Reverse Factoring in Export/Import Businesses. Does the Concept Help Third-World Suppliers in Latin America?

Table of contents

List of figures

List of tables

List of abbreviations

1. Introduction

2. Conceptual framework of reverse factoring
2.1 Supply chain finance
2.2 Accounts receivable purchase: invoice discounting and traditional factoring
2.3 Reverse factoring
2.3.1 Evolution and definition
2.3.2 Process of transaction

3. Reverse factoring in Latin America
3.1 Current developments
3.2 Legal framework
3.3 Practical examples

4. Advantages and drawbacks of reverse factoring

5. Conclusion

Bibliography

Abstract

The supply chains of large companies are often spread across the globe due to the globalization of markets, the need for specialized suppliers and the trend towards outsourcing (ICC, 2018). Within these supply chains, export and import activities play an important role in moving products and services from one stage to another. According to The Bank for International Settlements (BIS, 2014), one-third of international trade is supported and enabled by some form of trade finance. Reverse factoring is one of many possible solutions that covers a payment procedure and risk mitigation. The main objective of the paper is to examine whether the use of reverse factoring helps Latin American-based suppliers in terms of their development and business success. It was found that this scheme is particularly suitable for large creditworthy organizations with many small or middle-sized suppliers located in emerging markets such as Latin America. It provides several potential advantages for the suppliers: Above all, the access to affordable and fast financing without assuming the risk of insolvency of the buyer. Moreover, reverse factoring is an off-balance sheet transaction and there are several more benefits resulting from close economic ties between a smaller and a larger company. All in all it can be stated that as long as the buyer does not exploit its bargaining power, the usage of a reverse factoring program offers considerable opportunities for third-world suppliers in Latin America and helps them to develop as well as to achieve greater economic results.

List of figures

Figure 1: Different methods of supply chain finance

Figure 2: Reverse factoring mechanism

List of tables

Table 1: Standard definitions for techniques of supply chain finance

Table 2: Differences between invoice discounting, factoring and reverse factoring

List of abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1. Introduction

Emerging markets already account for 60% of global output¹ and are regarded as the engine of future growth (IMF, 2019a). Among them is Latin America - a large market whose companies are becoming an increasingly important part of the world economy. Its export activities contributes significantly to this development (Deloitte, 2014).

On the one hand, since the 1990s, large multinational corporations (MNCs) relocate the production of core product components - or the provision of services - to developing countries in order to exploit cost advantages (Parra and Haar, 2018). On the other hand, exporting offers many advantages for manufacturers, such as a time and cost-saving form of entry into new markets, economies of scale (Dijk, 2002) and technology spillovers (Pack, 1993).

The Bank for International Settlements (BIS, 2014) estimates that about one-third of world trade is supported by some form of trade financing. In today's challenging economic environment, however, it is not easy to find affordable and secure payment solutions for export/import transactions. Particularly companies in emerging markets such as Latin America, 99% of which are small and medium-sized enterprises (SMEs), face expensive short-term capital and limited access to bank loans (Alvantia, 2018). In a recent study (ECLAC, 2018), more than half of the small, Latin-American businesses identified access to finance as a major obstacle to development. It is worth noting that financial constraints of SMEs are exacerbated by the fact that it has become easier to obtain credit information on foreign trading partners. This has resulted in a reduced willingness to pay for risk coverage in traditional payment methods (UN, 2012). Above all, payment structures are changing as a result of new technological opportunities and the intensified competition caused by globalization. For all these reasons, other forms of financing are gaining in importance.

Reverse factoring is regarded as one of the most promising alternative financing solutions from which both SMEs in developing countries and MNCs can take advantage. With this method, potentially risky suppliers from the Third World can obtain low-interest working capital financing. Nevertheless, reverse factoring can also have some disadvantages in practice.

The aim of this paper is to examine whether the use of reverse factoring helps Latin America based suppliers in terms of their development and business success.

For the preparation of this work, theoretical literature and empirical studies on reverse factoring and related topics have been used. To answer the main question of the investigation the following sub-questions will be addressed:

- What is supply chain finance ?
- How does reverse factoring work and what are the key differences to similar methods?
- How is the current (legal) situation in Latin America regarding the factoring business?
- What are practical examples of companies in Latin America that use reverse factoring?
- How can reverse factoring help third-world suppliers and what are possible drawbacks?

The further course of the study is organized as follows. The subsequent chapter provides a conceptual framework of reverse factoring. This includes a brief introduction to supply chain finance as well as accounts receivable purchase. The subsection 2.3 then focuses on the concept that is at the heart of this paper: reverse factoring and its functioning. Chapter 3 describes the current developments as well as the regulatory environment of reverse factoring in Latin America and gives some practical examples. After that, Chapter 4 discusses the benefits and constraints of reverse factoring. Finally, Chapter 5 provides a final conclusion and gives an answer to the main question of this paper.

2. Conceptual framework of reverse factoring

The inconsistent definitions in the field of trade finance found in the literature can make it difficult for the reader to understand the subject. Therefore, this chapter explains and links all necessary terms in a comprehensible framework. Particular attention is paid to the description of the principles of accounts receivable purchase and the concept of reverse factoring.

2.1 Supply chain finance

There are many payment forms in international trade that differ in cost and risk mitigation. Open account (exporter pays after receiving the goods or services) and payment in advance (importer pays before delivery) are the most basic forms of trade. They are not supported by any banking or documentary trade instrument and - without any type of export credit guarantee- bear great risks for one of the parties. However, they are cheaper and more flexible than other methods (BAFT, 2016). A survey conducted by the International Chamber of Commerce (ICC, 2018) shows that traditional trade finance methods such as Letters of Credit, Documentary Collection and Guarantees, still account for an average of 85% of cross-border export/import activities. The remaining 15% are a wide range of programs and solutions that fall under the category of Supply chain finance (SCF)², which Figure 1 provides an overview of. However, a shift from traditional methods to SCF solutions can be observed (ICC, 2018).

Figure 1: Different methods of supply chain finance

Abbildung in dieser Leseprobe nicht enthalten

Note: Payables Finance is the same as reverse factoring. The same for Receivables Discounting and invoice discounting. Source: illustration adapted from BAFT, 2016, p. 23.

In literature, SCF represents the interface between logistics and finance, which has received increased attention over the last decade. The ICC worked for two years together with many industry associations to develop the Standard Definitions for Supply Chain Finance Techniques (see Appendix, Table 1). In line with this framework, SCF is defined as "the use of financing and risk mitigation practices and techniques to optimize the management of the working capital³ and liquidity invested in supply chain processes and transactions" (BAFT, 2016, p. 24).

These financing solutions are designed to meet the needs of both the supplier, who wants to be paid as soon as possible after delivery of goods or services, and the buyer, who wants to delay payment as long as possible to improve cash flow (BSR, 2018). SCF is typically applied to open account trade. B2B networks, logistic companies, electronic invoicing and other non-bank solutions are used to achieve greater security (BAFT, 2016).

2.2 Accounts receivable purchase: invoice discounting and traditional factoring

Traditional factoring, reverse factoring and invoice discounting are the worldwide most frequently used SCF programs. All of them belong to the category of accounts receivable purchase as it was displayed in Figure 1. In literature, however, there are contradictory figures about their exact ranking referring usage. Recent information from the ICC (2018) indicate that adoption of reverse factoring makes 28%, which is followed by invoice discounting (25%) and then traditional factoring (17%). Factors Chain International (FCI, 2019) - the worldwide largest association of the factoring business -states that traditional factoring still accounts for 80%, reverse factoring for 14% and invoice discounting for 6%. In this aspect, the paper is relying on the data provided by the ICC.

In order to grasp the concept of reverse factoring in its entirety, it is helpful to be familiar with the other two financing methods as well. In fact, reverse factoring could be regarded as a combination of these, using the advantages of both to redistribute the benefits to all parties involved. This section therefore briefly presents invoice discounting and factoring.⁴

Invoice discounting and traditional factoring have various similarities: they are all based on a three-way cooperation between a buyer, seller and a financial institution such as a bank - in this context also referred to as factor. In both cases it is the supplier who initiates the introduction of these procedures (BAFT, 2016). These forms of SCF allow suppliers to sell their unpaid invoices (receivables) to the factor at a discount and in return to receive a quickly disbursed short-term credit. The fees and interest rates that have to be paid to the lender vary greatly depending on the factor company, the specific type of the method and the economic situation of the supplier. Given the considerable amount of expenses, accounts receivable purchasing is generally rather a "last resort" financing solution (UN, 2012). Both in invoice discounting and factoring an extended payment term of typically up to 90 days is offered to the buyer.

Invoice discounting and traditional factoring are both accounts receivable (AR)-centric approaches. However, reverse factoring is an accounts payable (AP)-centric approach, which is why it is essential to know the difference between AR and AP. First of all, both are positions in the balance sheet of a company. The balance sheet provides an overview of all current and non-current assets (what a company owns), current and long-term liabilities (what a company owes) and shareholder's equity at a given point in time. AR represent the amount of money owed to a company by its debtors, such as customers for purchases that were made on credit. This means, the firm will still receive money in the close future.

AP represents an amount of money owed by a company to any third party, such as creditors or suppliers. This means that in the future, the firm still has to pay off a short-term debt (within one year). After all, neither invoice discounting nor traditional (or reverse) factoring can be regarded as financial debts; receivables are listed on the balance sheet as a current asset, while payables are classified as a current liability (Klapper, 2005; Accountingtools, 2019). Another key feature of factoring as well as invoice discounting is that the factor does typically not transfer the full face value of the purchased receivables in the first place. The difference between this advanced payment and the invoice amount is stored as a collateral to be prepared for possible payment difficulties of the buyer. The reserved amount will be transferred, if and when the invoices are entirely paid by the buyer to the factor (Klapper, 2005; BAFT, 2016).

Nevertheless, there are also several differences between the two methods. It is important to note that in factoring - but not in invoice discounting - the lender can have two other functions than financing. One is the service function; they can check the creditworthiness of the debtors before purchasing the receivables and regularly during the life of the contract. In this way, the factors are always informed about the economic situation of the companies and can adjust the terms of payment. Additionally, they can take over the dunning and collection process. The other is credit protection: If the factor assumes credit risk, this is called non-recourse factoring. In practice, this means that the borrower does not have to fear payment defaults. Even if one of the customers is insolvent, the companies will receive their money reliably. This facilitates liquidity planning and improves the balance sheet (ICC, 2018). Recourse factoring, on the other hand, means that the factor does not assume credit risk. This variant is slightly more popular than the first in developing countries, since it is often problematic to assess the risk of default (Klapper, 2005; FCI, 2019).

According to empirical studies, factoring and invoice discounting are more likely to be used in developed countries, the former being more attractive to small and the latter to medium-sized or large companies (Klapper, 2005; Summers and Wilson, 2000).

2.3 Reverse factoring

After the introduction to both the category of accounts receivable purchase and the two methods traditional factoring and invoice discounting, a more detailed examination of reverse factoring follows in this section.

2.3.1 Evolution and definition

Reverse factoring is a financial instrument that was not introduced until the 1980s. Companies in the UK, Italy and Spain were the first to use it as a purely domestic service (BNP Paribas, 2016; Hurtrez and Salvadori, 2010). A few years later, large companies in the automotive and retail industry of those countries began to source their raw materials from foreign SMEs, making reverse factoring international. The development of technology platforms to which all business partners have access was a key enabler. These platforms have made it possible for finance providers to compete with each other, which led to more favorable discounts and quicker payments (Hurtrez and Salvadori, 2010). Because of the many different synonyms used in literature, the ICC decided in 2016 to create a neutral and generic expression to bundle them. Since then, reverse factoring is often referred to as Payables Finance. Nevertheless, reverse factoring continues to be a common term in academic literature and is therefore used in this paper.

The adoption of reverse factoring programs has increased significantly in recent years and several organizations (e.g. BSR, 2018; ICC, 2018) believe that this trend will continue. Contrary to the other two methods presented before, this time, the buyer initiates the agreement; hence the term "reverse". The importer is also sometimes called client (of the factor). Using this form of finance, the factor usually purchases receivables only from a few large, transparent or internationally accredited companies that are supplied by many small firms. Since this technique is buyer-centric, the factor only needs to gather information about the few buyers and calculate their credit risk (Seifert and Seifert, 2011).

With the help of reverse factoring, large (international) clients can take advantage of their high credit rating to financially support their third-world suppliers who are inherently less creditworthy or are located in a country with a weak credit information infrastructure (Klapper, 2005). In other words, the credit risk is equivalent to the default risk of the high-quality buyer and not that of riskier SMEs. Exploiting this credit arbitrage can overcome some of the shortcomings of other SCF instruments as the interest charged is lower (Hurtrez and Salvadori, 2010).

2.3.2 Process of transaction

To better understand how reverse factoring works, Figure 2 shows a typical sequence according to the ICC standard (BAFT, 2016). The actions follow each other so that the completion of one step triggers the next.

First of all, a valid contract between the buying organization and the factor must be concluded. Then, the finance provider is authorized to factor the importer's liabilities against foreign suppliers and it checks the buyer's creditworthiness. After that, the concept of reverse factoring is presented to the suppliers, which are encouraged to make use of this program. A contract is then concluded between the importer and each of the interested suppliers that agree on the application of reverse factoring. Once the legal aspects have been clarified, the subsequent procedure is applied for a defined period of several years.

[...]

¹ based on Purchasing Power Parity.

² SCF programs in the region of Latin America account for an above average share (23%) of trade finance (ICC, 2018).

³ BAFT (2016, p. 91) defines working capital as "financial resources invested by a business in financing its current trading operations usually expressed as the difference between Current Assets (receivables, inventory and operating cash balances) and Current Liabilities (payables and short term debt)".

⁴ Forfaiting is not further discussed in this paper as invoice discounting and traditional factoring sufficiently contribute to the understanding of reverse factoring. However, a short definition can be found in Table 1 (appendix).