Mechanisms and financial reporting implications
In a traditional trading arrangement, a supplier finances its buyers by accepting payments of its invoices after a certain period (e.g. 30 days). If the supplier is in need of cash during the credit period, it can sell (with or without recourse) its accounts receivables to financial institutions at a discounted price (selling accounts receivable at a discounted price is known as factoring) and the discount rate depends, among other things, on the credit rating of the supplier. Many suppliers, particularly small and medium ones, do not have access to factoring facilities because of their poor credit ratings and thus find it difficult to keep funding their businesses. Since, buyers always want to delay the invoice payments to improve working capital conditions, both suppliers and buyers often find themselves negotiating hard on credit period, which sometimes leads to supply chain instability. Buyers with better credit ratings and market reputation can overcome such situation by supply chain financing (SCF), which is also known as reverse factoring. Here is how SCF normally works:
Three key features differentiate reverse factoring from other similar financing arrangements (e.g. factoring, accounts receivable assignment): reverse factoring is a buyer-led arrangement, without recourse and the fee/discount rate depends on the credit rating of the buyer not the suppliers. SCF therefore works when the buyer’s credit rating is superior to most of its suppliers’ credit ratings and the buyer has strong relationship with financial intermediaries. Factoring is supplier-led arrangement, can be with or without recourse and discount rate/fee depends on the credit rating of the supplier. Accounts receivable assignment is a loan against the security of accounts receivable and the interest rate depends on the creditworthiness of the suppliers/borrowers. Factoring, reverse factoring (supply chain financing) and accounts receivable assignment are different financing arrangements with different degrees of risks and rewards being assumed by different parties (suppliers, buyers and lenders). According to industry insiders, in Bangladesh, accounts receivable assignment is the most common source of financing for suppliers followed by factoring. Reverse factoring is not that common. It is important to note that, sometimes inaccurately, vendor financing or supply chain financing is used as a catch-all phrase for all types of trade financing and, hence, one needs to look at the features of the specific arrangement to understand the differences in risks and rewards associated with each arrangement.
All the parties (suppliers, buyers and financial institutions) can benefit from SCF. Suppliers can run their businesses with lower capital because they can sell approved invoices immediately and possibly at a lower cost. In return for giving suppliers access to easy and cheaper financing, buyers can negotiate for either better prices or extended credit terms and thus can improve the bottom line. SCF can also reduce personnel cost by reducing the efforts necessary for payment processing on the buyer’s side and for credit collection on the supplier’s side. For financial institutions or intermediaries (FIs), SCF offers an opportunity to add high quality assets (loans and advances backed by superior quality accounts receivable) in their balance sheet.
Implementing SCF, however, requires preparation on the part of the buyer. Controls and transaction processing activities related to procure-to-pay (P2P) business process have significant bearing on the success or failure of supply chain financing arrangement. Moreover, different financial institutions or reverse factoring platforms come with different strengths and weaknesses and, hence, selection of the financial institution or platform needs careful consideration.
Accounting treatment of accounts receivable in suppliers’ books and accounts payable in buyers’ books depends on the specific terms and conditions determining the sharing of risks and rewards among the parties. Since, SCF is a buyer-led arrangement, risks and rewards associated with the credit, normally, are transferred from the suppliers to the financial institutions when the suppliers sell the invoices. Hence, accounts receivable associated with sold invoices, normally, qualify for derecognition in suppliers’ books. Except for change in counterparty, nothing, normally, changes in relation to buyers’ obligation to pay when suppliers sell the invoices. However, because of change in counterparty (from suppliers to financial institution), classification of accounts payable in buyers’ books might change. If so, the buyers might not be able to get expected benefits in working capital. Both suppliers and buyers should consult an expert to determine the expected financial benefits and to understand financial reporting implications of SCF.
Reverse factoring can create substantial benefits across the supply chain and can be a better alternative to other working capital management schemes. Suppliers and buyers should make sure, before being engaged in this, that this is consistent with their long-term financial strategies and their back-office functions are efficient enough to get the maximum benefits out of this.
About the author
Syed Md Enamul Kabir, Managing Partner, ESS & Partners
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