NMC Health: Demystifying Reverse Factoring: The “Three-is-a-Crowd” Financial Analysis Problem

Matthias MeitnerManaging Partner, VALUESQUE

Abengoa S.A. (now bust) applied this technique heavily, Carrillion plc (now bust, see LINK to our former blog post [only in German]) too… and recently short seller Muddy Waters seemed to have it detected at NMC Health plc (LINK to the report), followed by a steep stock price decline of the United Arab Emirates based and UK-listed healthcare company. And NMC didn’t even deny this in a response where the company stated that it had never given the impression that this technique is not part of its business: You know already what we are talking about: In this blog post it is about a technique called reverse factoring – or more generally often: supply chain financing.

The examples above are certainly only the tip of the iceberg. Supply chain financing facilities are booming across the whole international corporate landscape, sometimes just as a normal tool of working capital optimization, but not rarely somehow associated with companies who want to dress-up their books or are in financial trouble already. So we think it is worth to disentangle this technique and explain why it is the preferred tool of companies who want to benefit from the “Three-is-a-Crowd” illusion.

Let’s start with the naked technical details. What is reverse factoring? While in a normal factoring situation companies sell (or at least transfer) some receivables to a bank or other factoring company before time of collection in order to early monetize these receivables, reverse factoring rather targets the liability sibling of accounts receivables: the trade payables! In reverse factoring the company uses a financing institution either for a) paying its suppliers earlier than the usual terms of payment would require, b) paying its suppliers in time, but with a payment duty of the company to the financing institution at a later point in time, or c) a combination of both. The following graph highlights the technical functioning of cases a) and b) as compared to a situation without reverse Factoring.

Of course the company has to pay a price for such supply chain financing, i.e. they have to pay interests. And I think that it is not a big surprise for readers that such techniques are clearly a sort of financial debt: Making use of a bank or similar to get a dedicated short-term interest-bearing loan on a more or less revolving basis. And that is it already from a technical point of view, not much of a mystery…. But stop! Things would be too simple if we only look at the isolated technical details. And in fact: Reverse factoring touches a big behavioural financial statement analysis topic: the intertemporal cash flow development analysis, or better: the “Three-is-a-crowd” problem!

So what is this “Three-is-a-crowd” problem? In very simple terms it goes back to typical techniques applied by financial analysts when trying to find out more on the “earnings’ quality” of companies. The underlying question is here: How good of a measure are accounting earnings as an indicator of future cash flows? This is an essential analysis step as current (or historical) accounting numbers are often the most important basis for deriving estimates of the future cash flow generation ability of companies. This ability then should flow into our valuations (e.g. discounted cash flow techniques) or at least in to our credit analyses (coverage questions). Usually, earnings quality is seen as “high” if accounting earnings translate stably into respective cash flows, i.e. if the non-cash components of earnings (the so called accruals) somehow even out over time. The translation of earnings into cash flows is generally called “cash conversion”. And it goes without saying that for analysts normally a poor cash conversion (i.e. if earnings fall short of cash flows) is a sign of deteriorating business fundamentals in the future, and vice versa. This assessment is just a consequence of the nature of our accounting systems. As cash conversion is such an important topic, we are going to shed some more light on it in one of our next blog posts.

But staying with reverse factoring here: what if a company feels that even if earnings are still ok, cash collection might become difficult in the next years? Or if companies want to strengthen their operating cash flows anyway? And this is the time of the “Three-is-a-Crowd” technique. When we look at the cash generation of the operations of a company we usually analyse the operating cash flow of a company. And this cash flow is not just a function of the pure buying-input-selling-output process of companies, it is also a function on how companies manage the payment terms to their input and output counterparts (suppliers and customers). To put it differently: If companies manage to prolong their payment duties to suppliers or manage to early collect payments from their customers, then this also has a positive effect on their periodical operating cash generation. The following graph illustrates this in a slightly simplified form for the derivation of a single-period operating cash flow (starting point: accounting earnings).

Of course, a one-period positive effect (e.g. from collecting a big customer’s payment early: reduction of trade receivables: positive cash flow effect in this period) would easily be spotted by financial analysts as what it is: a one-period effect. Probably reversed in future periods. And also for two periods, financial analysts usually are able to detect it as a transitory effect. Analysts know that there are some normal intertemporal variabilities between earnings and cash flows. But what if this effect is seen as sustainable over time? Then it would seem to be structurally positive. And it does not take many periods to make such effects seemingly sustainable: Often three periods are enough for analysts to feel that there are some structural positive patterns (just imagine a typical MS-Excel-Model where you see three historical periods with certain ratios, this is often the basis for at least some soft extrapolation in the future): Three is a crowd! If something goes on over so many periods than it should be lasting, many analysts think. With the respective consequences for future cash flow projections. As a matter of course this works only if analysts can only rely on the time series patterns and do not get any clear information on the transitory effect of the cash payment or collection patterns.

But how does the reverse factoring game play into this finding? Well, in the way it is often seen in practice it is such a nice hidden “Three is a Crowd” technique. Usually its characteristics are as follows:

  • The positive starting point for evil companies is: So far there are no duties for companies to publicly declare whether they engage in reverse factoring activities (or supply chain financing activities in general) or even classify them as financing, i.e. financial debt. This helps to hide what they do! Side comment: As what is written in this blog post is not a super-new evidence (most forensic analysts clearly understood the problem probably since the Abengoa fail in 2015, but definitely since the Carillion fail in 2017), it is a big surprise that it took the big four auditors in the US until 2 October 2019 to write a letter to the Acting Technical Director of the FASB requesting a clear indication on disclosure and cash flow statement representation of reverse financing techniques. Well, at least now they woke up.
  • With this non-disclosure advantage, companies do not declare the supply chain financing activities as what they are (i.e. financing) but rather hide it away as a part of the payables settling process (i.e. operating) – either actively or silently (e.g. by not mentioning the existence of supply chain financing techniques at all). This allows to keep all the effects of this technique as part of the operating cash generation process of the company.
  • Next, companies build up their position stepwise. I.e. they do not change their whole payables position into a reverse factoring position at once, but start with e.g. 30%, next year they enlarge it to e.g. 60% and the third year to e.g. 90%. This allows them to benefit from the “difference” (i.e. the step-up) every year. Remember: The operating cash flow effects are always the differences in the working capital position. With this they create the illusion of sustainability of the effects (“Three is a crowd”).
  • The real good (better: evil, super-cheater, etc.) companies play the above mentioned combination of case (c) (i.e. shortening the payment terms for suppliers by simultaneously increasing its own payment terms). Why? This allows them to benefit from another aspect: If your suppliers get paid earlier you can also talk them down to better contract terms, i.e. lower costs. Consequence: The gross margin of such companies increases, showing an additional periodical positive effect to the pure accounting earnings (and cash flows as well). So it seems as if these companies get really better in terms of their operating performance no matter what perspective (accounting or cash flow).

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