The recent high-profile collapse of Greensill Capital, a supply chain financier, has brought into the spotlight the use of invoice discounting (a type of factoring) and supply chain finance (a type of reverse factoring) as alternative finance options for companies.
Invoice discounting is a way of raising finance against a company’s book of receivables. Here, the financier’s customer (the client) is owed money by a third party (the trade debtor) on ordinary trade credit terms. For example, the client requires the trade debtor to settle an invoice within 30, 60 or 90 days. If the client wants access to working capital before the invoice is settled, the client sells the invoice to the financier immediately for a discount (being the margin). The financier (or the client on the financier’s behalf) later collects payment from the trade debtor in full on the terms of the invoice.
The financier in such arrangements takes credit risk on identifiable trade debtors as well as the client (the terms allow the financier recourse against the client should the debtor fail to deliver).
Reverse factoring (typically referred to as supply chain financing) is different. Here, the client owes money to a third party (the trade creditor) on ordinary trade credit terms. The client, the trade creditor and the financier agree that the financier will settle the invoice on behalf of the client at a discount (again being the margin), and the client later pays the full amount of the invoice to the financier. The trade creditor gets quicker settlement of the invoice, and the client can manage its cash flows.
Greensill’s use of “prospective reverse factoring” – lending against invoices which did not yet exist – was a strange iteration of supply chain financing whereby Greensill provided supply chain financing on the basis of invoices which did not yet exist, but which could hypothetically exist in the future.
The financier in a supply chain financing arrangement takes credit risk on the client only. This looks more like normal, unsecured working capital debt financing, rather than “true” factoring or invoice discounting.
Invoice discounting and supply chain finance arrangements are not presently treated as ordinary debt under accounting standards. Greensill’s practice has once again raised questions around whether supply chain finance is being used as a tool by companies to muddy balance sheets and disguise the true debt position of a company. Carillion’s insolvency in 2018 exposed this problem, and now potentially GFG Alliance (Greensill’s client) has once again brought it into the spotlight.
Notwithstanding the accounting treatment, the financing of receivables is and will remain an important mode of finance for business.
This is particularly true for scale up and growth stage companies who require fast access to working capital for sales and marketing expenditure. These SMEs have historically struggled to secure working capital facilities from mainstream financial institutions, so often turn to Fintechs who have filled this funding void. Fintechs in turn have adapted factoring facilities for the modern economy to serve this sector by:
- using API integrations with clients’ invoicing software and bank accounts, providing them with real time information and data monitoring
- directly plugging into payment processing so that revenue (especially recurring revenue) is captured by the financier with minimal administration or fraud risk on the part of the client
- developing sector specialisms to provide tailored solutions for their clients – e.g. digital advertising agencies.
Such facilities are often known as “revenue based finance” or “merchant cash advance”. As the ease of accessing these types of facilities increases in the digital age, its ability to be exploited for the wrong reasons increases as well. It is very likely however that regulators will now look at its accounting treatment, particularly the accounting treatment of reverse factoring, to prevent companies structuring otherwise vanilla debt facilities as off-balance sheet liabilities. Regardless, the financing of receivables remains a crucial form of financing for companies and is here to stay.
If you have any questions about these issues please get in touch with a member of the team or speak with your usual Fox Williams contact.