Manage exposure; but generate profit. Maximise yield; but minimise risk. Increase tenor; but reduce cost of funds.”
The Corporate Treasurer’s mandate has always been challenging but as the “lower for longer” school of thought continues to prevail in global rates, the concept of effective working capital management is becoming a focal point for many savvy treasurers seeking to minimise cost of carry. Increasingly lumpy cashflow cycles present yet another challenge, with many corporates seeking a smoother profile.
This combination has given rise to a phenomenon known as “reverse factoring”; an interesting twist on conventional factoring arrangements which has garnered significant media attention in recent months. By way of a refresher, conventional factoring (receivables financing) allows businesses to gain early access to funds owed to them by their customers, with a third-party financier settling the customers’ invoices at a discount, until the amount is recovered in full later.
Conversely, reverse factoring, commonly known as supply chain financing, involves the financing of a company’s payables with an intermediary paying their suppliers early, in exchange for a predetermined discount. On the face of it, there doesn’t appear to be anything wrong with this — indeed, many companies running such programs cite it as a “win-win” for large corporates and their small suppliers.
In practice, however, it has promoted some potentially questionable corporate behaviour, masking more sinister motives with notable names such as Telstra and Vodafone on the receiving end of considerable backlash from the Australian press, small business councils (including ABSFEO) and the government. Most of the backlash regarding reverse factoring is focused on three key aspects:
Many corporates have combined the implementation of a reverse factoring facility with a material extension to existing supplier payment terms. As reported by
the Australian Financial Review (here), the majority of CIMIC’s subsidiaries (including UGL, CPB and Sedgman) informed suppliers that standard payment terms would more than double, from one month to 65 days(1). If suppliers want to be paid earlier than 65 days, they can approach third-party financier Greensill Capital but invoices would not be paid in full as they would have to accept an unspecified discount commensurate to the funding cost.
Similarly, Telstra doubled its longest payment term from 45 to 90 days whilst ramping up its exposure to reverse factoring to almost $600m in 2019, compared to $42m in the prior year (AFR). Again, suppliers were able to access funds earlier than 90 days via Greensill Capital, in return for a discount amount imposed by the financier.
Per Bloomberg, similar examples have been referred to as “supply-chain bullying” whereby large corporates pressure their smaller suppliers to invoice them for less or accept even longer delays in being paid. Such behaviour is certainly on both the ACCC and ASIC’s radar though both have acknowledged that the fairness of payment terms “depends on the circumstances”. It is a critical point that these reverse factoring programs are driven entirely by the large corporate, with suppliers not having a say in determining the discount rate applied for early payment.
(1) Applies to all suppliers and sub-contractors working on projects not covered by the 2016 Building Code per [AFR (https://www.afr.com/companies/infrastructure/cimic-s-cash-flow-solution-could-backfire-20190919-p52t2b)
Inherent in reverse factoring arrangements is a great deal of ambiguity and discretion as to whether such facilities should be classified simply as trade payables or, alternatively, bank borrowings. This discretion is particularly attractive to companies looking to artificially boost working capital without impacting debt covenants or vesting conditions for employee incentives.
Clearly this decision is critical in determining whether reverse factoring rears its head in a company’s operating or financing cashflows. The litmus test looks at three key factors:
- Materiality — both quantitative (i.e. relative size) and qualitative (i.e. the nature of the item) characteristics. Quantitative materiality for balance sheet presentation can be assessed relative to total assets or liabilities, with 1% often used as a benchmark. Qualitative assessment looks at the nature of the transaction, acknowledging that trade payables are typically limited to suppliers of goods and services. Borrowings, on the other hand, typically relate to key sources of financing, usually from banks.
- Regularity of use — if the facility is used regularly as part of the financing of the business, then it is more akin to a borrowing. If it is used only on an ad-hoc basis such as at half year-end or year -end this supports presentation as an Other Creditor.
- Who initiates the transaction — if the use of the facility is at the discretion of the supplier this supports presentation as a Trade Payable or Other Creditor. If use is mandated by the customer, then this often indicates it is a borrowing.
In the case of Telstra, the c.$550m increase in reverse factoring represented 18% of the company’s free cashflow in 2019. CIMIC also accounted for their use of the facility in the operating cashflow line, describing it as an “innovative solution that optimises cashflow”.
Current accounting rules do not require companies to disclose the use of reverse factoring facilities. As such, it can be extremely difficult for investors, or potential investors, to determine actual underlying business performance versus one-off financing gains that will be difficult to replicate. Indeed, the Australian Accounting Standards Board (AASB) recently noted the increase in reverse factoring amongst corporates, stating it “will discuss further with the International Accounting Standards Board and other regulators”. Unsurprisingly, credit ratings agency Moody’s warned this month that “companies using reverse factoring should disclose it as a liquidity risk,” due to the artificial boost it can provide to working capital metrics.
Introducing the Earlytrade model
Clearly, the use of reverse factoring does not meet the environmental, social and governance (ESG) criteria that many large corporates use to guide their moral compass. Supplier payment terms have been in vogue for the past few years in Australia with industry bodies, councils and state government all advocating for small businesses (see the BCA’s Supplier Payment Code). Indeed, after conducting its latest Ethics Index the Governance Institute of Australia concluded that “Australians have lost faith in corporate ethics”.
The Earlytrade philosophy has always been to ensure that SMEs are given a fair go. We understand that cashflow is the lifeblood of any small business and extending payment terms can have a significant impact on the ability of SMEs to flourish, with potentially disastrous impacts to the broader economy.
A key difference between the Earlytrade marketplace model and reverse factoring arrangements is that it is entirely supplier-driven. If suppliers require funding prior to their contractually agreed payment date, they can access an alternative source of liquidity via the Earlytrade market by offering discounts, that they determine, on outstanding invoices. If they do not require early payment, they simply receive the funds per the contractually agreed payment term.
Furthermore, the Earlytrade model does not require involving third-party financiers. Funds still flow from the same corporate bank account and into the same supplier bank accounts, the only change being when this occurs. Corporate users supply liquidity to the market, essentially providing them an alternative investment for their low-yielding cash reserves which would otherwise sit in overnight or short-dated term deposits earning below 2%.
In summary, for companies looking to merely improve the optics of their year-end reports via an unsustainable sugar hit, reverse factoring can be an appealing tool. However, for those looking to provide an alternative liquidity source to their suppliers, improving the health of their supply chain whilst creating genuine, perpetual value for their own shareholders, the Earlytrade model presents a prime opportunity.