New supplier finance disclosures will affect operating cash flow

Reported operating cash flow, leverage and net working capital measures, may be misleading if a company engages in supply chain financing. The impact can be significant but, at present, calculating the effect and making adjustments is difficult. Additional IFRS disclosures proposed by the IASB will help.

We explain the new disclosures and provide an interactive model to illustrate how to use them to calculate more realistic measures of cash flow, leverage and working capital. The adjustments depend on whether liabilities are classified as trade payables or debt finance and may require the inclusion of a non-cash ‘effective’ operating cash outflow.


In our article ‘Leverage and cash flow effects of supply chain finance’ we explain how supplier finance arrangements (also referred to as reverse factoring) can distort operating cash flow and mis-state leverage. The problem for investors is that what may, in part, be a source of debt finance could be presented as trade payables in the balance sheet and not identified as a financing liability. Changes in this liability are included in operating cash flow, which may be artificially enhanced where the financing component increases. Even if a supplier finance arrangement is classified as debt financing, operating cash flow is still distorted, particularly due to the resulting ‘non-cash’ operating outflow.

Existing footnote disclosures are not sufficient to derive realistic cash flow and leverage metrics

Existing disclosure requirements in IFRS should provide investors with some information about supplier finance arrangements. However, these are not sufficient for investors to identify how operating cash flow and debt finance presented in financial statements have been affected or enable investors to derive more realistic measures.

The following extracts from the financial statements of Glencore illustrate the problem for investors. The company identifies that at 31 December 2020, out of $24.0bn of liabilities included under accounts payable, $7.2bn arise from supplier finance arrangements, up from $5.7bn the previous year. It also says that payables with maturities extended beyond 91 days due to the arrangements have increased from 2% of payables in 2019 to 10% in 2020 and that the average days payable for liabilities under the arrangement has increased from 86 to 91 days.

All of this suggests there may have been an increase in the financing element of trade payables and Glencore says that some transactions may contain “extended payment terms”. However, the company says that the economic substance of the transaction is operating in nature, and that extended credit is consistent with “supply terms commonly provided in the market”, which explains the accounts payable classification.

Supplier finance at Glencore

Note 1. Accounting policies – Critical accounting judgements

Note 24. Accounts payable

Glencore financial statements December 2020

The problem for investors is that it is not clear how much finance is being provided by banks under these arrangements and whether the main beneficiary is Glencore’s suppliers or Glencore itself. The company does not specify the financing component of the liability, or whether the apparent increase in 2020 had a material effect on reported cash flow. Glencore says that the “financing element is insignificant” but we cannot verify this from the information provided and other parts of the disclosure seem to indicate that Glencore is benefiting from additional financing.

Trade payable or bank borrowings?

Where payments by a purchaser to a supplier do not involve any external finance arrangement the trade payable and trade receivable are equal. The purpose of supplier finance is to break this link, with the intermediary bank paying the supplier before the bank is, in turn, paid by the purchaser.

There may be different objectives and structures for a supplier finance arrangement, which influences the accounting treatment:

  • Finance for the purchaser: If the arrangement increases payable days for the purchaser, while the supplier still receives payment on the normal due date, it is only the purchaser that benefits from additional finance. The same effect is achieved if the purchaser arranges for the supplier to grant longer payment terms but in return the supplier is provided with a facility whereby payment can be obtained on the original due date.
  • Finance for the supplier: The purchaser may enter the arrangement simply to improve cash flow for its suppliers. The purchaser still makes payment on the normal due date but earlier payment by the bank to the supplier provides the supplier with an alternative, and potentially cheaper, source of finance.
  • Finance for both: If the supplier pays later than it would have done without the arrangement and the supplier receives payment earlier both are receiving a financing benefit.

Our focus for this article is on the liability and cash payments by the purchaser.

Is the liability similar in nature to trade payables?

The classification of the liability under IFRS depends on whether the liability is regarded by the purchaser as “similar in nature and function to trade payables” and consequently whether the “liabilities are part of the working capital used in the entity’s normal operating cycle”. This depends on the extent to which terms of the arrangement differ from other trade payables.1The basis for classification of the liability under IFRS is explained in an IFRS Interpretations Committee agenda decision which can be found here. The liability is classified in its entirety; it is not split between a ‘normal credit terms’ trade payable and an excess financing component.

If the purpose of the arrangement is to provide finance for the purchaser by significantly extending the payment date, it is likely to be classified as a financing liability. Otherwise, it will be part of trade payables, as is the case for Glencore above. However, the classification requires judgement, and you may find inconsistencies between companies. Where payment terms are extended, but not beyond what could be considered the ‘normal operating cycle’, the liability may still be classified as a trade payable, even though the purchaser is effectively benefiting from debt finance.

The new proposed IFRS disclosures

The IASB has recently issued an exposure draft outlining proposed disclosures by a purchaser who engages in supplier finance arrangements. Some of these are reminders of existing requirements, such as the effects on liquidity risks and non-cash changes in financing liabilities. However, others are new, including information about payment dates. If a company uses more than one supplier finance arrangement the disclosures may need to be provided separately for each.

Here is our brief summary – the figures in blue are illustrative amounts we have used as inputs for the interactive model below.

Summary of proposed IFRS disclosures

The challenge for investors regarding supplier finance arrangements is that the purchaser’s liability is classified either as trade payables or as a financing liability in its entirety, with the effect on cash flows presented as either wholly operating or financing. However, the economics of the arrangement is that the liability, and the associated cash flows may, in reality, be part operating and part financing.

The result is that reported cash flow, leverage and working capital metrics are affected by the extent of the supplier finance, whether that finance primarily accrues to the supplier or purchaser, and how the liability is classified in the purchaser’s financial statements.The proposed IFRS disclosures are designed to enable investors to assess these effects and to adjust analytical metrics where necessary.

The new proposals will not change what appears in the balance sheet or change reported operating cash flow. However, the disclosures should enable you to better understand how supplier finance arrangements affect (and distort) these reported metrics and may well change what you should use in your analysis.

Using the proposed disclosures to adjust cash flow and leverage

To adjust reported cash flow, leverage and working capital measures it is first necessary to identify the total amount of bank finance provided under that arrangement. This is the amount that has been paid by the bank to the supplier, but which has not yet been paid by the purchaser to the bank. This figure is one of the new disclosures proposed by the IASB.

Finance supplied under the arrangement may benefit the supplier, the purchaser or both

The total finance amount can be split between that attributable to the supplier and purchaser. For the supplier it is the extent to which they are paid earlier than they would have been without the arrangement. For the purchaser it is the delay in their payment. We can estimate these by comparing the average payment date under the arrangement with what that would have been had the arrangement not existed. The proposed disclosure of payment dates is a range rather than a more useful weighted average – if companies do disclose a range, you will need to take a mid-point.

The amount of finance attributed to the purchaser is:

Reported liability under supplier finance arrangement
x
(Actual payable days – Normal payable days) / Actual payable days

The difference between the total finance provided under the arrangement and that attributed to the purchaser is therefore the amount attributable to the supplier.

The total liability of a purchaser under a supplier finance arrangement can then be split between the above amount of debt finance and an amount that represents the underlying trade payables that would have been present had the arrangement not been used. In our interactive model below (and using the inputs when this page is loaded) we obtain the following analysis.

Analysis of financing provided by a supplier finance arrangement

Note: The finance attributable to the purchaser should not be negative nor greater than the total finance provided under the arrangement – if it is outside this range there is an inconsistency in the data. In our model we set limits to ensure this is not the case.

If the finance provided under the arrangement is wholly attributed to suppliers no adjustments to operating cash flow or leverage are necessary. In this case the arrangement simply involves the purchaser facilitating bank finance for its suppliers, which is probably of limited interest if you are analysing the purchaser.

But if the finance is partly or wholly attributable to the purchaser you will need to identify the effect and adjust both leverage and operating cash flow. The nature of that adjustment depends on the classification of the liability in the purchaser’s balance sheet.

Liability classified as trade payables

If a component of trade payables is in effect debt finance, cash flow will be affected by changes in that financing amount, and leverage will be understated. You should reclassify this part of trade payables as debt financing and remove the change in this financing from operating cash flow – if the finance amount increases then reduce operating cash flow (the amount is 123 in our model).

Liability classified as borrowings

If the liability is classified as borrowings, the payments made by the purchaser to the bank would be presented as a financing cash outflow, probably combined with other debt repayments. The reduction in trade payables and increase in borrowings that occurs when liabilities enter the arrangement is generally not an actual cash flow. As a result, there is no operating outflow reported in respect of purchases and therefore operating cash flow is likely to be grossly overstated. However, the non-cash movement in financing should be disclosed as part of the existing financing liability roll forward disclosure.

Omission of the ‘effective’ outflow can seriously distort reported operating cash flows

We often refer to this type of non-cash flow as an ‘effective cash flow’ as it is, in effect, an offsetting operating cash outflow and financing cash inflow.2For more about effective cash flows see our article When cash flows should include ‘non-cash flows. To correct operating cash flow, it is necessary to deduct the non-cash increase in borrowings (the effective operating outflow) from the reported cash flow amount (5,189 in our model).

However, this is not the only required adjustment. To obtain what the operating cash flow would be if there were no supplier financing arrangement in place, the change in the liability component that represents trade payables should be included as part of operating cash flow. The adjustment is the total change in the liability under the arrangement less the financing liability component described above (377 in our model).

These adjustments are illustrated in the interactive model below. The inputs to the model are the disclosures proposed in the IASB exposure draft, with the exception that the payment dates are assumed to be weighted averages – the ED just requires a range.

We have presented the resulting adjustments for both (1) where the liability is classified as trade payables and (2) where the liability is classified as a debt finance. Obviously only one of these will apply for each arrangement. The indicated ‘likely’ classification shown in the model is simply based on whether the payment date is more than 20 days3The 20 days just represents our guess regarding how companies may be applying the IFRS guidance on classification. One of the problems for investors is that this guidance is not very clear, and we think that classification may differ for similar liabilities. longer than the normal credit terms. Our approach is simplistic, the actual classification applied in practice would depend on the overall terms of the arrangement and the judgement by the company.

 

Interactive model: Supplier finance arrangements

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The input data in the model when first loaded is the same as that in an example provided by the IASB in educational material aimed at investors. See Supplier Finance Arrangements – disclosures that reflect investor needs.

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When this page is first loaded, the data in the model reflects a significant financing component in the amount payable under the arrangement, as indicated by the payable days of 90 compared with an average 65 days for payables not within the arrangement. Accordingly, we think it likely this liability will be classified as a financing obligation.

However, because part of the liability effectively represents trade payables, and the settlement of the liability represents payment for operating expenses, classification as wholly financing will be misleading. The result is an overstatement of each of operating cash flow, net debt and net working capital.

If you change the model inputs to reduce the gap between the payable days to less than 20 you will see the shaded solution section switches to show the effect if the classification were trade payables. If there is no financing for the purchaser (payable days are the same) then there is no impact of supplier financing on these metrics. Try different inputs for the model and you will see by how much the metrics you use in equity analysis can be impacted by different scenarios.

Business transactions and exchange differences

The problem with calculating cash flow effects from changes in balance sheet items is that it only works in relatively simple situations. If trade payables and other working capital components change for reasons other than cash flow timing, such as changes due to business acquisitions, disposals, and exchange differences, the cash flow effect of changes in working capital is not equal to the balance sheet movement.

For example, if a business combination occurs during a year, and additional payables enter a supplier finance arrangement as a result, our adjustments would need to exclude that part of the change in payables due to the business combination. We have not reflected any of these complications in our illustrative model, but it is important that you to consider them in practice.

The proposed IASB disclosures do not specifically mention business combinations and exchange differences. However, there is a catch-all disclosure which says that additional information may be required for investors to “assess the effects of arrangements on the entity’s liabilities and cash flow” which should result in appropriate disclosures. Even better would be the presentation of a ‘roll-forward’ of the supplier finance liability which would clearly set out both the cash and non-cash changes in the period.4We note that the equivalent proposed US GAAP disclosures recently published by FASB include a requirement to provide a roll-forward. However, the FASB proposals fall short in other respects, in particular there is no requirement to disclose payment dates, which means that the adjustments we present in this article, and which we think are vital for investors, would not be possible.

Our view on the IASB proposals

We agree that improved disclosures about supplier finance arrangements are needed. While companies should already be clearly identifying how the liabilities are presented in financial statements and include them in liquidity and non-cash movements in financing disclosures, the re-emphasis of the importance of these for investors is welcome.

We also agree that it is necessary to provide investors with additional disclosures so that operating cash flow and leverage effects can be understood, and metrics can be adjusted where necessary. We urge companies to provide improved information immediately – there is no need to wait for changes to the standards to become effective.

As we have illustrated, the proposed disclosures enable these adjustments to be calculated. However, we have two reservations.

  • Payment dates: We think it would be more useful to express the payment terms as a weighted average rather than as a range. We see little use in having a range of dates and it is the weighted average that matters in terms of making cash flow and leverage adjustments.
  • Business combinations: We think that a roll-forward of the supplier finance liability should be disclosed so that investors can clearly identify the changes that should not be included in the cash flow adjustments.

Why does it have to be so complex for investors?

But our main criticism of the proposals is that they lead to unnecessarily complexity for investors. Even though the disclosures should enable investors to understand the effect of supplier finance arrangements on cash flow and leverage, and derive adjustments to obtain more relevant metrics, the calculations are by no means trivial. We think that disclosure of the adjustments themselves, together with pro-forma adjusted operating cash flow and borrowings, would be much more useful and no less informative.

You will find more detailed comments in our letter to the IASB shown below.

Insights for investors

  • Supplier finance arrangements can affect liquidity risk due to the concentration of the liability. Evaluate liquidity disclosures carefully, particularly where refinancing risk is potentially an issue.
  • Unless the arrangement is solely designed to provide finance to suppliers, reported cash flow and leverage metrics will be affected – how much depends on whether the liability is classified as trade (or other) payables or as borrowings.
  • If the liability is presented as trade payables, reclassify the financing component as debt and remove the change in this amount from operating cash flow.
  • If the liability is presented as borrowings, reduce operating cash flow by the non-cash increase in financing arising when payables are transferred into the arrangement. Also adjust operating cash flow for the change in the trade payables component of the liability.
  • New IASB proposed disclosures will help investors. There is no reason why companies cannot provide this information now.

The Footnotes Analyst response to the IASB


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