Rocky Mountain Trucking LLC

A recent rule change requiring the disclosure of the use of supply chain finance programs could alter how buyers and suppliers, both of which are considered shippers in the freight world, operate and how investors perceive them.

Supply chain finance, or reverse factoring, is a short-term arrangement allowing buyers to utilize the full payment window of an invoice while suppliers get paid quickly. A third party, usually a bank or other financial institution, pays an invoice approved by a buyer ahead of the due date but at a discounted amount. The buyer repays the financial institution the full amount of the invoice at a later date. The bank keeps the spread — the difference between the full amount and the amount paid by the bank, which was discounted at prevailing interest rates.

The tool improves cash flow for both buyers and suppliers.

The buyer is able to push payments out as much as six months to a year, and the supplier can be immediately compensated on sales. Both suppliers and buyers optimize cash flow by using a third party’s balance sheet. Further, large buyers often have stronger credit profiles than their suppliers. The programs allow a smaller company selling goods to a larger company to essentially access financing at a reduced cost.

The transaction is a sale of the supplier’s receivables and not considered debt for the buyer.

For years buyers were not required to divulge their use of supplier finance programs. However, a new Financial Accounting Standards Board (FASB) rule for the fiscal year starting after Dec. 15 will require users to disclose payment terms of the transactions, confirm the amounts of the invoices in the program, disclose any guarantees or assets pledged and provide a description of where those obligations will appear on the balance sheet (under accounts payable for most).

However, FASB’s ruling stopped short of requiring users to classify the amounts as short-term debt.

Headwinds to supply chain finance programs

Throughout the pandemic, inventory costs jumped as warehouse rents and labor expenses stepped higher. Also, some companies have taken on more space to store more goods. Many find themselves holding inventory longer, including products that remain unfinished due to supply constraints. Cash conversion cycles have been extended as customers are taking longer to pay. It’s not uncommon to see customer bad debt expense rise on the downside of the economic cycle.

Layer in incremental cost inflation in the form of interest rate hikes and supplier finance programs are becoming further stressed. As interest rates increase, the costs to fund these transactions increase. Banks use market interest rates and the buyer’s credit rating to determine how much they will discount a payment to a supplier.

The rule change could alter how some buyers (shippers) operate now that the magnitude of their usage of supply chain finance is known.

The extension of payment cycles, or days payable outstanding, have favorably impacted cash flow metrics. In fact, operating cash flow growth has outpaced sales growth “at a far faster rate” over the past decade, KeyBanc (NYSE: KEY) analyst Adam Josephson told clients in a Tuesday note.

Some of the paper and packaging companies he follows, like Ball Corp. (NYSE: BALL), have recorded compound annual growth rates in operating cash flow two times higher than that of sales over the past decade. Of those companies, some have extended days payable outstanding by more than three times.

“This type of financing is becoming increasingly expensive thanks to rising interest rates (from previously historically low levels), and the banks/financial intermediaries that provide it aren’t obligated to continue doing so; it’s an uncommitted line of credit, unlike other types of bank financing,” Josephson said.

He said tightening credit markets could induce banks to minimize exposure by reducing outstanding credit to the programs.

“In a tightening credit environment and given the possibility that some companies could experience credit rating downgrades, we believe there’s a real risk of less such financing becoming available in the months/years ahead,” Josephson continued. “If banks were to do that, the buyer and supplier would be forced to revisit their payment arrangement, potentially at an inopportune time.”

Supplier finance programs juice a company’s free cash flow, which is often used to make acquisitions or fund a share repurchase or dividend program. Many investors consider a company’s ability to generate cash in addition to its earnings performance when making investment decisions. An unwinding of extensions in days payable outstanding would affect valuation multiples.

“With the global economy deteriorating and corporate earnings falling, we expect investors to pay increasing attention to balance sheets and cash flow statements and less attention strictly to income statements, and we think this is precisely the type of topic that investors should and will become increasingly attuned to,” Josephson said.

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