Reverse factoring is an increasingly popular way for corporate treasurers to manage their cash by stretching payments to suppliers, but it can exacerbate problems if companies run into financial problems, Moody's said in a research brief released last week.

Almost half of companies on the payment side of supply chain financing transactions use some form of reverse factoring, and another 37% say they are looking into it, Moody's said, drawing on findings from a survey by the Supply Chain Financing Community and PricewaterhouseCoopers.

The trend raises concerns because risks of reverse factoring are not widely understood, the credit rating agency said. "These arrangements can carry more risks than the participants or their investors might expect," it said in its Sept. 19 brief.

Among other things, the financing tool creates a debt obligation that doesn't have to be disclosed on company balance sheets and rarely is, so investors typically are unaware of it even though it can have a material impact on liquidity if the company runs into financial trouble or if the arrangement is curtailed.

"There is a strong case for disclosing curtailment of reverse factoring availability as a liquidity risk which could lead to an immediate and material working capital outflow," Moody's said.

Like conventional factoring, but in reverse

Reverse factoring is a way to speed payment to suppliers, typically at a discounted rate, by entering into an arrangement with a bank to pay the supplier on your behalf as soon as you verify receipt of the goods.

Its main difference with conventional factoring is the origin of the transaction. The company buying the goods initiates the transaction with the bank. The supplier doesn't even need to know about it. In conventional factoring, it's the supplier who works with the bank to exchange an early payment for a discounted rate and have the bank collect the full payment from the customer.

The main benefit of the reverse form of factoring is the ability of the company to stretch its payments out considerably. Moody's uses 120 days as an example, twice the length of the typical payment period.

Stretching out payments enables companies to maximize their cash position, especially if their credit rating is higher than the bank that's making their payments for them, because they can lend out their excess cash to bring in interest income.

"Reverse factoring provides an opportunity for them to leverage their own strong credit quality to capture margin that would otherwise flow to suppliers' banks, while at the same time enabling prompt payment to suppliers and also exerting more control over their supply chain," Moody's said.

For companies using the tool, risk arises when they face a liquidity crunch and have trouble making payments in the agreed time frame and the bank curtails the arrangement and demands payment.

In this situation, the company faces payment obligation not only to the bank but to the supplier, which can demand immediate payment if it believes the company is at financial risk. "The deeper the credit stress, the more likely suppliers are to demand earlier payment," Moody's says.

The brief points to the September 2017 bankruptcy of Toys R Us. Media coverage of the company's financial troubles led to suppliers threatening to withhold products absent immediate cash payment. This accelerated the company's woes as it tried to stock up on inventory for the holiday shopping season.

"The media report acted as a conduit for immediate and concerted action by suppliers," Moody's said.

Other companies whose financial troubles were accelerated by the curtailment of their reverse factoring arrangements include the Spanish multinational Abengoa and the British multinational Carillion, which went bankrupt last year.

These companies, Moody's said, "have contributed to reverse factoring's growing reputation as a risky financing tool which can make bad situations worse and has the potential to push a customer company to the brink of default."

Disclosure helps

About 5% of reverse factoring arrangements are disclosed in company reports, Moody's said.

Increased disclosure won't mitigate the risk, but it will enable investors to determine if they're comfortable with the debt obligation that would otherwise be hidden from view, Moody's said. "Improved disclosure around reverse factoring would allow users of accounts to better understand the company and its operating and financing arrangements," it said.

To curtail the risk, the arrangement is best left to financially sound companies with strong credit quality. These companies have available cash to manage their accelerated payment obligations should the bank curtails the arrangement.