Since the publication of Moody’s report ‘Abengoa’ on reverse factoring – a situation where a bank pre-pays the company’s invoices to its suppliers – the world of supply chain finance has been holding its breath. Since then, more financial analysists have started recalculating the debt of companies with reverse factoring (RF) programmes. The consequences of this development have yet to be seen, but the debate is already taking place.
It all started with the Philips of this world that have been consistently stretching their payment terms towards suppliers as a way to polish up their balance sheet. Suppliers to large enterprises often have to wait 90 to 120 days to get paid. Meanwhile, big companies see their payables increase, improving their balance sheet. This practice has been stretching suppliers who require payment to cover operational expenditures and who have been forced to raise financing, often at high interest rates. This is where the big companies and their banks swoop in as benefactors. They offer their suppliers credit via a so-called reverse factoring programme. In cooperation with a bank, suppliers receive pre-payments at a cheap interest rate. In this arrangement, the large business guarantees payment of the invoices to the bank at the end of the payment term.
All parties benefit
In this setup, everyone benefits:
- Large corporations benefit because of ‘free’ credit without seemingly any impact on their indebtedness;
- Suppliers get their troubles eased by having access to cheap financing to cover ever-increasing payment terms; and
- The bank gets to earn a fee for their services.
It is a clear win for all parties and is advertised as such by financial providers and big companies everywhere.
Debt without the guilt
Of course, suppliers would not need cheap finance to cover the 90+ day of payment terms if they had not been stretched out in the first place. Moreover, big companies could have simply taken out a loan directly with their bank if they needed financing. So why use these complex programmes and pay financiers fees to setup and run them?
The answer lies in the current accounting treatment of RF programmes. For a big company, the obligation to the bank gets classified as a ‘trade payable’. Historically these are not included in most measures of indebtedness.
Hiding the RF programme’s debt
Big companies and their CFOs go to a lot of trouble to keep their debt as low as possible, and for a good reason. Their cost of capital is tightly linked to their indebtedness via covenants and credit ratings. Years of MBA schooling has taught us that short cash-conversion cycles are the best kind.
Because of the way financial analysts treat ‘trade payables’, RF allows a company to increase their external financing. But, because the programme is ‘hidden’ in the ‘trade payables’, it does not increase the company’s indebtedness. Of course, the company’s future obligations have increased but it does not seem that way because of how we view balance sheets.
If it walks like a duck…
As the amounts involved in RF programmes keep increasing (we are talking billions), the treatment of RF programmes is coming under scrutiny.
Moody’s and other financial analysts have started to include the obligations following from RF programmes in their calculations. Their argument is that there is no reason to treat these liabilities as anything other than debt. For some companies, like Abengoa, this results in a massive increase in their debt level.
Still a valuable tool?
Will RF be viewed as valuable if it is considered going forward? A few possible outcomes are:
- Materially, companies will not suddenly become more indebted when the view on RF changes. The liabilities were always there, and financiers were comfortable with them. It is possible that economic thresholds are adjusted to reflect the new reality.
- Alternatively, financial thresholds might stay rigid, and big companies decide to unwind their programmes. Often suppliers can only oblige to the stretched payment terms with the assistance of RF, so payment terms will need to be shortened. Big companies could then replace the lost supplier financing with other types of debt.
- However, large companies could also decide that the increase in indebtedness is worth the benefit. This is unlikely in our view, and an easier way to accomplish the same would be to shorten payment terms and take a loan directly.
Future of supply chain finance
The idea that large companies support their supply chain by providing financial aid has lost none of its appeal. Supply chains today are financed inefficiently, and big companies could do a lot to increase efficiency and lower costs. However, RF’s current focus on ‘balance sheet management’ fails to capture these benefits.
The discussion about the value of reversed factoring with its heavy focus as a tool to increase payment terms has started. We welcome this debate and view it as a means to take supply chain finance to the next level.