Supplier finance, also known as supply chain finance or reverse factoring, can be a useful tool for suppliers and customers to improve their working capital management. At its heart, it's simple--the customer arranges for the supplier to be paid by a bank or another intermediary, typically at an earlier date than originally agreed. The customer often pays the intermediary after the original payment date it agreed with the supplier, with the intermediary taking a margin for its efforts. In theory, everyone benefits from the transaction. Or do they?

We have long been concerned about one particular feature of supplier finance arrangements that may have contributed to their spectacular growth: insufficient transparency. For many years, this enabled companies to extend payment terms to suppliers and thus flatter their net debt and operating cash flow figures without clear disclosure.

Chart 1

How We Consider Supplier Finance In Our Rating Analysis

For several years, we have highlighted the risks related to the ability of supplier finance to flatter net debt, operating cash flows, and associated debt payback ratios of companies that we examine as part of our corporate credit analysis. Accordingly, we sought to make adjustments to treat amounts owed to financial intermediaries as debt where the company defers payment beyond the term that is customary for its supply chain.

The challenge we identified with this historic case-by-case approach consisted of identifying the "customary" terms for a supply chain. Indeed, we believe that "customary" terms rose over the past few years, precisely because of the increased use of supplier finance. This is because some companies renegotiated contracts with suppliers to deliberately arbitrage accounting rules, notably paragraph 70 of International Accounting Standard (IAS) 1 Presentation of Financial Statements, which explains that "some current liabilities, such as trade payables… are part of the working capital used in the entity's normal operating cycle." Companies could exploit accounting rules by extending payment terms with suppliers, at the same time as encouraging them to enter into supplier finance agreements.

For example, a customer might have persuaded a supplier to change the contractual payment terms from 90 to 180 days. From the supplier's perspective, they could be paid on day one by the intermediary because of the supplier finance. However, the change in contractual terms allowed the customer to claim that they were still settling their invoices--now paid to the intermediary--within a "normal operating cycle," albeit a new normal that they created on the back of supplier finance. The liabilities therefore remained trade payables, even though the customer could now settle invoices with a significant delay, compared with prior practice.

To break the deadlock of never-ending debates about what constitutes customary terms, since 2021 we have considered 90 days as a reasonable cut-off point. We usually view payments that are settled beyond that timeframe as a form of financing. Using a simplified example for illustration, if a company owed £500 million in liabilities to a financial intermediary at year-end 2023 and paid the liabilities after 180 days, then we would typically view £250 million as a normal trade payable and the other £250 million as a debt-like liability that we include in our adjusted debt figure. On the cash flow side, if that debt-like liability increased to £250 million at year-end 2023, from £200 million at year-end 2022, we would view the additional £50 million drawdown of debt as a financing cash flow and make an adjustment to reduce operating cash flow accordingly.

Better Disclosures, But Still Room To Improve

In response to concerns raised by investors and other stakeholders, including S&P Global Ratings, the FASB and IASB both embarked on projects to improve financial statement disclosures for supplier finance.

Generally accepted accounting principles (GAAP) in the U.S.

The FASB released "Accounting Standards Update (ASU) 2022-04, Liabilities--Supplier Finance Programs, Disclosure of Supplier Finance Program Obligations" in September 2022 to enhance the transparency of supplier finance arrangements. It became effective for fiscal years beginning after Dec. 15, 2022. The new accounting standard requires the customer to provide the following disclosures in each annual reporting period:

• The key terms of the program, including a description of the payment terms, such as payment timing and the basis for its determination; and
• Assets pledged as security or other forms of guarantees provided for the committed payment to the finance provider.

For the obligations that the customer has confirmed as valid to the finance provider, the customer must provide:

• The amount outstanding that remains unpaid by the customer, such as the outstanding confirmed amount, as of the end of the annual period;
• A description of where those obligations are presented in the balance sheet; and
• A roll-forward of those obligations during the annual period, including the amount of obligations confirmed and the amount of obligations subsequently paid.

When analyzing U.S. GAAP disclosures produced so far, we noticed that the disclosures on payment terms--meaning the time taken to pay invoices--are often not adequate or consistent. Companies have flexibility in how they determine and disclose payment terms, which has led to insufficient disclosures in some cases.

In 2023, we analyzed 134 companies that disclosed an outstanding amount. 59 of them did not provide any details on the timing of the payment, 26 companies disclosed days taken to repay as an upper ceiling (that is, the maximum amount of days it had taken them to repay the liabilities), and 33 companies reported a range. We observed some companies reported wide ranges, which are not particularly helpful for analysis.

Table 1

Only 15 companies provided a specific number of accounts payable days, such as 120 or 90 days, which are more helpful disclosures for our analysis.

Table 2

IFRS

In May 2023, the IASB issued disclosure requirements for supplier finance arrangements that became effective for annual reporting periods beginning on or after Jan. 1, 2024. The disclosure requirements mandate:

• The key terms and conditions of the supplier finance arrangements;
• The amount of liabilities that are part of the arrangements, including a further breakdown of the amounts already received by the suppliers from the financial intermediaries and the position of the liabilities on the balance sheet;
• Payment due date ranges; and
• Information on liquidity risk.

Several IFRS-reporting companies are currently publishing their 2024 annual reports, which are the first examples of financial statements following the new IFRS disclosure requirements. As with the US GAAP reporting, we already see significant variability in the usefulness of the supplier finance disclosures, ranging from excellent to poor. We intend to publish more detailed findings on this in due course, but we would encourage IFRS reporters to ensure that disclosures meet the following best practice recommendations:

• If payment terms for existing liabilities on the balance sheet vary widely--for example from 30 to 365 days, as we have seen in the case of some U.S. GAAP reports--the company should disclose a weighted average payment term.
• A granular breakdown of the liability, disaggregated by payment terms, would be extremely useful. In example 1, all supplier finance invoices are settled after exactly 30, 120, 180, or 365 days.

Table 3

In this example, we would calculate our adjustment to debt as (30/120 x £266 million) + (90/180 x £428 million) + (275/365 x £121 million) = £372 million.

If the weighted average payment terms of 141 days were disclosed instead, without any details available, we would calculate our debt adjustment as 51/141 x £1,159 = £419 million.

We recognize that, in certain instances, companies may decide that the most effective way to provide information on payment terms is to give ranges of payment dates for different portions of the supplier finance liability. For investors and analysts, it will be critical that such information is sufficiently granular, with ranges narrow enough to facilitate an analysis. Example 2 illustrates how we estimate the adjustment to debt when the supplier finance information is provided with the liability disaggregated into categories of payment term ranges.

Table 4

If companies provided considerably wider ranges than above and if the estimated adjustment was very significant, compared with adjusted debt, we might have to ask company management for furthers detail to accurately estimate the required debt adjustment. If further information is not provided, we might have to make more conservative assumptions, such as assuming average payment terms are at the upper end of the provided ranges.

As users of financial information, we believe the overall standard of disclosures would be enhanced significantly if the IASB and the FASB required some form of standardized information on the payment terms of supplier finance arrangements, such as requiring weighted average payment terms or disaggregation of the liability into narrow payment term ranges.

Adjustments For Suppliers

As explained in the adjusted debt principle set out in our "Ratios And Adjustments" criteria, published on April 1, 2019, we make a debt adjustment in certain instances when a company accelerates the monetization of assets in lieu of borrowing, such as through securitization, sale, or factoring of accounts receivable. Without such an adjustment, a company that accelerates the monetization of its assets as outlined above would gain an artificial advantage over peers. This is because debt payback ratios, such as debt to EBITDA, would improve, purely because of the accelerated monetization, which reduces net debt.

Where the monetization of assets is accelerated in this way, we cannot presume that the company will have permanent access to the securitization or factoring market. Instead, the company may need to incur conventional debt to replace this source of financing, very possibly at a time of credit stress when the securitization or factoring market is no longer available.

Accordingly, when rated suppliers enter into supplier finance arrangements and accelerate the monetization of their trade receivables by receiving cash from the financial intermediary more quickly, we make a debt adjustment in our calculation of adjusted debt for the supplier, just as we would for the normal factoring of trade receivables. We can find the information we need to make this adjustment if suppliers prepare high-quality and transparent financial statements under IFRS and U.S. GAAP.

For example, paragraphs 42A–42H of IFRS 7, among other IFRS requirements, apply to many receivables financing arrangements. These paragraphs include disclosure requirements for transfers of financial assets that are not derecognized in their entirety and for any continuing involvement in a transferred asset. Under U.S. GAAP, guidance is provided under Accounting Standards Codification (ASC) 860 Transfers and Servicing.

Nonetheless, we understand that some suppliers who enter into supplier finance arrangements and accelerate the monetization of their trade receivables may not be providing sufficiently clear disclosures. Standard-setters should take action and make clear that disclosures are always required for suppliers who accelerate the monetization of their trade receivables through the use of supplier finance.

Related Criteria And Research

• Hidden In Plain Sight: $85 Billion Of U.S. Supplier Finance Obligations Come To Light With New Disclosures, July 24, 2023
• Supply Chain Finance: How To Remedy Flawed Financial Reporting, June 7, 2021
• Corporate Methodology: Ratios And Adjustments, April 1, 2019