Lending money against the comfort of receivables is a well-established loan product offered by banks and non-banking financial companies (NBFCs), and an excellent example of real life classic 'win-win-win' game.
However, even the much-trumpeted trade receivables discounting system (TReDS) product introduced by the Reserve Bank of India (RBI) with much fanfare also failed to consider the various nuances involved in receivable financing and has become a virtual non-starter.
Receivables arise when a seller makes a sale on deferred payment terms, i.e., on credit, whereby the goods are sent to the buyer, but the buyer need not make the payment immediately and would pay it after some time (or payment for services rendered is expected to be received after some time).
'Receivable' refers to the amount of money owed by the buyer to the seller. The actual credit period (i.e., the receivable period) may vary from 15 to 180 days or more (or less) and depends on various factors, such as, market conditions and practices, explicit or implicit agreement between the buyer and seller.
A financial intermediary, such as a bank, arranges to loan money to the seller equivalent to the amount of receivables (amount expected from the buyer equivalent in value to the value of goods sold or services rendered) less discount (i.e., interest charges) and other handling charges, with the expectation that the sale value, when received from the buyer, would enable full repayment of the loan.
The seller wins by getting cash upfront against the comfort of his receivables so that his liquidity improves and he can comfortably continue operations.
The buyer wins, since it can process and sell the purchased goods to third parties and make a profit before it has to make payment for the purchased inputs. The bank or NBFC wins, since it can profitably deploy its funds on short-term, self-liquidating loans.
This kind of lending is considered low-risk and lucrative for several reasons.
First, the bank expects to receive the payment from the buyer and, in case the buyer fails to make the payment, the bank generally has recourse to the seller too. Therefore, there is comfort from two sources of recovering its dues.
Second, such lending consists of taking a series of short-term loans and, as such, the asset and liability and associated interest rate risk for the bank is lower.
Third, at the slightest indication of deterioration of the financial condition of either the buyer or the seller, the bank can stop further lending against receivables for the particular borrowing entity and can have an orderly exit from a potentially sticky relationship.
The icing on the cake against receivables lies when the financing is done to the seller which falls under priority sector norms while the buyer is a well-established and credit worthy entity. In such cases, banks can very correctly report such exposures to qualify for priority sector lending, while, at the same time, keeping its risk low since the buyer from whom payment is expected is a much better credit risk.
'Invoice discounting' is an example of receivable financing and something bankers and policy-makers love to talk about and consider a very lucrative and safe business proposition. But is it really so? Let us deconstruct its individual terms to better understand what is being sought to be done when a banker offers this loan product.
'Invoice' is a bill which the seller makes out in the name of the buyer and lists out the items being supplied, their quantity, value, and tax (if any) and gives the total of money payable by the buyer to the seller for the particular transaction. It might or might not give the due date by which the money is payable.
'Discounting' is a process whereby the monetary value to be received after a period is given immediately, less the discount amount. That is, it is a process where the seller can get the sale proceeds upfront immediately instead of waiting for the credit period. For this to happen, the seller approaches its bank with a request to discount its sales bills. The bank does so and charges a discount which is a function of the receivable period and amount.
To make it clear, suppose the amount of Rs1,000 is receivable after 90 days from the date of discounting. If either the seller or the buyer is of a good financial standing, the bank will be willing to discount the sale bill and give the seller Rs1,000 less the discount amount.
If the rate of interest is say, 12% per annum, the discount amount on Rs1000 would be the interest on Rs1,000 for a period of 90 days, which comes to Rs30 (1000 X 12% X 90/360). Therefore, the discounted value of the sale bill would be Rs970 in exchange for a sale bill of Rs1,000 payable after 90 days. In addition, banks also charge some flat fee for offering this service which goes towards augmenting its bottom-line.
The twist in the 'invoice discounting' game arises from the fact that there are a number of perfectly valid reasons why the amount mentioned in the invoice may not be payable (fully or partially) by the buyer to the seller.
For example, (a) the goods supplied may not be what the buyer had ordered or the buyer finds that there are quality and / or quantity discrepancies. The buyer thus would be within his rights to pay only for the actual goods received which are also as per the agreed quality standards, (b) the buyer may deduct dues on account of earlier supplies which were found to be defective or for short quantity, (c) the buyer may exercise his right of set-off and adjust payment for the supplies mentioned in the invoice against other unrelated transactions.
Furthermore, there might be a long-term ongoing relationship between the buyer and the seller whereby the buyer makes payment on ad hoc basis (not invoice-wise) and the two periodically reconcile the actual payments to be made or received, say once every quarter.
The second twist is that even when the date of payment is mentioned on the invoice, the legally binding nature of making the payment by that date may be extremely weak. And many a time, there may not be a payment date mentioned on the invoice, with buyers making the payment based on a separate understanding (say, a separate sale or purchase agreement) between the two, or some flexible market conditions.
For any 'discounting' to take place it is essential that both the due date and the amount receivable should be explicitly clear upfront. In the absence of either of these parameters the discount amount cannot be calculated with any level of certainty and causes confusion and misunderstanding. Both are sources of avoidable risk.
As would be apparent from the above discussion, neither the amount mentioned in the invoice nor the date of its payment is fixed with any degree of certainty beforehand. In view of these infirmities, 'invoice discounting' is something which is logically (and legally) impossible to execute.
Financing against receivables in the form of invoices needs a different approach from 'discounting' in terms of operating procedures, legal underpinning, margins, and accounting treatment. But bankers are prone to rush in where even angels fear to tread and freely offer invoice discounting and many a time get stuck with unpaid bills.
Is it surprising that there is a log jam in something as simple as receivable financing or even this safe credit product results in non-performing assets (NPAs)!
(The author worked with various banks - public, private, and foreign both in India and abroad - for nearly 30 years and is currently on a self-imposed sabbatical to try and understand as to what ails Indian banking and what, if anything, can be done to improve its functioning.)