It’s important for professionals in any line of work to engage in serious debate about their industry and the role they fulfil – and supply chain finance professionals are no different. There are stakeholders beyond the immediate parties and counterparties who have a legitimate interest in what we do. So when an opportunity arises to exchange views and increase each other’s understanding, that opportunity should be seized with both hands.
Just such an opportunity materialised recently when Fitch, the highly-respected credit ratings agency, wrote a circular to investors about supply chain finance, describing reverse factoring as a “hidden debt loophole” that is “tricky to spot”.
Alex Griffiths (pictured, right) runs the EMEA corporate analytical group at Fitch and is a co-author of that report. He kindly agreed to have a conversation with me about his paper and his views on supply chain finance. (Alex will also be taking part in a discussion panel at the Supply Chain Finance Forum in Amsterdam on 29 November 2018, so you will be able to hear for yourselves what he and others have to say about where supply chain finance is and where it’s going.)
Alex’s paper focused primarily on reverse factoring, in part because that was such a significant part of the funding strategy at Carillion, the UK construction group which collapsed in January this year. But the first thing to note is that he agrees that supply chain finance isn’t just about reverse factoring. “That’s just one part of a very broad area of expertise,” he said.
I asked him if he thought that reverse factoring was a positive or a negative development and he replied with a very good point: “It would be a positive development if we could keep track of it.”
I asked him if he thought that reverse factoring was a positive or a negative development and he replied with a very good point: “It would be a positive development if we could keep track of it. If companies are diversifying their funding, finding additional liquidity sources, or ways to sustain a supply chain over a bad period, there is nothing wrong with that. I’m not against reverse factoring. But we do need to realise that there are some debt-like elements to it. The main problem is we can’t tell [the scale of it]. We’re not able to make that judgement.”
The key to the box
For investors and many investment analysts, how companies manage their working capital is something of a black box. Organisations such as Fitch generally have the opportunity to have in-depth conversations with the companies they rate – but his point is that you need to have access to that key in order to unlock the box.
I shared with Alex some of the findings from the SCF Community’s own research which suggested that, while retail companies’ trade payables days were about 20-30 days higher in companies that used supply chain finance, that simply wasn’t the case with the automotive industry: trade payables were actually lower for the players in the industry that use SCF. Our reckoning is that this is because some companies do, indeed, deploy reverse factoring as an aggressive tool to extend payment terms – but others use it more as a strategic tool to support their supply chain.
“Absolutely,” Alex agreed. “We’re aware that there are a lot of companies that do it for the reasons you say. It’s very often not to extend payable days but maybe to bring them up to industry standard.” He added that part of it was to do with the bargaining position of the buyer and seller. “It’s nice to suggest that people are being altruistic and helping their supply chains out but I’d be very surprised if there wasn’t a very large quid pro quo there, negotiating discounts from their suppliers and splitting some of that benefit in some way,” he said. “It could feed into commercial discussions which are broader than extending payables days: how much business you’re given, what delivery terms you’re given, etc. It’s another bargaining chip, which is fine: it’s a sensible thing to do.”
One of the things that SCF professionals are very clear and vigilant about is the fact that, legally, the negotiated payment terms and the acceptance of the financial structure are two separate things. Alex argued: “Legally – but if you listen to the industry rhetoric and the way these programmes are discussed, it’s a programme. They’re not two distinct things. Why would I, as a large corporate in times when financing is fairly cheap, just help out one of my suppliers for the fun of it? Fine if there is a real risk that they won’t make it, but in reasonably good times, you don’t need to extend that to the bulk of your supply chain because they should be self-financing. There is a legal distinction but in practical terms you have a relationship with your supply chain and this is part of that relationship.”
Interestingly, Alex said that he really is not very bothered about whether extended trade payables get reclassified in the balance sheet as debt – the very thing that many of us obsess about to keep the balance sheet clean.
“I don’t care if it’s shown as debt or not,” he told me, “as long as it’s clear what it is. If there is a note that says ‘This payable reflects money owed to a third party other than our normal trade creditors under our SCF programme,’ then that’s great. That will be absolutely fine. We would probably reclassify some of that in our metrics but I don’t mind where it’s classified in the balance sheet.”
Alex acknowledges that it would be a challenge for the standard setters to try to create an accounting standard that accommodates SCF programmes. Moreover, he reminds us that IFRS doesn’t even have a definition of debt – “which is part of the fun of all this!” But as long as a supply chain finance arrangement is disclosed somehow, that’s the main thing from his perspective. “There are quite a few of us who actually read the notes.” Quite right: any accountant knows that you start reading the financial statements from the back.
Fitch Ratings naturally looks at things through the lens of default risk. Alex’s concern, therefore, is “the situation where you have a very large creditor base – a bank creditor base – hidden in the accounts somewhere. When that bank gets wind that for some reason there’s a problem, they pull their lines and suddenly the company needs to be able to fund their working capital somehow.”
“One of our rating factors is management and corporate governance and that includes transparency. If you have a great set of accounts which very clearly discloses a reasonable reverse factoring programme it will be incorporated in the rating – but the transparency is important.”
Technically, of course, it’s the suppliers who need to find replacement funding – but as he rightly emphasises, “Suddenly, the supplier might say, ‘I haven’t got the SCF any more, so I’m not giving you 180 days, I’m giving you 60 days like we had before.’ That’s when it becomes the company’s problem. You could just have been pushing problems onto the supply chain which then ceases to be able to supply – which makes any problem you were having in the first place worse.”
What matters, said Alex, is transparency. “We’re trying to get a holistic view of a company’s position. We need to be able to see everything to do that. A lot of what we do is based on trust. One of our rating factors is management and corporate governance and that includes transparency. If you have a great set of accounts which very clearly discloses a reasonable reverse factoring programme it will be incorporated in the rating – but the transparency is important.
“What would be viewed far more negatively would be if you’d reported nothing, suddenly things get a bit tough – and , oh, by the way, there’s this reverse factoring programme that nobody was told about.”
Of course there are many ways that a company can dress up its balance sheet. We’ve seen companies, for example, that make payments to credit insurers so that they can afford to underwrite bigger credit lines for suppliers. Arguably, therefore, it’s a little unfair that the Fitch Ratings report singled out reverse factoring as a mechanism for engineering the payables line, and I think Alex saw our perspective on this when he replied: “I completely understand that this is a very complicated environment and there are a huge number of grey areas and ways to influence your payable days.
“But the more that we get exposed to the SCF space the more it’s clear that there are a lot more options out there and a lot more ways to influence payables than a more simplistic view of the world would suggest. We are absolutely open to a sensible conversation with people from the industry and issuers in terms of what’s out there, what are they doing and is there any better way that we could reflect this.”
I look forward to taking the debate another step forward with Alex at the Forum in Amsterdam. You won’t want to miss that.
Check out the agenda and speaker line-up for the SCF Forum Europe by clicking here. The event takes place in Amsterdam on Thursday 29th November 2018. Reserve your place today.