Published: December 01, 2008
Supply Chain FinanceGregory Cronie, Head Sales, Payments and Cash Management, ING
In the last edition of TMI, we explored the elements, which comprise the financial supply chain. We looked in some detail at the order-to-cash (receivables) and purchase-to-pay (payables) processes and how these can be optimised to create internal efficiencies, reducing the number of cash days for a company and therefore working capital requirements.
The benefits of automating internal processes are not restricted to internal efficiencies. Reducing the working capital requirement enhances the balance sheet and reduces the need for short term borrowing, improving financial ratios and therefore increasing the ability to obtain financing for more strategic purposes.
Furthermore, once a company has achieved good visibility over their order-to-cash and purchase-to-pay processes, particularly the former, receivables at different stages in their life cycle, including purchase orders and invoices, can be used as a source of financing. With risk pricing very high for many corporates, and demand for credit vastly exceeding supply, particularly for lower-rated firms, tapping into the financial supply chain is an increasingly important means of sourcing finance.
With risk pricing very high for many corporates, and demand for credit vastly exceeding supply, particularly for lower-rate firms, tapping into the financial supply chain is an increasingly important means of sourcing finance.
At ING, we have over 40 years experience of providing both pre- and post- shipment financing to corporates of all sizes and industries. One of the important distinguishing factors of our financing services is that we assess our clients not just on their past, but on their future too. 2009 is likely to be a difficult year for virtually every organisation, which could further damage corporates’ ability to raise finance. However, at ING, we recognise the challenging environment in which every company is operating and look at their strategy and prospects as well as recent and longer term performance. In consequence, supply chain financing with a financial partner that has the vision and balance sheet to support a company over the long term could mean the difference between success and failure during the months ahead.
In this section of the Guide, we explain some of the different ways of unlocking value from the financial supply chain and how they can contribute to an appropriate and flexible financing strategy. In addition, we look at some of the new and evolving opportunities for supply chain financing
The term “supply chain finance” itself is used in various ways within the industry and can be used to describe:
Asset-based Financing
The process of using the assets created through the supply chain to unlock working capital. This can take various forms, such as selling receivables at a discount to a financial institution or using different stages in the supply chain, such as purchase orders, receivables or inventory as assets for loan collateral.
Buyer-Led Financing
Financing provided by large buyers to their smaller suppliers, working with a financial institution to leverage the buyer’s credit standing to enable suppliers to be paid earlier, supporting suppliers and therefore enhancing the stability of the financial supply chain. It is this type of financing that we will refer to as Supply Chain Financing or SCF during this section of the Guide.
Supplier-Led Financing
Financing provided by large suppliers to their smaller customers, working with a financial institution to leverage the supplier’s credit standing to enable customers to access more favourable payment terms, whilst not jeopardising the supplier’s working capital. In this way, suppliers can encourage customer loyalty and create competitive advantage.
Asset-based financing linked to the physical supply chain is not a new concept. As illustrated in fig 1, there are a variety of traditional techniques for accessing finance both pre- and post-shipment, of which inventory financing, factoring and invoice discounting are well-established methods. However, with the development of eCommerce, which is having an increasing impact on processes in the financial supply chain, such as eInvoicing, there are increasing opportunities available for supply chain financing, particularly in buyer-led financing as we shall explain later in this section. [[[PAGE]]]
Factoring
Factoring, or accounts receivable financing, is a well-established method of business financing, traditionally used by companies with a lower credit rating. Increasingly, however, we are seeing customers across a wide spectrum of credit quality seeking accounts receivable financing as a flexible means of maintaining working capital without affecting capital ratios.
Factoring is seller-led i.e. the company which has provided the goods/services and is awaiting payment decides to enter into a financing arrangement with a financial institution. Rather than waiting for the due date for payment, which may then be late or the timing unpredictable, the company may seek to receive the amount due earlier, which they pay for in the form of a discount to the receivable. This improves the firm’s ability to forecast cash flow accurately so they can manage their working capital requirements more effectively.
Unlike a loan, where the assessment is based on the company’s credit status, factoring involves the direct purchase of the firm’s receivables. Therefore, it is based on the value of the receivables, as a financial asset, rather than the company’s credit worthiness.
Typically, companies can factor between 70% and 90% of the value of their receivables, according to criteria such as the percentage of non-payment of invoices etc. Unlike borrowings, which are subject to a credit limit, the amount available to a firm through a factoring arrangement varies according to the value of receivables due. There are ways of increasing the proportion of receivables which can be factored, including outsourcing credit management to a specialist provider such as ING Commercial Finance.
A typical factoring arrangement takes place as described in Fig 2 below.
In some cases, specific large invoices are factored, or invoices due from one or more specific customers; however, in most instances, companies aim to factor a large proportion of their receivables. Usually, but not always, customers are notified of the sale of the receivable, and amounts are then paid directly to the financial institution (factor), but this is not always the case. For example, ING Commercial Finance has a confidential arrangement in which customers are not made aware that the invoices are being sold to a financing company. Invoices are collected into the company’s account as usual and then debited or paid on to ING.
As the financial institution takes on the risk of non-payment by customers, factoring can prove a relatively expensive financing option for some companies where they do not have a record of payments from regular, reliable customers. However, credit insurance can mitigate this risk and therefore reduce the cost of factoring programmes. Although credit insurance has a cost, in the form of a premium, many companies find that the reduction in the cost of the factoring programme more than compensates for the cost of taking out the credit insurance. [[[PAGE]]]
Invoice Discounting
In many respects, invoice discounting closely resembles the factoring process. However, there is an important distinction to be made: while factoring is “non-recourse financing” – i.e. the rights and risks associated with the invoices are passed to the buyer, invoice discounting is a secured borrowing where the invoice value is used as collateral i.e. the company ultimately takes responsibility for payment by its customers as opposed the financial institution.
...with the continued expansion of eCommerce, companies are increasingly demanding web-based applications, which allow greater collaboration between parties to a financial transaction.
Consequently, invoice discounting can be a more economical option for companies looking to enhance their working capital, as they are not paying the bank to take on the credit risk. Again, credit insurance can reduce the risk of non-payment by customers for many companies.
Inventory/Asset Based Financing
Alongside accounts receivable financing programmes such as factoring or invoice discounting, companies can increase the amount of cash available by borrowing against assets such as inventory, and in some cases plant and machinery, land and buildings.
Purchase Financing
Purchase financing is a flexible form of financing suited to companies that have strong seasonal peaks in both procurement and sales. For companies that may need to pay for orders in advance, purchase financing offers a form of bridging loan, covering the period between procurement of inputs and sale of outputs. Purchase financing can be combined with a Letter of Credit, and affects a company’s credit utilisation far less than an unsecured loan as the stock is used as collateral.
New Demands for Financing
The techniques described above can be very helpful for companies which are looking to accelerate cash flow and use their financial assets for loan collateral. With traditional forms of financing becoming less easily accessible and more expensive, these types of financing solutions can be extremely valuable in maintaining working capital levels.
Addressing imbalances in the Financial Supply Chain
However, as we saw in the previous section of the Guide, the financial supply chain does not simply refer to the financial processes which take place within the company, but extends to suppliers at one end of the chain, and customers at the other. In many cases, there will also be a variety of other players such as distributors, which also fulfil an essential role in the supply chain. While a firm may be leveraging their assets very successfully to optimise working capital internally, treasurers and CFOs also need to recognise that their suppliers, customers and distributors may:
This creates instability for both buyers and sellers. In the case of buyers, there is the risk of interruption to essential supplies, which could jeopardise the company’s own production, distribution to customers and therefore customer satisfaction. For sellers, revenues and working capital could be put at risk, and cash flow tied up in surplus inventory.
However, despite the importance of “shoring up” the financial supply chain, corporates do not want to become a bank to the partners in their supply chain. Consequently, companies with a stronger credit rating are increasingly seeking to work with a financial institution to find ways of leveraging their credit rating to provide more favourable terms to their customers and suppliers, thereby enhancing the stability of their supply chain.
Collaboration in the Financial Supply Chain
Another way in which financing within the supply chain is changing is in response to the evolution in technology. Many firms have highly sophisticated technology, such as ERP applications, which closely align the physical and financial supply chain. Furthermore, with the continued expansion of eCommerce, companies are increasingly demanding web-based applications, which allow greater collaboration between parties to a financial transaction. For example, as we described in the previous section of the Guide, eInvoicing enables a common version of information to be imported/exported into both buyers’ and sellers’ systems and manual processing or paper invoices is substantially reduced. This same objective: to work more collaboratively to promote a common view of information and better integrate this information into each party’s internal systems also extends to financing.
Consequently, we see the development of initiatives where financing is triggered by events in the physical and supply chain, as illustrated in the lower part of fig 1. This requires the use of technology platforms accessed by buyers/sellers and financial institutions to ensure the timely, consistent and automated processing of transactions. [[[PAGE]]]
Supply Chain Financing (SCF)
These new demands are leading to innovations in supply chain financing, which we believe is just the start of a transformation in the way that such financing takes place. In this section of the Guide, we will focus mostly on buyer-led financing which we believe offers the most significant opportunities.
Unlike traditional factoring, this type of financing, which we are describing as Supply Chain Financing or SCF, is led by buyers (customers) rather than sellers (suppliers) although there are benefits to both. It involves buyers offering financing and information reconciliation services to key suppliers based on approved invoices. Buyers, suppliers and the financial institution are connected through a central technology platform to facilitate invoice and credit note reconciliation, invoice trading and settlement between the parties.
SCF can also be described as ‘reverse factoring’, which is a familiar financing mechanism; however, while reverse factoring could be paper-based, SCF relies on automated business processes such as reconciliation, eInvoicing and payment and uses a central technology platform. An example SCF process is shown in fig 3.
The main difference between SCF and factoring is that the financial institution’s risk is concentrated in a single buyer, as opposed to one seller and many buyers. This is an important distinction in the way that risk is priced, and therefore the feasibility of such a solution for companies looking to strengthen their financial supply chain.
Benefits of SCF for Buyers
The primary benefits for buyers include working capital efficiency, supply chain stability, lower cost of capital and the ability to focus on core skills, as follows:
Working capital and free cash flow improvements
Supply chain stability
Cost savings
Focus on core skills
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Sellers benefit primarily from access to capital and cash flow certainty:
Additional access to capital
Rate arbitrage
Transparency and cash flow certainty
Off balance-sheet benefits
Additional savings on costs and fees
Focus on core skills
Many solutions claim to provide equivalent benefits for both buyers and sellers, but SCF has substantial potential to enhance cash flow and DPO for buyers and improve cash flow and finance costs for suppliers. In situations where buyers are heavily reliant on key suppliers, SCF is an attractive financial tool to create an incentive for partnership. Furthermore, there is an even greater need for collaboration in low-margin sectors. SCF creates the opportunity for large corporate buyers to extend their payment terms or seek better pricing, but without detriment to their suppliers. Suppliers welcome the additional credit as it generally does not compromise the credit which may also be available from their existing banks.
There are various issues to be taken into account when setting up an SCF programme and companies should seek advice from the outset.
Lengthening payment terms is often considered desirable by buyers, but it can be damaging to supplier relationships and jeopardises suppliers’ financial stability. Average payment terms differ between countries and are generally longer for southern European countries than in Northern Europe. In Spain, a version of SCF, known as confirming, has been available since the early 1990’s, which enables suppliers to receive early payment while buyers can continue to benefit from long payment terms, often more than 180 days. SCF is now more widely available, although it is not currently used by the majority of companies. Those that take the opportunity to implement SCF are in a position to gain competitive advantage through more secure supply chains, better relationships with business partners and stronger balance sheets. [[[PAGE]]]
Fig 4 provides an illustration of a potential SCF solution in practice.
Costs of SCF
SCF is generally set up without cost to the buyer, so long as the volumes are sufficient. Instead, costs are paid by suppliers, which could include:
However, as the illustration shows, these costs are generally more than offset by improved financing terms, making an SCF arrangement highly beneficial for suppliers. [[[PAGE]]]
Legal and Accounting Issues
There are various issues to be taken into account when setting up an SCF programme and companies should seek expert advice from the beginning. Many SCF solutions, which have been operational for some time, should be reviewed in line with IFRS and US GAAP requirements to avoid possible negative accounting issues.
For suppliers, in order that the receivables are derecognised as assets, it needs to be clear that the credit risk has transferred to the financial institution. If the financing is “non-recourse” – i.e. the bank has no recourse to the supplier in case of non-payment by a customer, the asset is derecognised and therefore constitutes off-balance sheet funding. However, companies may have to report under different accounting principles where the requirements may vary. As a general principle, the position of the financial institution in the SCF arrangement cannot differ from the rights of the original creditors – i.e. the suppliers. Any additional improvement, such as:
is likely to result in reclassification from off-balance sheet financing to bank debt.
Reclassification clearly has an adverse impact on debt ratios and could trigger critical covenants in existing loan
documentation. Companies need to review restrictive covenants in place with their existing banks and ensure that they have the right to enter into SCF arrangements.
Bank Issues
Financial institutions providing SCF services are clearly most concerned with buyer-related risk. For example, the jurisdiction in which the buyer is located needs to be stable, such as an OECD country. Some of the specific risks a bank will consider include:
Inter-departmental Relationships
SCF relies on significant interaction between departments, particularly procurement and finance. In many organizations it is that individual departments have evolved more-or-less independently, so there is often too little integration of information flows. While processes within a department are frequently highly efficient, there has been less focus on the automation or timeliness of data transfer between departments. Dealing with this issue requires significant management attention and potentially investment in technology and business processes.
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Technology
Most platforms today are web-based, providing an easy-to-use, low cost interface for both buyer and suppliers in an SCF programme with little additional hardware or software requirement. When first starting to use such a platform, it can take a short time for users to become familiar with it, and initially, the number of exceptions may be relatively high, but this is likely to be resolved over time. In some cases, the platform will be configured according to the specific nature of the SCF programme. For example:
When setting up an SCF programme, the technology platform as well as financing arrangement is important to encourage suppliers to make use of the technology.
Supply Chain Finance has still not yet been leveraged to its greatest potential by many organisations; however with traditional debt forms of financing becoming more expensive and less accessible, SCF provides significant opportunities for both buyers and suppliers. Technology will play an increasingly important role in the delivery of effective SCF solutions, both to automate the exchange of information between buyers, sellers and financial institutions, but also to integrate the financial and physical supply chains. In this way, not only can financial counterparties share a common view of information and import/export data easily to/from their systems, but events in the physical supply of goods can trigger financing events. This leads to more efficient, timely financing, specifically adapted to the needs of each organisation.
Currently, SCF offerings are based on invoices approved by buyers. In the future, we anticipate that such solutions will be made available earlier in the financial supply chain, towards the time of the purchase order.
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