the borrower. Here, a third-party agency purchases the company’s individual accounts receivable and pays the company for them upfront, typically at a discount.
- Impact on Company’s Balance Sheet :
Receivables Securitization: As the company sells its trade receivables to a third party, it has to qualify as a “True Sale”, which is one of the main criteria for securitisation. Hence, these assets move out of the company’s balance sheet completely, making it “off balance sheet” funding. In short, this financing doesn’t show as a loan on the company’s books.
Invoice Financing: Unlike securitization, here there is no requirement of a true sale, hence, financing mostly is “with recourse” to the company, appearing as a loan on the company’s balance sheet, further increasing its liability.
- Risk Retention:
Receivables Securitization: The company retains a portion of the risk and transfers the balance credit risk to the third-party agency. In most cases, the business no longer makes a loss if a customer fails to pay except for the portions they hold.
Invoice Financing: Invoice financing can be done with or without recourse to the company. With recourse, the company retains the entire risk and has the repayment obligation to the financer if their customer doesn’t pay. Whereas, without recourse has similar treatment as securitization. In India, most of the invoice financing is still done on a recourse basis.
- Use of Funds:
Receivables Securitization: The funds obtained have more flexibility in terms of end-use, i.e. — whether to reduce existing debt, originate new assets, or meet other business capital needs.
Invoice Financing: Since many lenders (Banks/NBFCs) treat this mode of financing as working capital funding, restrictions on the end-use are higher. Funds are typically used for immediate operational needs, such as paying employees and suppliers or reinvesting in day-to-day operations.
Why Should MSMEs Consider Receivables Securitization?
Unlike developed countries, in India, MSMEs and even large corporates still depend largely on banks /NBFCs for their funding needs. This, in my view, will change dramatically in the near future, given pockets of liquidity are shifting to other market participants like mutual funds, insurance companies, etc. Apropos, lending to MSMEs is also likely to change accordingly, shifting from bank loans to debt capital market instruments like commercial papers, non-convertible debentures, pass-through certificates, etc. Hence, for MSMEs to tap a wider set of lenders, it is imperative that they align to these instruments through funding structures like receivables securitization.
As discussed above, receivables securitization does not load the company’s balance sheet by increasing debt, and thus, is an efficient form of raising capital.
Timely collection of receivables is important for securitization to work, which compels companies to bring discipline in the collection, also solving one of the major issues faced by many startups and MSMEs today.
For MSMEs, receivables securitization offers a more flexible and cost-effective way to access liquidity compared to traditional invoice financing. Securitization allows businesses to maintain control over their receivables and customer relationships while transferring a significant portion of the risk out of their books. The funds raised can be used for various needs, such as expansion or improving cash flow, offering greater flexibility. Moreover, securitization widens the network of lenders enabling these businesses to obtain financing at more competitive rates.
By embracing this method, firms can unlock new growth opportunities, reduce financial stress, and position themselves for long-term success in the ever-competitive market. With initiatives like TReDS (Trade Receivable e-Discounting System), which is designed to make receivables financing more accessible, MSMEs in India can expect greater financial inclusion, paving the way for more robust economic development in the future.
Shantanu Bairagi is the Chief Executive Officer of Veefin Capital. Views expressed are personal. Reproducing this content without permission is prohibited.