Tag: Financial Engineering

Reverse factoring, a form of financial engineering, is on the rise. This is a technique used by a number of companies to dress their financial results.

An AFR article “CIMIC’s UGL stretches out bill payments to 65 days” has been picked up and discussed by one my my favorite Finance Sites, Wolf Street “Hidden Debt Loophole” Becomes Popular with Australian Corporations.

Australian engineering group UGL, which is working on large infrastructure projects such as Brisbane’s Cross River Rail and Melbourne’s Metro Trains, recently sent a letter to suppliers and sub-contractors informing them that as of October 15, they will be paid 65 days after the end of the month in which their invoices are issued. The company’s policy had been, until then, to settle invoices within 30 days.

The letter also mentioned that if the suppliers want to get paid sooner than the new 65-day period, they can get their money from UGL’s new finance partner, Greensill Capital, one of the biggest players in the fast growing supply chain financing industry, in an arrangement known as “reverse factoring”. But it will cost them.

Reverse factoring is a controversial financing technique that played a major role in the collapse of UK construction giant Carillion, enabling it to conceal from investors, auditors and regulators the true magnitude of its debt until it was too late. Here’s how it works: a company hires a financial intermediary, such as a bank or a specialist firm such as Greensill, to pay a supplier promptly (e.g. 15 days after invoicing), in return for a discount on their invoices. The company repays the intermediary at a later date.

In its letter to suppliers UGL trumpeted that the payment changes would “benefit both our businesses,” though many suppliers struggled to see how. One subcontractor interviewed by The Australian Financial Review complained that the changes were “outrageous” and put small suppliers at a huge disadvantage since they did not have the power to challenge UGL. Some subcontractors contacted by AFR refused to be quoted out of fear of reprisal from UGL.

CIMIC is one of Australia’s largest construction and infrastructure groups. It is majority owned by the German company Hochtief, which in turn is majority owned by the Spanish consortium ACS. In August ACS, the world’s seventh largest construction company, admitted it is making “extensive use” of both conventional factoring and reverse factoring “across the group,” to “more efficiently manage cash flows and match revenues and costs over the course of the year.”

Conventional factoring is a perfectly legitimate, albeit expensive, way for cash-strapped companies to speed up their cash flow. It involves selling accounts receivable — the amounts a company has billed to its customers and expects to be paid in due time — at a discount to a third party, which then collects the money from the customers.

Reverse factoring, by contrast, is a much more pernicious yet increasingly prevalent form of supply chain financing that is being used by large companies to effectively transform their supply chain into a bank. Put simply, if suppliers want to get paid in a reasonable period of time, they must pay an intermediary for the privilege.

More importantly, in most countries there is no explicit accounting requirement to disclose reverse factoring transactions. The companies can effectively borrow the money from the third party lender — thus incurring a debt — without having to disclose it as debt, meaning it expand its borrowing while maintaining its leverage ratios. This process causes the debt to be understated.

Credit rating agency Fitch warned last year that reverse factoring effectively served as a “debt loophole” and that use of the instrument had ballooned, though no one knows by exactly how much since there is so little disclosure.

The use of an accounting loophole allowing companies to extend ‘payables days’ by the use of third-party supply chain financing without classifying this as debt may be on the rise, according to Fitch Ratings. We believe the magnitude of this unreported debt-like financing could be considerable in individual cases and may have negative credit implications.

Supply chain financing continues to be actively marketed by banks and other institutions in the burgeoning supply chain finance industry. A technique commonly referred to as reverse factoring was a key contributor to Carillion’s liquidation as it allowed the outsourcer to show an estimated GBP400 million to GBP500 million of debt to financial institutions as ‘other payables’ compared to reported net debt of GBP219 million.

The debt classified as ‘other payables’ was unnoticed by most market participants due to the near complete lack of disclosure about these practices and the effect on financial statements. Whether these programmes require disclosure under accounting standards depends greatly on their construction, which in practice allows many companies not to disclose them.

In the six months to June, CIMIC used reverse factoring and other supply chain financing techniques to increase its total days payable to 159 days from 135 days in the previous six months, according to New Zealand investment bank, Jarden. By the end of June, its total factoring level was almost $2 billion.

More and more Australian companies are following the same playbook. Rail group Pacific National told suppliers in May that it was using global financial group C2FO‘s services to facilitate what it calls “accelerated payment of approved supplier invoices.”

Telecoms giant Telstra has ramped up its exposure to “reverse factoring” more than 14-fold in the space of just one year, from $42 million to almost $600 million. This $551 million increase, which is also reportedly being provided at least in part by Greensill, represents a staggering 18% of Telstra’s 2019 free cashflow, according to a report by governance firm Ownership Matters. Yet the company’s credit is still rated A- by S&P Global, making it one of Australia’s highest rated industrial corporations.

A Telstra spokesman said the company strongly denies that its accounts “are not an accurate reflection of our business,” adding for good measure that “supply chain financing is a practice commonly used worldwide – it provides our suppliers the option of getting paid upfront while at the same time getting the benefit of Telstra’s strong credit rating.” Once again, it’s a win-win for both company and suppliers.

Yet in its last financial report, Telstra disclosed that it had extended payment terms to suppliers from 30 to 45 days to 30 to 90 days. This is part of “a persistent trend” that is hurting the cash flows of small and family businesses across Australia, revealed a review of payment terms released in March by the Australian small business and family enterprise ombudsman.

There is a persistent trend in Australia of payment times being extended beyond usual industry standards. Late payment, where businesses get paid beyond contract terms, adds to the cash flow problem faced by suppliers. It appears as though large Australian companies and multinationals apply these policies to improve their own working capital efficiencies at the expense of their suppliers. While the average days to get paid is declining, it is still above 30 days at an average of 36.74 days

This average obscures the imbalance between large and small business as large business are the worst for late payments and small business the fastest.

This imbalance intensifies cash flow pressure for small and family businesses. Scottish Pacific, a large independent finance provider, estimates the cost is $234.6 billion in lost revenue. That is, SMEs would have generated more revenue if cash flow was improved, as late payments accounted for a 43% downturn in cash flow.

Small and family businesses must find other ways to finance the short fall in their working capital. This places stress on smaller businesses with significant ramifications for solvency and mental health.

The outcome; small businesses cannot invest in growth and cannot increase employment.Since the Hayne Royal Commission, banks have tightened responsible lending standards across the board which has caused a ‘credit crunch’ for small businesses. They are finding it increasingly difficult to demonstrate ‘employee-like’ cash flow like a consumer. A high growth, entrepreneurial SME is highly unlikely to demonstrate cash flow in this way.

The increased bank focus on ‘employee-like’ cash flow means more needs to be done by large corporations paying their suppliers on time. Where large corporations delay payment to their small business suppliers beyond the contracted payment time, small business cash flow is unpredictable and presents significant difficulties in their ability to access and service finance.

Not only that, it’s also making it more likely that Australia will sooner or later have a Carillion of its own on its hands.