Carillion, Moodys and Accounting Transparency with Supply Chain Finance

Back in March, Moody’s came out with a note titled Carillion's collapse highlights shortcomings in the accounting for reverse factoring.

Claiming the scale of the supply chain finance program was not evident from their balance sheet, Moody’s wrote:

"A company with a net debt-to-EBITDA ratio reportedly below 1.0x is an unlikely candidate for bankruptcy, yet UK support services and construction group Carillion plc (unrated) entered into compulsory liquidation less than a year after its directors approved the accounts for 2016 on a going concern basis. A reverse factoring arrangement, a form of supply-chain finance, that commenced in 2013 had enabled Carillion to delay the outflow of cash to many of its suppliers. Determining the appropriate accounting treatment for this arrangement would have a significant bearing on the accounts, and involve a high degree of judgment."

The note is insightful in the way it shows how these large programs can essentially make DPO flat even if the company extends their suppliers, in the case, Carillon went from 60 to 120 days but DPO remained flat from 2013 onwards.

What Moody’s is really suggesting in this note is to fix these problems in future, you need proper disclosure.  Supply chain finance can and does impact capital structure at scale. Extending your terms from 60 to 120 or 180 days provides in an accounting sense, an increase in Payables on the liability side and an increase in Cash on the Asset side. This is a big one-time benefit in working capital.

What Moody’s could have done beyond just pointing out the opaqueness of this particular case is to suggest how we fix this problem.  Do we need subcategories for SCF programs for analysts to better analyze?  Who will make this case to the accounting bodies and regulators?  I doubt Moody or S&P will – its far easier to do post game analysis than try and change the rules of the game.

And these issues are not unique to construction.  Yes construction has many issues when it comes to payment which I have highlighted in the past, see Is Construction Finance the Next Big Thing in Early Pay?

Whatever I have been able to glean from Carillion's liquidation, I think companies were borrowing against those receivables.  Many of us get confused about Early Pay but fundamentally did you as a supplier sell your receivable or did you borrow against it?  Essentially you are getting paid before you are contractually required to be paid.  Then we get into all the nuances such as did I sell it, is there recourse, no recourse, etc.  What are the characteristics?

Why did putting in a SCF program impact Carillion

As Moody’s said in their note:

"At the beginning of 2013, the company put in place a reverse factoring arrangement that subsequently expanded considerably in scope.  Although there was no disclosure of the arrangement in the accounts for 2013, Carillion's management reportedly adopted a policy that pushed payments to suppliers out to 120 days. However, the company simultaneously introduced an Early Payment Facility (EPF), provided by its banks, that enabled the affected suppliers to avoid the adverse consequences of the extended payment term.  My guess is these were loans to suppliers, not receivable purchases."

What I suspect happened were two events:

1) Moody’s estimated that £498 was owed to the banks under the reverse factoring arrangement.  As I said “estimated” it was because this liability was reported with ‘other creditors and excluded from borrowings.  Banks probably withdrew some or all of this £498 because a missed debt payment could have happened from one bad receivable.  If you are extending credit indirectly through banks and they withdraw that credit, and you have one bad receivable, its easy to create a solvency event and miss debt payments.

2) The company then loses leverage with suppliers, so new contracts no longer are under 120 days but shorter.  When SCF enables you to stretch terms say from 30 to 120 days, you increase cash by over 4x, as you increase your payables and cash. When banks pull their lines, and the CORPORATE NO LONGER HAS LEVERAGE TO KEEP COMPANIES OUT TO 120 days what happens to cash? Payables decreases, and so does cash. This creates a big problem.

Again, this is all speculation on my part.

And herein lies the real point.  You cant look at SCF outside of broader capital structure – its a component part.

And perhaps at some point we need a consistent accounting format for reporting supply chain finance structures.  Or else, we may find Carillion's case is not unique.

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