Leverage and cash flow effects of supply chain finance

Supply chain finance, such as factoring and reverse factoring, are often labelled as tools used by companies in financial distress. Although we believe they are valid financing techniques, the reporting of these arrangements can affect leverage and cash flow. Due to poor disclosure you may not even know about it. 

Debt finance may not appear as debt in the balance sheet.  Operating cash flows may not include payments for some operating expenses or may be distorted by changes in financing being classified as operating. We explain how supply chain finance works and how you may need to adjust key metrics.

Supply chain finance has recently come under increased scrutiny, both in the context of financial reporting and its implications for investors. Some commentators claim that poor disclosure about supply chain finance, particularly related to reverse factoring, contributed to the lack of understanding of companies in financial distress. A good example is the demise of Carillion, where the investigative report highlighted that the lack of disclosure about reverse factoring obscured the company’s financial difficulties. More recently the short-seller Muddy Waters cites the use of supply chain finance by healthcare provider NMC Health to support their assertions about its overvaluation.

Supply chain finance impacts key reporting metrics such as leverage, cash flow and working capital ratios. The accounting by the supplier for advances it receives under factoring arrangements is covered by accounting standards. However, there is less guidance regarding delayed payments by the purchaser. More on financial reporting later, first a short summary of how supply chain finance works.

What is supply chain finance?

In a normal trading relationship, the trade receivable of a supplier equals the trade payable of its customer or the purchaser. Supply chain finance results in the receivable being less than the payable, with the difference equal to the advance by a bank or other financial institution.

Supply chain finance arrangements can be varied and complex; however, the common link is simply that a bank pays the supplier before it is, in turn, paid by the purchaser.

Trading relationship with supply chain finance

In this diagram the normal payment date, if no external finance were present, is assumed to be tn and the resulting payable and receivable X. The use of supply chain finance results in either a reduction in the receivable held by the supplier (B) due to earlier payment by the bank (β) or an increase in the payable of the purchaser (A) due to its later payment to the bank (α). The former is a typical factoring arrangement whereas the latter is commonly referred to as reverse factoring.

Clearly a finance charge is payable to the bank (potentially there may be payment for other services such as credit insurance) such that the amount payable to the bank by the purchaser is greater than the amount paid by the bank to the supplier. Which party explicitly pays this may vary. In a factoring arrangement the amount received by the supplier would generally be lower than the stated invoice price paid by the purchaser. For reverse factoring it would generally be the purchaser that pays an explicit charge. But who bears the explicit finance charge may be misleading as, in effect, both parties also have implicit finance costs or benefits related to their operations.

Even without supply chain finance present there is implicit financing because the supplier lends the amount of the invoice price to the purchaser for the period of credit. To reflect this the invoice price should, in principle, be discounted for the time value of money. Revenue of the supplier and expenses of the purchaser should be reported at this discounted amount. The additional payment is then interest expense for the purchaser and interest income for the supplier.

In financial reporting this implicit financing is not always recognised. IFRS 15 Revenue recognition allows the time value of money effect to be ignored if the period of trade credit is one year or less.

`The beneficiary of reverse factoring may not be the party that actually arranges it

Supply chain finance can be more complicated than simply the supplier arranging factoring to reduce receivables or the purchaser arranging reverse factoring to increase payables. For example, a purchaser may request that its suppliers increase their stated credit terms, but, at the same time, the purchaser puts in place an arrangement where the supplier can obtain early payment from a bank intermediary. This gives the purchaser the benefit of longer trade credit but allows its supplier access to finance to offset their increased investment in receivables.

This type of arrangement can create additional financial reporting and analytical challenges because, while the purpose is, in effect, to raise finance for the purchaser, it is the supplier that is the direct beneficiary of the finance and who bears the explicit interest expense.

Reporting and analytical issues related to supply chain finance

We believe that supply chain finance can be a legitimate approach to managing working capital and raising short-term and flexible finance. We do not think that the use of reverse factoring, in particular, should necessarily be a warning sign for investors, as some commentators suggest.

Reducing trade receivables benefits the supplier by eliminating what can be regarded as an unproductive asset and reducing the cost of financing that asset. Extending trade payables for the purchaser provides an increase to what may already be a reliable and cheap source of finance. Getting paid earlier and/or delaying payment improves a company’s net working capital position, which is generally well regarded by the investment community.

However, such an improvement in working capital is achieved by borrowing rather than by more efficient working capital management and could compromise liquidity in times of financial stress. The concern regarding supply chain finance is that it is great when a company is successful and growing, but that it can contribute to instability when times are more challenging. It is for this reason that the existence and presentation effects of supply chain finance must be disclosed by companies and why investors need to take note, even where the direct impact is on the reporting company’s customers or suppliers.

There are two main financial reporting issues related to supply chain finance of which you should be aware: (1) the presentation of receivables, payables, and related bank finance; and (2) the presentation and classification of cash flows. Unfortunately, accounting standards explicitly deal with these only in part.

Balance sheet presentation

If a bank provides finance to the supply chain, then either the supplier or purchaser (or possibly both) is the recipient. The question is in which balance sheet is this debt finance presented. The answer, in practice, is often neither.

Supply chain finance presentation by the supplier

The accounting issue for a supplier using factoring is whether the advance from the bank, pending settlement by the purchaser, represents a reduction in trade receivables (in accounting jargon the receivable is derecognised) or a separate bank liability which is repaid when the purchaser pays the bank. Fortunately, in this case, the answer is clear as it is covered, in international standards, by IFRS 9 on accounting for financial instruments (although the application can be complex and often requires judgement).

In essence, derecognition of the receivable applies if the rights to the cash flows have been transferred and, if so, additionally whether substantially all of the risks and rewards of ownership are transferred to the bank. Key to determining the accounting in many factoring arrangements is whether credit risk is born by the bank or not. If the transfer of the receivable to the bank includes the risks associated with collection from the purchaser, then derecognition will usually result.

Supply chain finance presentation by the purchaser

The purchaser’s liability is clear – it is the amount owed, whether to the supplier or to an intermediary bank – the question is how this is presented. Is the longer credit period obtained through reverse factoring simply an increase in trade payables or should the liability be reclassified as bank debt? And if it is reclassified when should this take place? What about the situation we describe above where the purchaser secures longer credit terms from the supplier by arranging for the supplier to receive finance? Does this ‘financing by proxy’ result in a different classification?

Trade payables, other payables or bank debt – reverse factoring liability presentation varies

There are no clear answers to these questions, and you may find different approaches by different companies. It appears that many companies that use reverse factoring are presenting the liability as trade payables and not as bank debt and that this may be giving the wrong impression regarding indebtedness. Certainly, that is the view of short seller Muddy Waters as regards NMC Health.

It is not easy to find comprehensive disclosure about the use of supply chain finance. Below we show that provided by Australian company CMIC.1CIMIC Group is an engineering-led construction, mining, services and public private partnerships leader working across the lifecycle of assets, infrastructure and resources projects. It identifies derecognised receivables under a factoring arrangement and the use of reverse factoring, aimed at helping its suppliers rather than providing finance for CMIC such that the liability is, in this case, not classified as bank debt.

CMIC supply chain finance disclosures

Source: CMIC 2018 annual report

Our view on leverage and disclosure

Leverage is an important metric for investors and the danger with supply chain finance is that not all bank debt, whether explicit or implicit in trade finance arrangements, is reflected as part of borrowings. Even though there may not be a specific requirement in accounting standards, we think that trade payables that have been increased through supply chain finance arrangements should generally be classified in the balance sheet as bank debt and not simply regarded as higher trade payables.

In addition, it is important for investors that the existence of supply chain finance is clearly disclosed by companies, even if it is not explicitly reflected in the balance sheet. For a purchaser, bank debt has characteristics different from trade payables. While both are financing that could be withdrawn, it may be the case that trade payables are more stable in times of financial stress. For a supplier, a reduction in trade receivables due to factoring should be transparent even if the receivables have been derecognised.

The benchmark for disclosure should be the normal credit terms that would be applicable without supply chain finance. This should apply whatever the type and source of that finance. For example, if a purchaser has negotiated an increase in trade payables with its suppliers beyond that expected from normal trade terms but has arranged for its suppliers to be supported through bank finance, then this should be disclosed.

“In practice … almost nobody is disclosing anything”

Unfortunately, disclosure seems to be poor in practice. One of our auditor contacts advised us that “… in practice these arrangements are pervasive and yet almost nobody is disclosing anything. When people do call it out, the disclosures are fairly short.” Although explicit disclosure requirements, particularly for reverse factoring, may be limited, the general disclosure requirements of IAS 1 in IFRS accounting should ensure transparency for investors. It is disappointing this is not the case.

We understand that supply chain finance disclosures are “on the radar” of securities regulators and also note that the big-4 audit firms have recently sent a letter to the FASB, the US standard setter, asking them to address some of the presentation issues. We hope to see better disclosure in the future.

What about enterprise value?

Bank debt and trade payables (or a reduction in trade receivables) are treated very differently in equity valuation that is based on the concept of enterprise value. Bank debt is a component of EV whereas payables and receivables are generally excluded from EV and are part of net operating assets. You can obtain a consistent valuation, whether or not a specific liability is included in EV, as long as the related metrics such as free cash flow or EBITDA are consistent. The consistency issue is something we have emphasised previously – see for example our article Enterprise value: calculation and mis-calculation.

However, EV based valuations are most effective where all financial leverage effects are excluded from the operations being valued. This means that, ideally, only receivables and payables consistent with a ‘normal’ working capital cycle are included in net operating assets and that any supply chain finance effects are regarded as financing and included in enterprise value. In practice, due to the limited disclosure, this may be challenging and probably not worth the effort unless the effect is particularly significant.

Cash flow presentation of supply chain finance

Total cash flow (the change in the cash balance) is unambiguous and is clearly affected by the timing effects of changes in supply chain finance. However, measuring cash flow subtotals, particularly operating cash flow and the related enterprise free cash flow, in the presence of supply chain finance is more challenging.

The issue is whether payments to and receipts from the intermediary bank are operating flows, finance flows or whether should there be a ‘gross-up’ to reflect both the operating and financing nature of the transaction. As with disclosure, accounting standards offer little guidance and, as a result, you may come across different approaches.

Operating flows

Where a supplier obtains earlier receipt of cash related to trade receivables or a purchaser pays trade payables later, the cash flows could still be classified as operating flows. This makes sense considering that the flows themselves originate from operational sale and purchase transactions. However, changes in the use of supply chain finance would then produce changes in operating cash flow that have nothing to do with operations or the normal cash conversion cycle.

If, for example, a company makes increasing use of reverse factoring in successive years then operating cash flows and free cash flow metrics are flattered. Cash flow arises, in effect, from borrowing and not from efficient management of cash from operations, but this may not be readily apparent if there is inadequate disclosure.

Pay particular attention to the receivable and payable days outstanding metrics as changes in these may be an indication that changes in supply chain finance are impacting operating cash flow.

Financing flows

Normally amounts advanced by or repaid to a bank would be classified as financing flows in a cash flow statement.  Where supply chain finance is present and cash flows involve payments to and from a bank then arguably these flows also represent financing flows.

The problem with presentation as a financing flow is that it can severely distort cash flow metrics. For example, under a reverse factoring arrangement, the only payment made by the purchaser is to a bank. If this were classified as a financing outflow, then there would be no operating cash outflow as a result of purchases. Without separate adjustment, operating cash flow, and consequently enterprise free cash flow, would be severely overstated.

A ‘gross-up’ approach

A method that resolves the problems we identify for both operating and financing cash flow classification is to do a cash flow gross-up. This involves reporting offsetting operating and financing flows at the time when settlement of the receivable or payable would have taken place without the supply chain financing. This is then followed by a financing flow at the time of eventual settlement with the bank. For example, in the case of reverse factoring this would involve an operating outflow when the bank pays the supplier with a financing inflow on the same date. When the supplier later pays the bank, this would be a financing outflow.

The gross-up approach for cash flow reporting best reflects the economics

In our view this approach provides a much more useful and realistic measure of operating cash flow and avoids the distortions identified above. The only problem is that this, in effect, introduces non-cash items into a cash flow statement. It is questionable whether this complies with accounting standards, although this depends on precisely how the supply chain finance is structured.

Our view on cash flow

Ideally, we would like to see cash flow information presented using the gross-up method when supply chain finance is present. If this is not possible then the equivalent information should be provided by disclosure. We believe that the requirements of IAS 7, cash flow statements, regarding the disclosure of material non-cash transactions, already makes this mandatory.

Regular readers of The Footnotes Analyst will notice a similarity between the cash flow consequences of supply chain finance and those for lease financing. In both cases offsetting financing and operating flows create analytical issues. See our article In search of free cash flow – Amazon for more about this topic.

Insights for investors

  • Liabilities reported as trade payables may, in substance, be bank debt. Look for evidence in the notes.
  • Financing that contributes to reduced receivables or increased payables, beyond what would be expected from normal trade credit, should be included in debt finance for the purpose of assessing leverage.
  • Remember that for valuation multiples and analytical ratios it is important to obtain consistency. Always make sure that the cost of financing included in EV or invested capital is excluded from operating expenses.
  • Watch out for payments under a reverse factoring scheme being reported as a financing cash outflow and hence an over statement of operating flows. If supply chain financing cash flows are reported as operating flows, then changes in financing activity may distort this metric.
  • Try to modify your operating cash flow metrics using the ‘gross-up’ method.

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