With the credit crunch pushing up the cost of borrowing, now is the perfect time for CPOs to get to grips with the financial supply chain
Under pressure to release capital, treasurers and finance directors are turning their attention to supply chain management and procurement. With the help of banks and other financial institutions, they now have some powerful tools at their disposal in the emerging area of supply chain finance (SCF).
Finance looks for cash tied up in inventory, payment terms and days payable outstanding (an indicator of the average length of time it takes a company to pay its suppliers) and seeks to change processes that are using unjustified amounts of cash.
Procurement support is invaluable in this kind of exercise, yet it appears to be lacking. I recently presented at an SCF conference in Hong Kong, and although procurement strategies were at the centre of every debate, I couldn’t find a CPO in the room. In the current climate, CPOs need to build their knowledge of SCF, understand whether and how their company can use it, and seek to influence the decisions made by their finance colleagues.
Why is SCF now on the agenda?
As well as the need to find financial efficiencies, there are structural reasons. The letter of credit (LC), traditionally used to finance small and low credit suppliers, particularly in emerging countries, can be cumbersome and costly. For cheaper finance, the current trend is to move suppliers from LC to “open account” (the international trade equivalent of a bank current account). This has worried the banks. An LC needs the bank as an intermediary throughout the transaction, whereas open account only needs the bank at the end to make the final payment. Because an estimated 85 per cent of world trade is now done on open account, banks have responded to this shift by improving their SCF services.
What is SCF?
Supply chain finance generally relies on so-called “factoring” techniques. Between 2001 and 2007, global factoring volume grew by 89 per cent (see figure 1). China alone saw growth of over 2,500 per cent. In standard factoring, a supplier sells its accounts receivable to a lender – or “factor” – at a discount, usually including interest and a fee. This allows the supplier to receive cash immediately and reduce its days sales outstanding.
To get access to this type of finance, the supplier needs to be creditworthy, but in some emerging countries credit information is not always available. Without an excellent credit rating, suppliers will not get this type of financing at a reasonable cost.
Whether the supplier gets a loan to finance its working capital or discounts its invoices through a local form of factoring, the cost is likely to be prohibitive. The solution is “reverse factoring”, based on the concept that the buyer – usually a large multinational company – has a better credit rating than its suppliers.
How does SCF work?
A buyer uses its company’s high credit rating to get cheaper finance for its supplier and inject cash into the supply chain. The lender/factor (bank or financial institution) checks your business credit information and calculates the credit risk on your organisation, rather than your supplier. Since the cost of financing for a large company is much lower than for a small supplier located in an emerging market, sourcing becomes financially efficient.
In practice, the supplier sends you their invoice for approval via the factor/bank system. Once approved, the supplier can discount the invoice immediately and get access to cash or, alternatively, can choose to wait until the invoice is due. Lastly, your company pays the factor/bank at the invoice due date.
Your supplier can even finance its production cycle with a pre-shipment formula. In this case, the buyer sends a purchase order (PO) to the supplier, along with a copy to the bank. Within days of confirmation, your supplier can have access to working capital. When your order is ready, the supplier dispatches the goods and sends copies of the invoices and shipping documents to the bank. Again, your company pays the bank at the invoice due date.
Based on this format, the financial industry has developed a whole series of highly automated, web-based services and can finance almost any stage of the supply chain, from raw material to final inventory in almost any country, for manufacturers and distributors.
Generally, SCF is reserved for regular suppliers with a trading history and covers only a certain percentage of the invoice total. It works well for strategic suppliers or suppliers with a lower credit rating operating in an environment where there aren’t many competitors to choose from.
What are the benefits of SCF?
Supply chain finance brings several benefits. The supplier can get access to cheap working capital financing at the stage of the PO, and improve its cash flow and its borrowing by not using its credit line. The bank gets access to a group of new suppliers and has some opportunity of cross-selling while getting closer to its customers.
For the buyer, meanwhile, the benefits can be found at different levels of the business. At the operational level, SCF reduces the total financial cost and therefore the total ownership cost. By providing your suppliers with working capital, you can strengthen the relationship with the supplier, which in return might be willing to negotiate better terms. From a management standpoint, SCF will increase your days payable outstanding and help reach business targets for working capital and cash-flow performance indicators. Furthermore, whereas a letter of credit is treated as a debt on the company’s book, often SCF is not.
At a strategic level, SCF might help you to outsource accounts payable, because in practice you will make one payment to one factor instead of several payments to a group of small suppliers. Under certain circumstances, SCF can even move inventory off the balance sheet to a third party, although whether this process is compliant with accounting rules is being debated in several countries at the moment, particularly the US.
Are there any limitations of SCF?
There are plenty. For instance, if your company doesn’t have an ERP system already in place you might face high initial costs in integrating with a bank’s systems. Internally, business processes and systems might have to be redesigned. There is also an aspect of tax treatment that might have to be considered, as in some countries VAT is charged on the entire transaction instead of the factor’s fee. And the cross-border regulatory environment for SCF can be quite complex.
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Although it is managed by finance, SCF can’t work without procurement because it has the primary relationship with suppliers. But to contribute effectively, it needs to improve its visibility into the financial supply chain and master the business-critical operating and working capital indicators to identify where savings can be generated.
CHECKLIST:
Getting started
- Check the regulatory environment in both buyer and supplier countries.
- Choose the most appropriate financial partner (not necessarily a firm’s bank).
- Choose the right software to work with your ERP system and provider’s platform.
- Design a process to select, train and convert suppliers to SCF.
- Convert suppliers by group, not all at once, and do a test run before going live.
- Use written procedures to support every process.
- Regularly audit your SCF processes.
Catherine Truel (ctruel@mac.com) is a director of International Trade Instrument, a provider of business intelligence, based in Glasgow, Scotland.
