The hard facts about Reverse Factoring –  Part 3

The hard facts about Reverse Factoring – Part 3

As we pointed out in our last two blogs here and here, Carillion was less than transparent in its 2016 financial statements about its reverse factoring arrangements. 

For a much better explanation of supply chain financing (an alternative name for reverse factoring), see Note 19 ‘Trade and Other Payables’ on page 177 of the 2018 financial statements of AstraZeneca Plc.

Since Carillion commenced the arrangement in 2012 , Carillion’s customers were taking longer and longer to pay – by 2016, receivables were 38% of sales. Carillion was taking even longer to pay its suppliers. By 2016, if you include the reverse factoring, payables were around 50% of sales, or six months. 

As Carillion was a very low-margin business, its operating margin (operating profit/sales) over the 10 years from 2006 was highly variable, but was in the range of 1% to 4% according to the LBS article. Its earnings margin (earnings/sales) was between 2% and 3%. 

But what did these numbers actually mean? Long-term contracting always rings alarm bells because it offers companies discretion over when to report the income from a contract, with the risk that they will be tempted to report revenues earlier and costs later. Carillion’s financial statements offered no clue as to how it was accounting for long-term contracts.

IFRS 15 on Revenue Recognition would have forced the company to write down retained earnings by well over £100 million, according to a 2017 disclosure note. Apparently, Carillion included the change in the reverse factoring creditor – essentially a financing cash flow – as an operating flow in the calculation of operating cash flow and thus in the calculation of cash conversion. 

In the 2016 financial statements, Carillion reported operating profit of £145 million and an operating cash flow of £115 million, which is a decent cash conversion ratio. But that operating cash flow was increased by the approx. £200 million increase in ‘other creditors’ during the year. Without that, operating cash flow would have been £-85 million. 

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Reverse Factoring – Part 2: Watch the disclosures

Factoring in Ireland and the UK worth more than €400 billion.

Last week we discussed how reverse factoring works. Now we look at how it works in a little more detail.

Broadly there are two different objectives from the originator for such schemes: 

1) Supplier focused – to support smaller suppliers 

2) Company focused – to support the originator’s working capital management and financing. 

Whilst these two objectives are quite different, it is often difficult to assess from the available disclosure what the company’s objective is.

Normal payment terms might see a purchaser pay a supplier within thirty days. The switch to a reverse factoring facility might also see the payment terms increase, to as much as 120 days, as the facility provider will agree terms with the originator. Any increase in payment period will have the effect of improving the originator’s working capital cycle.

How prevalent is reverse factoring? 

It is difficult to get accurate and up-to-date data but the European Factoring Association estimates that the total of factoring and reverse factoring for the UK & Ireland combined was £350bn (or over €400bn) in 2017.

Collapse of Carillion

According to a January 2018 analysis by the London Business School (LBS), Carillion used reverse factoring to its detriment. 

Carillion was less than transparent about this arrangement in its 2016 financial statements. The facility was recorded in Carillion’s balance sheet within ‘other creditors’ of £760.5 million, on page 118 of the 2016 financial statements – without any explicit note.

More to follow next week in our last blog on reverse factoring.

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Do your clients use Reverse Factoring?

Some lessons for us all from the Carillion collapse.

A very useful publication was issued recently by the little known Financial Reporting Council Lab called ‘Disclosures on the Sources and Uses of Cash’.

Tucked away in the appendix of the publication is a very interesting explanation of reverse factoring. This financing method had a role to play in the downfall of Carillion as reported by the Financial Times in January 2018. 

Reverse factoring is a type of finance transaction akin to factoring. In a traditional factoring arrangement a business will sell its accounts receivables (i.e. invoices it has raised with buyers) to a third party (usually a bank) in exchange for a significant proportion of the cash value of the invoices. 

Factoring provides earlier access to cash from sales than would otherwise follow the traditional credit terms.

Reverse factoring is similar to factoring, but it is the purchaser rather than the seller who is the originator of the facility

In reverse factoring the purchaser of goods organises a facility with their bank or other finance provider. This facility allows suppliers to get their invoices factored, and receive cash at a point before the purchaser intended to pay. This type of scheme is particularly beneficial to smaller suppliers who may not have sufficient financial strength to obtain competitive factoring terms themselves. Sometimes reverse factoring is called by a different name like ‘supplier chain finance’.

Whilst normal payment terms might see a purchaser pay a supplier within 30 days, the switch to a reverse factoring facility might also see the payment terms increase up to 120 days, as the facility provider will agree terms with the originator. Any increase in payment period will have the effect of improving the originator’s working capital cycle. 

Unfortunately, in Carrillion’s Annual Report for 2016 the existence of reverse factoring arrangements was not fully disclosed. It can only be presumed to be included on page 116 of the 2016 Annual Report within Note 20 Other Creditors of £760.5m (2015 £561.7m). In 2012 Carillion had announced a switch from paying its suppliers on normal credit terms to paying them, after 120 days. If supplier needed payment earlier, Carillion had arranged a bank to pay them sooner.

The message for readers is: do your clients have financing arrangements like reverse factoring? If so, you need to ensure this is properly disclosed.

A good example of supply chain financing disclosure is in Note 19 Trade and Other Payables on page 177 of the 2018 financial statements of AstraZeneca Plc where it states ‘Trade payables includes $166m (2017: $64m; 2016: $nil) due to suppliers that have signed up to a supply chain financing programme, under which the suppliers can elect on an invoice by invoice basis to receive a discounted early payment from the partner bank rather than being paid in line with the agreed payment terms.’  

More on this in our next blog.

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Also see our newest engagement letter publications for Partnership Compilation including Tax Engagement Letter under FRS 102 and FRS 105 for €50 each.