Fitch Sounds Warning On Corporate Debt Loophole Of Trade Finance

Trade finance is a critical part of cross-border trade, particularly for small businesses. The explosion of different kinds of trade finance enables businesses to address multiple areas of cash flow gaps for both buyers and suppliers, all with the same goal: keep the global trade gears turning.

But a warning recently released by Fitch Ratings may cause some businesses to be hesitant about certain trade financing opportunities.

According to the analytics firm, there is a trade finance-related corporate accounting loophole that may be widespread in the U.S. and Europe, and it could be contributing to longer supplier payment terms. Outlined in Fitch Ratings’ report, “What Investors Want To Know: Supply Chain Finance,” that loophole allows companies to extend their Days Payable Outstanding by using third-party supply chain financing, which does not have to be classified as debt, allowing those companies, in essence, to keep that debt hidden.

“We believe the magnitude of this unreported debt-like financing could be considerable in individual cases and may have negative credit implications,” Fitch said in the report.

Also known as reverse factoring, supply chain financing enables businesses to sell unpaid invoices once they are approved by a corporate buyer. Corporate buyers then have more time to pay those invoices, while suppliers get financed more quickly. Though the trade financing solution can be a helpful cash flow strategy for both ends of a trade agreement, Fitch noted that the corporate buyers — which must repay the financing — can classify the debt as “other payables.”

Fitch warned that this classification allows corporate buyers to operate with a lack of transparency in their finances. Defunct U.K. government contractor Carillion, which suffered a high-profile bankruptcy earlier this year, reportedly engaged in supply chain financing that ultimately contributed to its demise, according to Fitch.

Supply chain financing programs offered by banks and alternative lenders do not necessarily require disclosure of the debts under corporate accounting standards.

A survey of 337 U.S. and Europe, Middle East and Africa (EMEA) companies found that median payables days increased 14 days in 2014, reaching their highest in 2017. The survey traced supplier payment practices back to 2004. Collectively, the total value of payables increased by $327 billion, Fitch Ratings said.

Supply chain financing (SCF) is not the sole cause of this increase in days payable outstanding (DPO), however; Fitch noted that other supply chain management strategies, restocking, capital investments, mergers and acquisitions (M&A) and other factors also have an increase in DPO.

But as Carillion showed, supply chain financing “could have a potentially large impact on vulnerability to default for specific issuers, making awareness critical.”

Trading businesses shouldn’t entirely discount supply chain financing, however. In addition to supporting the cash flow for both buyer and supplier, Fitch noted that the trade finance product allows vendors, which are often SMBs, to take advantage of the strength of their corporate customers’ credit to have their invoices financed, instead of having to become the direct borrower themselves.

On Tuesday (July 31), trade finance platform PrimeRevenue published data on adoption of supply chain financing. According to a survey of businesses on its platform, 90 percent of vendors onboarded to a PrimeRevenue program accepted payment term extensions from their corporate customers, up from 78 percent in 2015.

A more in-depth report published by PwC and the Supply Chain Finance Community last December similarly concluded that use of supply chain finance is on the rise. In the “SCF Barometer” report, analysts found that banks’ reverse factoring offerings remain the most popular for businesses, with companies citing working capital optimization as the most important reason for adopting a supply chain financing program.

Addressing suppliers’ liquidity needs, and improving the supplier relationship, were also top reasons, PwC found. Overall, companies surveyed by PwC agreed that their supply chain financing programs were successful and most said they planned to expand their SCF initiatives.

But Fitch Ratings’ notice signals a downside to supply chain financing in how corporates employing the cash flow management strategy are able to hide their debts — and, if Carillion is any sign, it could lead to disastrous effects for corporate buyers and their supply chains.