Robert Kugel's Analyst Perspectives

We added purchasing, sourcing and payments to our core Office of Finance focus areas this year to reflect new and important opportunities to use technology to gain effectiveness through greater efficiency. Technology continues to lubricate the wheels of commerce, aided by a financial services sector that is constantly innovating, responding to market-driven opportunities to reduce costs, increase demand or lower risk. Ventana Research asserts that, in many cases, technology makes new forms or techniques of finance possible, while in others it amplifies existing methods. Over the past decade, a relatively new twist on an old financing technique called reverse factoring has grown in popularity. Over the next five years, technology is likely to make this process of supply chain financing more efficient.

Reverse factoring is a buyer-initiated method of supply chain finance that optimizes working capital utilization by having a financial intermediary provide reliable or even early payment to suppliers while enabling buyers to defer their payment to that intermediary. Typically, the suppliers in this arrangement are small-to-midsize enterprises with higher borrowing costs and more limited access to credit. By ensuring prompt or early payment, buyers expect to gain favorable pricing or other considerations from suppliers, while suppliers benefit from accelerated cash flow. Reverse factoring is popular in instances where the buyer has a better credit rating than the seller because the financing cost of the working capital involved in these transactions is lower or because financing its working capital is unavailable to the seller. In recent years, reverse factoring has become increasingly popular because it can lower total costs along the value chain and reduce transaction frictions. This is part of a larger trend the streamline finance processes in commerce. Ventana Research asserts that through 2027, advances in payment technologies will drive down costs and frictions in transactions processes, enabling greater efficiency in supply chains.

Factoring is a centuries-old form of finance, where cash-strapped vendors sell (“factor” in the ancient parlance) their accounts receivable to an intermediary at some discount. The discount covers the cost of borrowing the money and the risk of non-payment. It's called reverse factoring because the transaction is initiated by the buyer to finance its account payables rather than the seller to finance its receivables. A buyer uses it to accelerate the payments to vendors using a third-party organization to serve as an intermediary. The process accelerates the cash flow of its suppliers, reducing the sellers’ working capital and related costs while enabling buyers to negotiate and receive early-payment discounts and other concessions or benefits from the seller. Reverse factoring also helps buyers with their working capital management. Rather than withholding payment or extending payment terms, which strains suppliers and increases selling costs, buyers use reverse factoring to ensure timely payment. Total financing costs can be lower with reverse factoring in cases where the buyer has greater creditworthiness or easier access to financing than its suppliers. Reverse factoring also can mitigate supply chain risks by improving the financial stability of smaller, less well-capitalized vendors. This is enlightened self-interest since a well-financed supplier base can protect the buyer from potential production delays, quality issues, or interruptions caused by supplier insolvency. Although it can be hard to quantify the exact benefit, avoiding payment delays also can lead to a better working relationship and more useful supply chain collaboration. For both buyer and seller, reverse factoring can increase efficiency in back-office transactions processing by simplifying the accounts payable process. Suppliers submit invoices to a financial institution for early payment, removing the need to wait for the buyer's approval or payment processing, and accelerating invoice processing, reducing the overall administrative burden on both sides.

Reverse factoring’s popularity was also driven by a desire by some companies to “flatter their financial statements” — that is, obscure or even misconstrue the fine details of their short-term debt and cash flows. In the UK, a serious abuse of how these transactions were treated, along with lax oversight, has been cited as a contributing factor in the collapse of Carillion Group in 2018. This has led to changes in how reverse factoring is treated by financial standards setters to more accurately reflect the substance of the transactions involved. The old saying, “if it looks like a duck…” now applies. However, eliminating the scope for accounting legerdemain does not eliminate the underlying economic benefits that remain.

Enterprise software systems have been evolving from a once monolithic structure to platforms that facilitate connections with other systems and data sources. A logical extension of this trend is the creation of vendor-supported, platform-based networks capable of direct connections between members of that network which can substantially reduce costs and frictions of everyday transactions. In the case of reverse factoring, technology has the potential to cut the time and hands-on effort necessary to connect a buyer, seller and financial institution to set up the transaction, monitor events, execute steps and perform the accounting. These sorts of improvements collectively will cut the cost of doing business and significantly improve the productivity of finance and accounting departments. I recommend that as organizations evaluate ERP and supply chain planning and execution software, they pay attention to these vendors’ technology roadmaps to ensure that they will be able to accrue the benefits of technology improvements as soon as possible.

Regards,

Robert Kugel