Trade receivables securitisation is a more complex financial instrument than invoice factoring. Trade receivables securitisation takes illiquid existing and future receivables and converts them into tradable debt and equity obligations.
To turn trade receivables into securities unpaid invoices are sold to a SPV (Special Purpose Vehicle). The value of the invoices does not change when they are transferred to the SPV.
The SPV then collateralises the portfolio of receivables and refinances itself by issuing various classes of asset-backed securities. These securities will vary in their risk to investors.
Once the outstanding invoices are bundled together and turned into securities their value increases because these financial assets are worth more to investors once they have been legally separated from the company who has originated such receivables (the originator).
This is because the securities are scrutinised by rating agencies and classified by risk. They are also underwritten by a pool of sponsoring banks. The underwriting by a bank makes taking on securities composed of outstanding invoices far more attractive to a potential investor.
Factoring or Securitisation?
Whereas factoring is a form of credit finance, securitisation is capital market-based finance. This has the key advantage of allowing companies to improve liquidity without increasing their liabilities. Factored invoices stay on a company balance sheet (this is the case with recourse factoring and invoice discounting). In contrast, invoices turned into securities are no longer legible for the company’s balance sheet.
Also, since securities are underwritten by banks, they reduce a company’s reliance on unsecured debt.
When to Opt for Securitisation?
A key metric for a company when it comes to making a decision about whether to offer a credit line to debtors, apply for a bank loan, factor trade receivables or securitise trade receivables is liquidity ratio:
LIQUIDITY RATIO = Current Assets/Current Liabilities
This is calculated by taking a company’s most liquid assets (i.e., current assets, those easiest to convert to cash) and dividing that monetary number with the amount of short-term liabilities (current liabilities) that are on the books. Thus, a high liquidity well over 1 means that a company is in good financial health and can pay its debts. A liquidity ratio below 1 means that the company may experience a liquidity crunch. Furthermore, if the debt-to-equity ratio, an indicator of a company debt leverage, is high than both factoring and securitisation should be considered.
DEBT-TO-EQUITY RATIO = Total Liabilities / Equity
Securitization normally offers sellers broader access to capital at a lower rate, especially if the seller has a credit rating worse than their customers. In such instances there is an opportunity to do credit arbitrage. A well-structured securitisation can achieve an investment-grade rating even for a seller that is not investment-grade rated. Sellers are able to leverage their receivables by credit insurance, appropriate structuring, effective servicing and standardised underwriting so as to gain access to attractive capital markets financing.
Most of the times, large companies with high volume of receivables use securitisation as an effective tool for funding their short-term working capital.
Trade receivables securitisation takes outstanding invoices off a company’s liabilities. Via a Special Purpose Vehicle, the invoices are bundled together and sold as securities to investors. Changing receivables to securities creates attractive income streams for investors because they are rated by independent rating agencies and also underwritten by banks.
The downside of securitising trade receivables is the legal and administrative costs involved in their creation. However, if a company has a debt-to-equity ratio higher than 2 then securitisation makes good financial sense.