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1/ A topic that has chased me for several mth's now is reverse factoring. Clearly, the recent media hype around the magic triangle of Greensill, Softbank/ $SBG and CS / $CSGN helped, but lets not forget that this technique is with us for quite some time now.
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Prominent (ab-)users inc Abengoa, Carrilion & NMC Health. The market is huge. As @steveclapham and @MarcRuby note: "In FY15, McKinsey estimated the volume of financeable highly secure payables globally to be US$2trn. For intermeds they estimated that could be worth US$20bn."
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Whilst the technique can be very valid to optimize working capital, there are several material risks attached to it. In fact, not rarely is the technique used by Co's to dress-up, cover up and cook their books.
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What is reverse factoring? Lets keep it simple.
In reverse factoring the company uses a financing institution either for a) paying its suppliers earlier than the usual terms of payment would require...
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In reverse factoring the company uses a financing institution either for a) paying its suppliers earlier than the usual terms of payment would require...
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b) paying its suppliers in time, but with a payment duty of the company to the financing institution at a later point in time, or c) a combination of both.
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Of course the Co has to pay a price for such financing. They have to pay interests to the financing provider. Ie this is clearly a sort of financial debt: Making use of a fin institution to get a dedicated short-term interest-bearing loan on a more or less revolving basis.
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So far, so good. Where does the issue kick in then?
Neither IFRS nor US GAAP specifically addresses reverse fctring.
Ie Co's can exercise discretion in classification of factored payables, continuing to include balance within the op. balance sheet line of trade payables.
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Neither IFRS nor US GAAP specifically addresses reverse fctring.
Ie Co's can exercise discretion in classification of factored payables, continuing to include balance within the op. balance sheet line of trade payables.
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This has ultimate effect of (artificial) DPO extension. Worse, many Co's do not even disclose it, ie analysts not adjusting for it will underestimate debt & overestimate operating CF. Given the scale for some names, this can have materially adverse effects on valuations.
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Another big risk is that Co's become over-reliant on reverse-factoring CF benefits (stretched WC together with enhanced cash conversion and inflated op. cash flow metrics). Any curtailment of the structure could create an immediate cash call on WC...
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...that is, the Co has to repay its reverse-factored debt back to the bank and reset its normal credit terms to more traditional levels ex- reverse factoring.
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The latter risk is not immaterial. One of the basic issues to recognise with reverse factoring is the concentration of the funder's (eg bank) credit risk. The credit risk of the structure is concentrated on a single client, the original purchaser of the goods & the sponsor.
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A more traditional factoring structure (receivables factoring) benefits from relying on the credit quality of many customers. This portfolio effect delivers a degree of credit diversification that reverse factoring does not have.
Lets go through the adjustments one-by-one.
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Lets go through the adjustments one-by-one.
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One effect of reverse factoring is potentially understating debt, as factor payables are debt-like obligations but are often classified as trade payables.
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I suggest removing factor payables from the account payables line and adding it to debt, such that operational and financial decision making are separated. For some names that is rel easy, as they disclose the full information (eg $ZAL). The majority doesnt disclose though.
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In that case, one approach is to normalize DPO towards sector median level. I use a hypothetical Co to illustrate how I would approach the analysis of a reverse factoring structure, where there is a lack of disclosure.
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1. Crunch some no's to get a quick handle for reported DPO, op. CF and Net Debt trends as per table.
2. Compare DPO with peers or overall sector comps in order to assess whether there is a material delta. If so it might be reverse factoring.
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2. Compare DPO with peers or overall sector comps in order to assess whether there is a material delta. If so it might be reverse factoring.
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In our method, we assume that Co should have payment terms with suppliers that are similar to other companies in the sector, and excess payable days above the sector median are attributed to reverse factoring (an assumption).
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Therefore, we normalise Co's payable days to the sector median level, i.e. its payable days will be 43.2 instead of 85 in 2014 and 54.3 instead of 120 in 2019 if we remove factor payables from the payables line.
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From the normalised payable days, we can back out the trade payables adjusted for reverse factoring.
Again, the delta b/w reported and adjusted trade payables is assumed to be reverse factoring.
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Again, the delta b/w reported and adjusted trade payables is assumed to be reverse factoring.
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For 2014 in our example, it would look like this:
43.2 sector peer DPO/365 days *19,324 COGS as per table above = 2,287m adjusted trade payables
vs.
4,500 reported, ie 2,213 lower due to factor payables (assumption).
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43.2 sector peer DPO/365 days *19,324 COGS as per table above = 2,287m adjusted trade payables
vs.
4,500 reported, ie 2,213 lower due to factor payables (assumption).
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Once we have the absolute level of adj trade payables, we also can calc the change in adj. trade payables. As you are all aware the latter is a major component of net WC and op. CF.
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To clean up op. CF, we use reported op. CF of 2,000 - reported change of trade payables of 800 (as per table above) + adjusted change of trade payables of 357 (using same methodology as for FY14 above) = 1,557. The deltas in op. CF can be material, as per chart below.
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25/ The (net) debt adjustment is even more dramatic in many cases. We simply assume that the delta b/w reported and adjusted trade payables is reverse factoring, hence to be classified as debt.
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Therefore, we add the difference to Co's reported ND to calculate its adjusted ND. In 2014, Co's reported net debt was $5,000m (as per table above), therefore its adjusted net debt would be: 5,000 + (4,500 reported trade payables - 2,287 adjusted trade payables) = 7,213.
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I would like to re-emphasise that I am not saying all increase in DPO is due to reverse factoring. There are many other reasons that could lead to companies having higher payables days than the sector median, e.g. different product mix and hence different supply chains.
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However, we should consider the downside risks that reverse factoring might bring to the company, especially for those with lower credit ratings.
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