Reverse factoring is transforming the way in which companies fund their working capital. Often used as a catchall term for trade or supply chain financing, reverse factoring conventionally involves a third-party financial intermediary providing external funding to accelerate the settlement of a supplier's invoice (trade receivables). The offer of funding often coincides with a lengthening of payment terms (trade payables). Early payment is usually offered at a discount.

There is nothing inherently wrong with reverse factoring. While a relatively new addition to a treasurer's toolkit, reverse factoring has the potential to diversify a company's funding sources and improve its balance sheet efficiency. Customers benefit via extended payment terms while suppliers access early payment of their invoices, albeit at a modest discount. Everyone wins. Or do they?

S&P Global Ratings may treat drawings under a reverse factoring facility as a debt-like obligation in cases where the customer or supplier generates a material working capital benefit. Reverse factoring poses certain risks--for customers, it is the extension of payment terms beyond what is customarily acceptable; and for suppliers, it is the accelerated monetization of assets in lieu of borrowing. In both cases, the initial working capital benefit is likely to be unwound if the reverse factoring facility becomes unavailable.

Poor accounting disclosures help keep reverse factoring arrangements hidden. This can obscure a company's underlying health and frustrate like-for-like comparisons. The consequences can be significant if it results in mispricing of risk or misallocation of capital. Further, reverse factoring is subject to refinancing and liquidity risks.

How Does Reverse Factoring Work?

Reverse factoring is simply an alternative method to fund a company's working capital. Third-party financial intermediaries provide supply chain financing with reference to the customer's creditworthiness. Indeed, it is the customer's obligation (trade payable) that needs to be settled.

Trade receivables can be some of a supplier's better quality assets: the term risk is low (commonly 90 days or less, but can be longer) and the customer offering early settlement (via a financial intermediary) tends to be larger and more creditworthy than their supplier (but not always).

Key to understanding the economics of reverse factoring is the discount tied to early payment. A financial intermediary settles the supplier's invoice on behalf of the customer. Financiers are effectively lending against a receivables asset with the payment discount acting as a proxy for the interest expense. Viewed through this prism, reverse factoring allows a supplier to access its customer's lower cost of funds.

Chart 1

The offer of reverse factoring facilities may coincide with the customer's extension of payment terms to its suppliers. The customer generates a working capital benefit by paying a financial intermediary later than they would have paid the supplier under the original supply arrangements. The financier often passes on the payment discount to the customer in exchange for a fee (effectively a proxy for the interest expense). The financial intermediary may then package the invoices into short-term bonds and sells them to outside investors, keeping a margin for itself.

On some occasions, large corporates use their market power to encourage participation or impose terms on suppliers who are economically reliant on providing them with goods and services. On other occasions, reverse factoring is initiated by customers who are motivated by a genuine desire to help their supply chain access working capital funding more easily and on better terms.

The extension of payment terms can force suppliers to accept reverse factoring arrangements in order to avoid an additional impost on working capital funding. Customers pushing reverse factoring facilities may also receive rebates, fees, or other benefits from the supply chain finance program.

How S&P Global Ratings Treats Reverse Factoring Facilities

We generally view financing arrangements that accelerate the monetization of assets in lieu of borrowing (such as traditional factoring) as debt. This is because the cash flow benefit arising from these arrangements will generally need to be refunded if the financing arrangement becomes unavailable.

We may also consider a material working capital benefit arising from an extension of payment terms beyond those customary for a customer's supply chain as akin to debt. Similar to the above, the credit risk arises not from the initial extension of payment terms, but from the potential call on a company's liquidity if the financing arrangement ceases and the customer is forced to revert to standard creditor payment terms.

Our adjustment approach is best illustrated by way of example. Consider a customer that has historically paid its creditors on terms of 60 days, in line with standard industry practice.

Chart 2

If the customer is able to extend its payment terms beyond 60 days (resulting in higher accounts payable and lower reported debt), we may add the working capital benefit to the customer's adjusted debt if the benefit is material.

Similarly, if the supplier uses reverse factoring arrangements to receive payment prior to 60 days (resulting in lower trade receivables and lower reported debt), we may add the working capital benefit to the supplier's debt if the benefit is material.

Implicit in the above scenarios is our ability to identify standard industry payment terms (60 days in the above example), and then apportion the benefit of the reverse factoring arrangements (and any associated debt adjustments) to the customer and the supplier.

We acknowledge that the counterfactual is hard to determine: That is, what standard industry payment terms would exist in lieu of reverse factoring arrangements? These amounts are not standardized or static, so company-specific considerations will apply in each case. Where appropriate, we may seek additional information from our rated issuers to help us better understand the potential risks.

We will also consider the potential liquidity risks associated with the expiry of these financing arrangements. For suppliers in particular, there is significant uncertainty regarding the ongoing availability of these facilities. Indeed, access to reverse factoring facilities is often determined by factors outside the supplier's control.

Reverse Factoring Vs. Traditional Factoring Facilities

Factoring in its traditional sense is a much simpler form of supply chain financing. It typically involves a supplier selling the invoices of certain approved customers to a financial institution, usually a bank. The financier purchases these invoices at a discount that references the credit quality of the customer. The supplier is appointed as the financier's collection agent and is required to transfer payment when it is collected. Facility sizes are generally capped.

For a supplier, reverse factoring operates in a similar manner. In both cases, the monetization of a trade receivable (invoice) is accelerated via its sale to a third party and the implied funding cost is determined with reference to the customer's credit quality. Both forms of factoring, therefore, can theoretically offer a cheaper funding alternative for suppliers with weaker credit profiles than their customers.

A key difference is that traditional factoring facilities are typically initiated by the supplier, whereas reverse factoring facilities are typically initiated by the customer. Factoring facilities are a bilateral agreement between the supplier and financier, typically part of a wider suite of transactional and ancillary products offered by banks. Moreover, it is not uncommon for customers to be unaware that their invoices have been sold.

By contrast, reverse factoring tends to be established by the customer and may be accompanied by a lengthening of payment terms. The customer may effectively act as an agent for the financial intermediary. Traditional factoring facilities are not usually accompanied by a change of payment terms.

Whereas factoring generally requires the invoices sold to be of sufficient value to justify the transaction costs, reverse factoring is intended for a wider pool of suppliers given the customer's incentive to lengthen payment terms across the greatest possible volume of invoices. Future potential innovations, such as factoring of employee wages, may also add to potential risks.

Table 1

Existing Disclosure Standards Are Inadequate

Reverse factoring analysis suffers from a general lack of disclosure. Neither international accounting standards nor U.S. generally accepted accounting principles (GAAP) provide specific guidance on reverse factoring; in particular, how associated accounts receivables or accounts payables should be recognized and de-recognized, or how transactions are recorded in the cash flow statement. Some companies make voluntary disclosures (of varying effectiveness) to supplement mandatory disclosures (with or without quantifying its impact). Others remain silent (see Appendix A).

S&P Global Ratings routinely adjusts statutory accounts for a range of financing arrangements, which may include reverse factoring, for global consistency and to better understand a company's underlying financial health. In order to form an independent opinion on the substance of reverse factoring arrangements, investors require disclosure of key accounting policies and judgements, as well as a details on how these arrangements function.

Indeed, we view proper disclosure as fundamentally more important than the enforcement of highly prescriptive standards that may not provide a reasonable basis for professional judgement, nor keep pace with the evolving nature and complexity of supply chain financing.

In lieu of such disclosures, supply chain financing remains difficult to detect, measure, or analyze. Its presence may only be identifiable via extended trade payable days or lower trade receivables days, or perhaps by deposits set aside for the facility's repayment.

A "Sleeping" Risk

Poor disclosures can obscure a company's underlying health and frustrate like-for-like comparisons. The consequences can be significant if it results in mispricing of risk or misallocation of capital. Further, reverse factoring is subject to refinancing and liquidity risks.

Reverse factoring arrangements are designed to create an upfront benefit to a company's working capital and cash flows. This does not necessarily pose a risk in and of itself. However, without proper disclosure, investors may form an incomplete or inaccurate picture of a company's underlying cash flows and financial position.

A company's cash conversion cycle might appear to be healthier than it actually is. Cash inflows from reverse factoring facilities may give a misleading impression of a company's operational efficiency or hide underlying financial problems. This can also put undue pressure on other companies who do not employ such tactics, because their cash flow conversion may appear to lag their competitors.

In more malign circumstances, reverse factoring can be deployed to mask a more fundamental deterioration in a company's financial health. It may also enable a company experiencing financial stress to artificially comply with its financial covenants when it otherwise would not. Further, reverse factoring can accelerate cash flows in a stress situation. Indeed, this was the case with Carillion PLC (see "Carillion's Demise: What's At Stake?", published March 24, 2018).

Taken to its logical conclusion, reverse factoring allows customers to treat their supply chain as akin to a bank without any recognition of borrowings. There are instances where companies have extended payment terms up to 364 days, creating a working capital benefit equivalent to almost a year's payables. This has significant ramifications that may initially go unnoticed.

Like other forms of short-term funding, reverse factoring is subject to refinancing and liquidity risks. If facilities are not rolled over or withdrawn, the supplier would be left with a working capital shortfall and would subsequently seek to reinstate shorter payment terms that existed before the reverse factoring facility was established. By doing so, the supplier would effectively transfer part of the working capital shortfall to its customer. The original benefit to customer and supplier would, therefore, unwind.

The risk of withdrawal of a reverse factoring facility is lower for more creditworthy customers and their suppliers. Although reverse factoring facilities are often evergreen with no maturity date, financial intermediaries are generally under no obligation to provide ongoing supply chain financing. Facilities are most likely to be withdrawn in response to a deterioration in the customer's credit quality. Moreover, we have already witnessed a drift down the credit spectrum for these facilities to speculative-grade customers, where the risk of sudden withdrawal is more likely.

Funding can also become unavailable for a variety of other reasons, such as loss of market confidence or broader credit market disruption. Reverse factoring facilities are particularly sensitive to changes in disclosure standards prompted by standards bodies or market forces. Demand for these specialist facilities could quickly fade if prevailing accounting disclosures improve and highlight the financial exposures created by these arrangements.

Appendix A: Reverse Factoring Disclosure Standards

There is no specific accounting standard for reverse factoring. However, the following international standards provide some guidance: International Accounting Standard (IAS) 1 "Presentation of Financial Statements"; IAS 7 "Statement of Cash Flows"; and International Financial Reporting Standard (IFRS) 9 "Financial Instruments". U.S. GAAP also lacks specific guidance, although SEC staff papers have discussed the issue. Sometimes reverse factoring arrangements are only revealed in the management discussion and analysis section of the audited accounts.

For suppliers, it may be possible to keep factoring arrangements (both traditional and reverse) off-balance sheets if an auditor accepts the "true sale" nature of the transaction. The financier generally has no recourse to the supplier against a customer's nonpayment or payment shortfall as the result of insolvency. The associated cash inflow can therefore be presented as either operating cash flow received from the customer (early realization of a trade receivable) or financing cash flow received from a financial intermediary.

The accounting standards governing customer disclosures are open to even wider interpretation. The liability can appear on a company's balance sheet as either a trade payable owed to a supplier, other payables, or a financial obligation owed to creditors. There is no specific requirement to disaggregate reverse factoring amounts recognized in trade payables. Similarly, the associated cash outflow can appear either as an operating cash flow for the payment of goods or services or financing cash flow for the settlement of debt.

For instances where trade payables are derecognized and debt recognized, the cash flow statement could present the transaction as either: (1) an operating outflow and financing inflow; (2) a noncash financing transaction; or, (3) not recognize or disclose the transaction. Consequently, the corresponding debt repayment could be recognized as either a financing or operating outflow.

For the statement of profit and loss, discounts are often taken to sales but rarely itemized. In these instances, the payment discount is reflected via the gross margin rather than as a financing expense. There is typically a corresponding boost to the customer's gross margin.

Related Research

• Reward With Risk: U.S. Consumer Goods Companies Use "Reverse Factoring" To Free Up Funds, Oct. 23, 2019
• Criteria | Corporates | General: Corporate Methodology: Ratios And Adjustments, April 2, 2019
• Carillion's Demise: What's At Stake?, March 24, 2018