Supply chain finance is a surprisingly common form of finance, and its use has increased significantly over the last decade. However, it isn't well disclosed by companies and is usually a form of off balance sheet finance, and it's important therefore to understand how it works and its effects on the financial statements. Now, the simplest form of supply chain finance is traditional factoring, and this arrangement involves selling receivables to a bank and works in the following way. The first step is that the company sells its goods to its customers and sends an invoice offering standard payment terms. Let's say payment is due after 30 days. The second step is that the company then assigns the invoice to a bank, which means that the bank has essentially purchased the receivable owed by the customer. The third step is that the bank then makes an immediate payment to the company for the amount due from the customer. This payment is made net of a fee, and its fee is essentially an interest charge because the bank is advancing funds which will later be reimbursed when the customer settles the invoice. The fourth step is at the end of the 30 days, the customer settles the invoice directly with the bank. Now, this is a great outcome for the company. Firstly, they receive the cash owed by the customer before the 30 days are up. However, they will have to pay a small fee for this because the payment received from the bank relates to a trade receivable. The related cashflow is classified as an operating cashflow rather than as a financing cashflow, which is how a bank loan would be treated. A more complex and newer form of supply chain finance is reverse factoring, and this arrangement involves assigning trade payables to a bank and works in the following way.

The first step is that the company purchases goods from a supplier and receives an invoice. Understand the payment terms. Again, let's assume payment is due after 30 days. The second step is that the company then assigns the invoice to a bank, which means that the bank agrees to pay the invoice on behalf of the company, whilst also allowing the company to settle the invoice with the bank under extended payment terms, let's say after 60 days. The third step is the bank then makes payment to the supplier at the end of 30 days for the amount owing. And the fourth step is at the end of 60 days, the company settles the invoice directly with the bank. This payment includes an additional fee, which is essentially an interest charge because the bank is advancing funds to the supplier, which is settled by the company at a later date. Again, this is a great outcome for the company. They settle the invoice after 60 days instead of 30 days, so they have an extra 30 days of cashflow. However, they do pay a small fee for this, but because the payments to the bank relate to a trade payable, the cashflow settling, the obligation to the bank is classified as an operating cashflow rather than as a financing cashflow, which is how the repayment of a bank loan would be treated while the fees paid by the company are treated as a finance expense in the income statement. So how can we spot the use of supply chain financing by companies? Well, there are three key things that we need to look for here. Firstly, we'll see unusual cash inflows in working capital. In the cashflow statement, many of the companies that engage in supply chain finance have positive operating working capital. So if we see working capital inflows for a growing company, this will be quite unusual. Secondly, we'll see trade receivable days well below those of peers or trade payables days, well above those of peers. And thirdly, we'll see an increase in interest costs relative to the company's total level of borrowings on the balance sheet.