Improving Working Capital Through Reverse Factoring Programs
In today’s business climate, organizations in every sector are under pressure to improve efficiency and working capital across all departments. It means corporates cannot afford to waste opportunities to free up their working capital even though the current interest environment provides the opportunity to acquire loan capital at historically attractive rates. While there are numerous ways to free up working capital, one proven successful way is to implement a Reverse Factoring program, also known as Supply Chain Finance. Next to improving working capital performance indicators (KPIs), Reverse Factoring also has an impact on other related KPIs, such as a decrease in gearing or improvement of the Return on Capital Employed (ROCE). Furthermore, the delivery and social performance of single suppliers and the entire supply chain can be enhanced.
Payment Term Extension as a Core Strategy Can Cause Challenges
One key strategy to improve working capital KPIs should always be to extend payment terms against suppliers. Almost all businesses implement this strategy by extending payables as long as possible to maximize free cash flow. Unfortunately, while this approach can deliver exceptional results, there can also be downside effects. Quite frequently, delaying payment can reduce the supplier’s responsiveness and trust, resulting in slower delivery times or less willingness to work on strategic projects together with the buyer. Other negative impacts can be the reduction of supplier investments into research and innovation to develop new tools or find solutions for defects. On the other hand, paying the suppliers early can stabilise the entire supply chain. Suppliers can use the early payments to reduce debt or invest in growth. Furthermore, they can make use of additional discounts in situations where their suppliers offer rebates for early payment.
Implementation of a Reverse Factoring Program as a Solution
Implementing a Reverse Factoring program can support to resolve the conflict between long payment terms for the buying company and receiving cash early for suppliers. In a traditional Reverse Factoring program, it can be achieved through the buyer extending payment terms against its suppliers while simultaneously offering suppliers the opportunity to request early payment of their invoices via a third-party funder. At maturity of the invoice the buyer then pays the full nominal invoice amount to the funder.
A well-structured Reverse Factoring program should result in a “win-win” situation for all parties involved. Suppliers on the one hand can access refinancing rates that are usually below the suppliers’ alternative funding opportunities, due to the comparably better credit rating of the buyer. For funders, a clean structure of the program documentation ensures that they only bear the credit default risk of the buyer (group) and not any supplier related risks, while the buyer can use such programs to stabilize his supplier group while simultaneously improving his company KPIs.
This being said, the offering of attractive pricing to suppliers in isolation will not result in a successful Reverse Factoring program. In addition, it is important that all relevant departments, starting from Finance or Accounts Payable alongside Procurement, IT and Legal, within a company are fully aligned and collaborate closely to inject a working capital culture throughout the business. Furthermore, support from senior management and a clear company-wide working capital strategy is required to avoid conflicting priorities within the different departments.
Creating a Successful Program to Deliver Working Capital Improvement
For a very successful working capital program, it is essential to design clean concepts and principles. So, it should be clear to the suppliers, that the program has attractive financing conditions, e.g. due to competition among funders. Supplier price increases due to the longer payment terms should not be accepted and addressed from the start of negotiation about the new payment terms. This must be monitored closely and largely depends on the bargaining power of each party. Furthermore, the trade payables themselves should not be re-classified and must remain as trade payables, which can be achieved by clean and well-structured documentation. Otherwise, working capital KPIs will not be improved and even worse, many other important KPIs like gearing would deteriorate.
By implementing a successful Reverse Factoring program, it can deliver the added liquidity to fund growth, streamline processes as well as reduce costs. Furthermore, other related KPIs like ROCE or the Operating Cash Flow (OCF) will be continuously improved in a sustainable manner.
Find out how the OCF and ROCE can be impacted by a Supply Chain Finance or Receivables Finance program in our article “Financial Measures in Supply Chain Finance – The Example of Operating Cash Flow and Return on Capital Employed“.