Although the economic turmoil has forced many companies in Latvia to optimise their operations or even cease operations, there are those that are able to adapt to the current situation and take advantage of the circumstances to improve their financial situation.
In addition to borrowing for working capital, companies can finance their day-to-day operations through factoring or invoice finance and reverse factoring – both invoices issued by the company itself, where payment would be expected from the buyer, and invoices issued by the seller, which would have to be paid by the company itself. Let's start with the second one – reverse factoring. A solution that provides both longer creditor days, additional income in the form of a procurement discount and an additional positive impact on the PFA in the form of a capitalised credit risk differential.
Why consider reverse factoring?
There is a common joke among economists about the invisible hand of the market and its absolute efficiency. Specifically, a hundred-dollar bill was being thrown on the street. One economist accidentally notices it, but keeps walking without picking it up. The other economist asked him: "Didn't you see the money thrown on the ground?" The economist replied: "I thought I might have seen something like that, but I thought I had only dreamt it. If there really was a hundred-dollar bill, someone would have taken it long before me."
Reverse factoring is, in a sense, a hundred-dollar bill that you have to spot in your supply chains and just pick it up. This is a relatively new form of financing in Latvia, but already widespread in the major economies of Western Europe. According to the data Factors Chain International, reverse factoring accounts for 30% of the total factoring market worldwide and grew by more than 29% in the last available annual report, indicating the rapidly growing popularity of this financial solution.
How does reverse factoring work?
In essence, it involves the financier or creditor buying from the supplier a right of recourse or invoices, which the supplier has agreed to pay. The creditor pays the supplier instead of the company, while the company pays the financial institution instead of the supplier, on the due date specified in the invoice or later if agreed with the financial institution. Consequently, payment will be made not to the supplier but to the financial institution that purchased the invoice from the supplier and paid the invoice on behalf of the company.
Essential added value of this solution is when the buyer and supplier have different credit risk assessment. Therein lies the possibility of arbitration and the bill on the ground to be picked up.
Typically, the buyer of reverse factoring is a company with a very good risk rating, such as state-owned companies, multinational organisations or local companies with a high turnover and solid financial results.
In contrast, the supplier is usually a newly established company, or one that has already made large financial commitments and whose risk assessment has become weaker, or additional financing is not available at all. Thus, there is a significant difference in credit risk assessment between the two companies. This, in turn, creates the possibility of risk arbitrage or risk restructuring.
How is this implemented in practice?
Through a reverse factoring solution, the financial institution receives an assurance from the buyer, i.e. the financially strong company, that the invoice will be paid after a certain period of time. Thus, when pricing financial resources, the financier only assesses the buyer's credit risk. The cost of credit risk in this scenario will be much lower for the buyer than for the supplier, for whom the cost of raising finance may be many times higher or even non-existent.
At this point you can start to see the potential benefits. That is to say, as long as the supplier is able to raise finance for its business at the buyer's cost of credit risk, it would be prepared to grant the buyer some (a) purchase discount or (b) extension of the payment dates originally invoiced or (c) to allow the buyer to also earn by partially capitalising the interest rate differential at which the supplier borrows and which the buyer can raise.
In addition, if the difference in credit risk is significant, it is possible to negotiate with the supplier a purchase discount or extended payment days, freeing up working capital in the buyer's company. In this way, the buyer can use his good credit rating to support his supplier and improve his financial situation at no extra cost to his company.
Where and if reverse factoring is currently used?
The largest industries where reverse factoring is currently used are telecommunications, IT, agriculture, retail, and construction. SEB, as a leading corporate financier, has in the past and is currently discussing reverse factoring opportunities with both large Latvian companies and leading companies in the SME segment in order to strengthen and improve the financing of their supply chains.
But when is it better to use classic factoring?
However, if it is not possible to negotiate a reverse factoring programme with a financially strong buyer, or if the buyer does not have an impeccable credit rating, classic factoring is a successful way to enable your business to receive working capital for goods and services sold while you wait for the invoice to be paid. In this option, credit risk is based on the seller's or customer's risk and the buyer's involvement is minimal.
SEB classic factoring solution is one of the most competitive solutions on the market. This is reflected in the increasing market share and the fact that more and more customers are opting for this solution with their bank. For example, in the segment of small and medium-sized enterprises, the classic factoring portfolio has increased by 8.2% compared to the same period of the previous year, according to SEB results for the month of February. This is based on the Bank's strategy to offer sustainable solutions to its clients, supporting the cash flow of companies. This increase is also justified by the advantages of the classic factoring solution (immediate receipt of cash for invoices, reduction of currency risk through widely available invoice financing currencies, possibility to insure the debtors' solvency, easier access to finance - no need for commercial mortgages or other additional collateral, etc.). The application process has also become more convenient and can be done remotely.
We also see active development of the factoring market in the non-bank segment, as well as the emergence of platforms combining the offers of several factoring providers in one place, which contributes to the overall visibility of the factoring solution in the market. Compared to the Lithuanian and Estonian factoring markets, the Latvian market is 2 to 3 times smaller, which explains the activity of new factoring companies in the Latvian market. Of course, non-bank solutions are many times more expensive, so we encourage companies with at least one year's track record to obtain a classic and reverse factoring offer from a major bank before making a final decision on a financier. We also observe that clients appreciate SEB's broad client base, which allows us to quickly address debtor payment issues and find solutions even in the most challenging market conditions.
Jānis Moisejs
Senior Manager Factoring Products at SEB
