Published: June 02, 2012
Supply chain finance, and especially reverse factoring, is on the rise. Starting in the car industry, this form of financing has gained increasing popularity in other industries as well. Although much attention is given to the virtues of this innovative way of financing and its bright future, less attention is paid to the implementation side of things. All nice and well, but why then does SCF not triple every year, and what exactly does it take to reap the real benefits? In this article, we try to give some of the answers, and propose an approach for interested companies to determine whether SCF is worthwhile for them and how implementation can be managed.
Reverse factoring is a form of supplier financing where suppliers sell their accounts receivable on a large creditworthy buyer to a bank, in return for quick payment by the bank. The bank, in turn, collects the receivables from the large creditworthy buyer on a longer term than the payment term which is usual between the buyer and supplier. This way, the large buyer uses its creditworthiness to get better payment conditions for both its suppliers and itself.
In schematic form, Figure 1 shows how it works.
As Figure 1 suggests, the process is simple:
1. Supplier delivers the ordered goods and sends the invoice to the buyer (as usual)
2. The buyer checks the delivery and the invoice (as usual)
3. After approval, the buyer sends the invoice to the bank for payment
4. The bank pays the invoice (-/- discount) to the supplier on behalf of the buyer (immediately after receipt)
5. The bank collects the advanced amount from the buyer (after an extended time period)
6. Supplier and buyer can monitor the status of the supplier invoices on the bank’s web portal.
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As a result, the supplier gets paid quicker and the buyer may pay later than usual. The bank shortens both parties’ cash conversion cycle and gets paid by the discount in return. It’s important to see how the contractual relations between the parties change, as shown in Figure 2.
Figure 2 shows that:
(1) The relationship between supplier and buyer remains unchanged (a normal sales & purchase contract)
(2) The buyer gets an ‘uncommitted borrowing facility’ from the bank, meaning that the latter can end this facility at any time. The bank engages to limit its discounts to suppliers to a maximum % of invoice value.
(3) The supplier gets the bank’s commitment to pay the invoices immediately after approval by the buyer, against a discount rate, representing the interest the supplier pays over the invoice amount which is now received so much earlier than usual. This interest rate is significantly lower than normal, thanks to the creditworthiness of the Buyer.
Although the contents of the contracts are perfectly harmonised, they are legally independent. In addition, the borrowing facility is callable at any time by the bank, because its validity is conditional upon the existence of the sales and purchase contract between supplier and buyer.
In sum, SCF is a win-win-win proposition: the bank increases market share, the buyer gets longer payment terms and a steadier supply base, suppliers get cheaper and quicker finance.
Many foresee a bright future for supply chain finance, but it depends on who you ask. Academics and banks are convinced of the rise of this innovative way of finance, and propose a compelling argument in favour of their expectations: both suppliers and buyers are looking for alternative sources of cash, now that banks are increasingly restrained in providing classical credit facilities. Of course, companies can create substantial additional cash flow by better managing their operating working capital, independently of their banks. But if there is a way of unlocking cash flow potential through the bank, why not use it? For the banks, this is a way of regaining some of the territory they lose as a result of restrained rules for credit supply. In addition by providing credit the traditional way (unsecured, or just based on the buyers’ accounts receivables and inventories), they can now also finance the buyers’ accounts payable by buying the invoices from suppliers. By entering the supply chain of their clients, banks not only increase their financing volumes, they also strengthen their relationships with clients as strategic partners. SCF also reduces the risk of dispute about the invoice (electronic screening signals possible disputes in an earlier stage), and lowers the bank’s costs of credit assessment.
But what about the clients themselves, the buyers and suppliers - are they equally keen to embrace SCF as a strategic solution, and embed it in their ways of doing business? As with many innovations this takes time, and economic circumstances, technological (im)possibilities and human behaviour (awareness, attitude) turn out to be the key determinants. Car makers started to use the reverse factoring principles in the 1980s to keep their suppliers in business and to negotiate better margins. It has subsequently spread to the retail industry, where payment terms are critical in every negotiation. In the US and the UK, the SCF concept has gained substantial recognition among large corporations like Wal-Mart, M&S, Sainsbury’s and Tesco. In the Netherlands, a few multinationals (like Unilever, IFF and Philips) are currently using supply chain finance techniques.[[[PAGE]]]
The concept has proved to be relevant for industries with a long supply chain and strategic relationships between buyers and suppliers and where there is a requirement to hold inventory and to extract efficiencies from operations, as in retail, automotive and manufacturing. It is also common in the engineering and machinery industry and gaining interest in the chemical, pharmaceutical and telecom industries. Some surveys suggest that, although half of the companies discuss capital cost differences with their suppliers, in practice the majority still choose to set payment delays as late as possible or according to industry standards. As Professor Seifert put it in 2009: ‘Financial integration today is more spoken about than really brought into practice.’ In 2010, a Demica survey among 1,500 European companies (UK, Germany and France) indicated that some 25% of European large corporations had gained experience with SCF programmes. In 2011, a GT News global survey reported that 43% of buyers and 34% of sellers used SCF to manage open account associated risks, and that 45% of respondents would consider the launch of a supply chain programme in order to use the possibilities in the balance sheet in the future.
The key challenge for buyers in launching their SCF programmes is the participation of their suppliers. As a rule, at least a 60% participation rate in the first wave is required for a successful SCF programme launch. Being used to their buyers’ classical negotiating style (i.e., using their bargaining power to obtain longer payment terms and/or better margins), many show initial scepticism about a seemingly complicated programme which seems to be ‘too good to be true’.
In the end, the success of SCF and its pace of adoption is determined by its weakest link. Parties have to learn to trust each other in order to make this collaborative form of financing work. Banks have already invested heavily in facilitating this form of financing, and buyers and suppliers are gradually adopting it, requiring considerable adjustments and investments on their part as well.
Whereas the benefits of implementing SCF techniques are significant, reaping them involves overcoming significant hurdles. Complications can be classified as Legal & jurisdictional, Technological, Operational and Organisational.
Because this collaborative form of financing is a set of interdependent agreements between principally three partners (but in practice a multitude of these, due to the legal structures of the incumbent parties), their tailoring to each parties’ requirements and restrictions as well as national differences is a meticulous, knowledge-intensive process.
In practice, SCF arrangements will take different forms, e.g., recourse or non-recourse based, combinations with open account or L/C financing, or combinations with inventory financing arrangements. The banks who are buying receivables want to make absolutely sure that they become the legal owners of the receivables, and can exercise their rights in the concerned countries. The biggest challenge for the bank is to make sure that the buyer makes a payment commitment to the bank upon approval of the supplier’s invoice, because this is the basis on which financing is granted to the supplier. Not only this payment commitment but also the speed of approval requires attention.
From an accounting perspective, regulations regarding the treatment of extended payment terms may differ between countries: dependent on the length of the payment term, the buyer’s outstanding amount to the bank can be treated as an account payable or must be treated as debt, the latter affecting the company’s solvency ratio.
Facilitating an error-free, seamless and efficient processing of the transaction streams requires sophisticated technology platforms and outsourced solutions, demanding considerable investments by the providing banks and, to a lesser extent, the buyers. The challenge is to tailor them to the supply chain’s specific needs and make the technology accessible for participants without forcing them to invest heavily in IT development, nor burdening them with additional manual work for correct invoice treatment.
It is obvious that the error-free, seamless and efficient functioning of the SCF framework is not achievable by technology alone. It equally requires adapted operating processes and measures of internal control in the areas of purchase-to-pay, order-to-cash and record-to-report. Processes must be (re)designed to meet the new performance criteria in accuracy, reliability and speed. In particular, the time needed for receipt and approval of goods by the buyer is critical in the total cycle time of the suppliers’ invoices, and thus, the working capital gains both suppliers and buyers achieve through SCF. Suppliers’ processes (i.e., timely invoicing) should therefore be assessed before accepting them in the SCF programme. In some cases, self-billing has proved to be an effective instrument in reducing through-put time and the dispute rate.[[[PAGE]]]
As mentioned, whether an SCF programme is successful is largely determined by the participation of suppliers. They are large in number, are used to hard bargains with their buyers and mostly do not have the specialist treasury and financing knowledge of their buying counterparts. In addition, they may experience resistance from their current banks about the SCF-driven co-operation with new banking partners. Convincing a sufficient amount of suppliers, often sceptical about complicated programmes they may not fully understand, is a challenge which requires effective cross-function co-operation within the buyers’ organisations and with the involved bank(s).
Launching an SCF programme, including the on-boarding of a majority of suppliers, requires strict alignment between treasury, finance, legal, IT, logistics and procurement departments about the priority given to SCF as well as its objectives, approach, milestones and responsibility schemes. However, although treasury and finance may perfectly see the economical benefits and financial mechanics, these insights may not be equally shared by operational and procurement professionals, dealing directly with the suppliers, for whom transparent communication about the benefits and challenges is essential. Therefore sponsorship at the highest executive level in the organisation is a necessity. Some even suggest that the CEO should lead the initiative, because functional executives don’t always have the required clout to keep all stakeholders (including suppliers) on board.
Keeping in mind the impressive benefits associated with SCF on the one hand, and the respectable challenges to make it work on the other, buyers have strong reasons to invest in a careful, phased approach for considering and implementing it. The approach must provide for the key success factors: 1) sound decision-making and executive board sponsorship 2) selecting the right bank partner (legal strength, geographic presence and financial strength) and 3) sufficient participation of qualified suppliers.
First, a thorough feasibility study must reveal the real potential for the buyer firm, taking account of its financing history and trading terms with its suppliers and potential improvements and efficiencies in operations, payment terms and cash flows. This will also involve quantitative assessment of the potential benefits and costs for the suppliers, as this determines the possible suppliers’ participation rate. The feasibility study must carefully explore and weigh the implementation challenges as described briefly above. It also identifies and assesses the alternative banking partners, IT and process partners for the implementation, and outlines the strategy for on-boarding of the suppliers. A sound feasibility study is the basis on which top executive sponsorship and internal alignment is built.
Secondly, in the design and testing phase, the SCF structures (legal, technological, processes) are designed and tested, and both buyer departments and suppliers are assessed and trained in using the technological and process solutions. Parallel with this, the on-boarding strategy is executed, by means of which suppliers are selected, convinced and prepared for participation in the programme. The go/no go decision to launch is determined by the test results and the expected participation rate.
Finally, the SCF programme is launched to go live, during which multi-discipline teams guide and support buyer and supplier departments in the application of the new processes and platform technologies, and in effective cross-functional and cross-organisational communication. During this phase, teething problems will be solved in order to stabilise processes and performance, and new suppliers will be added to the programme after stabilisation.
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