Supply chain finance explained is a critical look at how to optimize the financing and flow of goods and materials through your supply chain. Most businesses, especially small businesses, don’t have a dedicated team to focus on it, which can lead to missed opportunities for cost savings and improved cash flow. This article will help you understand what supply chain finance is, what benefits it offers, and how you can start implementing it in your business.
What is Supply Chain Finance?
First, let’s start with what supply chain finance is. It’s an umbrella term that deals with the flow of funds through a business’s supply chain to increase cash flow. Working capital can be an extremely valuable resource for growing companies, as it injects liquidity into your business. Assets in businesses that are not long-term investments or fixed assets are referred to as working capital. They include short-term, liquid assets like accounts receivable (AR), inventory, and accounts payable (AP) and also include cash held within your operating cycle. Working capital is a requirement by every business and is the lifeblood of all businesses.
Supply chain finance (SCF) is a form of funding that optimizes working capital by paying suppliers immediately and then waiting for payment from the buyer at maturity. In this way, the buyer facilitates cheap borrowing for his suppliers. Usually, suppliers have to wait for some time before they receive payment from their customer (the buyer). SCF steps in to offer liquidity to suppliers on the understanding that payment will be forthcoming from the buyer.
Why is Supply Chain Finance Important?
It is important to buyers as it incentivizes the sellers to continue trading with them. You need your suppliers to continue supplying you with goods and services. Any support to them works well for you. Supply chain finance accomplishes this by introducing liquidity (money) to your customers without seeking banking facilities. By ensuring the buyers pay on time and the suppliers deliver quality goods, thereby helping maintain discipline in trade.
Maybe you are asking yourself who this buyer? The buyer is a large organization that procures goods and services from many suppliers. This could be Tesla Inc that has over 300 suppliers spread across the globe.
How Does Supply Chain Finance Work?
Now that we understand what supply chain finance is, let’s discuss how it works.
It starts with the buyer and sellers establishing a working relationship. The buyer intends to ensure that the supplies continue coming without disruptions, despite being supplied on credit terms. The sellers on the other hand want timely payment and assurance of new orders.
Banks and other working capital providers will be ready to finance if they are happy with the buyer’s commitment to making payment at the maturity date. The next challenge is how to manage this process because there are many small invoices involved. That is where FINTECH companies come in. They provide technical support linking the three parties, buyer, sellers, and the bank. Some banks already have the infrastructure to support supply chain finance in-house.
Essentials for supply chain finance
#1. The buyer is an established company with a good credit rating and requires a steady supply from sellers.
#2. The seller is able to supply to the buyer but requires working capital to continue doing so. The buyer wants goods on credit and is willing to support the seller by providing comfort to a third party that will finance the receivables.
#3. Fintech Company integrates the sales data between the buyer and seller with the bank’s system. This data allows the bank or other funding institution to know how much money is owing.
#4. Banks will be funding the buyer by discounting the payables on the understanding that the final payment will be coming from the buyer. Essentially, the bank will take the risk of buyer not paying.
What types of supply chain facilities are available?
Supply chain finance may be either receivable purchase focused or loan based. Under the receivables purchase arrangement, the bank discounts seller’s outstanding invoices with the understanding that payment will come from the buyer. The bank will hold the receivable as security, essentially removing the invoices from the balance sheet. On the other hand, under the loan-based structure, the banks take a view on the outstanding book and offer loans based on the same. These facilities do not reduce the receivable book.
Broadly speaking, the following are some solutions under this funding
This is where the bank funds medium to long-term receivables (mainly a financial instrument such as a letter of credit) without recourse to the seller. It mainly relates to international transactions and covers 100% of receivables.
Accounts receivable financing
Receivable financing based on accounts receivable (AR) is when a third party provides capital to your business by advancing payments for the invoices that are sent out to customers. For example, they can choose to provide up to 80% of the invoice amount. They also calculate an average collection period, your customers’ payment habits, current AR aging status, and past sales performance when making advance determinations. At maturity, the buyer will make the repayment. Disclosure of discounting agreement to the buyer is not necessary, making it cheaper than factoring.
This is where a lender (Factor) purchases the receivables at a discount from the seller. The factor then takes responsibility of managing the debtor book. At maturity, the Buyer makes payment. Discounting can be either with or without recourse. Recourse means that the factor has the option to claim unpaid invoices from the seller when the buyer defaults.
Also referred to as buyer finance, this program is initiated by the Buyer. Banks use the Buyer’s credit status to lend to sellers with lower credit ratings. Repayment will come from the buyer at maturity. Needless to state, there will need to be an agreement between the bank and buyer for this structure to stick. Discounting to the seller is without recourse.
Manufacturers sometimes steps in to support their distributors to get finance from banks. These are loans to the distributor to buy from the manufacturer. The funding goes to procure stocks held for onward re-selling. The manufacturer (anchor) needs to be keen on distributors repaying the loans to keep the facilities revolving. The anchor and the bank will need to have an agreement, although funding is normally without recourse to the anchor.
Loans against receivables
These are loans secured by current and future receivables to sellers with strong credit ratings. This is different from account receivables finance discussed above. Finance is with recourse to the seller and facilities are reviewed once a year.
In international transactions, supply chain activities start way before the goods are exported. Banks will fund exporters to procure goods for value addition before exporting. Or they will fund the exporters to procure and export without value addition. The exporter or the seller receives a loan for procurement with the expectation that repayment will come from the international buyer.
Also referred to as stock finance, these are loans to sellers to help them buy inventory. The inventory may be for value addition, re-selling, or hedging. Either way, banks hold the inventory as security and may even involve Collateral managers. Repayment of these loans will come from the buyers. This is a popular funding structure for commodities such as wheat and oil.
It is common for banks to mix some facilities discussed by offering customer-specific solutions. For example, the bank can offer a pre-shipment facility to you with the understanding that repayment will come from forfeiting facility once goods are exported.
How Do You Start?
You start by analyzing your operations and matching them to an existing solution. If this is difficult, do not worry. Engage a supply chain finance expert or even your bank.
What Should You Expect During the Process?
The process will depend on your operations and industry. If your operations are advanced with IT support, you should expect a quick turnaround. The onboarding process will take some time, but when the system is set up you will not be required to do anything except supply under contract.
What Are The Benefits Of Using Supply Chain Finance?
Benefits to the buyer
#1. Certainty of supply
There is the certainty of supply when payment is made upfront to sellers. So you can be sure that the items will be available to fulfill orders.
#2. Flexible terms: Working capital providers are able to accommodate various requirements from buyers, such as a requirement to have an invoice paid within 24 hours. Buyers can receive 30days, 60 days, or even up to 180 days terms of credit. They will have the option to match their cash conversion cycle with seller invoices.
#3. Digitalization: The use of electronic systems that allow them to get information from banks that provide funding for suppliers almost immediately. Making it possible to provide funds faster than other traditional forms of funding, such as corporate bonds or term loans.
#4. Healthy Balance Sheet: Supply chain finance removes debt from the books of buyers. By doing this, there is another benefit. It avoids costs relating to lending activities that are effectively transferred to sellers. Sellers are too happy to take these costs as the cheaper funding replaces expensive ones.
Benefits to the supplier
#1. Working capital availability to continue supplying. A supplier would otherwise have to wait longer for payment from buyers necessitating the need to borrow.
#2. Cheaper funding: this funding is at a lower rate of interest than other solutions. This is because pricing is based on the good credit rating of a buyer who has a proven track record.
#3. Continous growth on the balance sheet and profitability: The continued supply to the buyer will lead to the good business health of your company.
#4. Replication: Although difficult, suppliers are also buyers of goods and services from other companies. For example, an SME may be buying from MSME. You can replicate this structure.
What Are Some Tips For Ensuring A Successful Experience With Working Capital Products?
When choosing a working capital financing product, you should be sure to structure your business in such a way that it is flexible and can handle any changes in terms. Working-capital loans are typically structured as revolving credit lines, which means that you will have access to the funds and can use them whenever and however you want. You will also need to be sure that your business can manage these funds properly to avoid debt. Working capital loans usually have a low-interest rate associated with them, but this may not be the case if you do not repay on time.
- Understand your supply chain well.
- Offer credit terms that coincide with the terms you have been provided to avoid a mismatch in funding.
- Analyze the funding costs in detail.
- Do not discount for the sake of it. If you don’t have a funding mismatch or have adequate supplier finance, then don’t discount.
What are risks in supply chain finance?
The following are the risks to :
- Nonpayment by the buyer. When the buyer is unable to pay at maturity, it means that the SCF provider will be out of pocket.
- Goods returned, and commercial disputes, can dilute the value of sellers’ debtor book, thereby jeopardizing the bank. In the course of business, events will happen where credit notes will be issued. Credit notes and similar instruments jeopardize SCF structures.
- Double financing is another risk. The seller may present the same invoice to two funders fraudulently.
- The seller can also generate fake invoices.
- There are no guarantees that supply chain financing will improve your company’s cash flow. Working capital financing may take a while to have many positive effects on your business’s cash flow, and it is important to note that this solution is only temporary. Working capital lending arrangements often last for one year or less.
- In an economic downturn such as the COVID-19 pandemic, companies are not able to repay their loans. Working capital financing may make it more difficult for companies to repay their loans if business conditions are bad, which can result in the company defaulting on its agreement.
- The seller and buyer may collude to defraud the banks.
- Nonperformance by the seller is another risk that will expose the buyer and lenders. For example, offering substandard goods.
- If you are dealing with an international buyer, then you are exposed to country risks as well.
Difference between Trade Finance and Supply Chain Finance:
Supply Chain Finance is a form of trade finance that makes it possible for a supplier to secure goods or services on behalf of the company. It solves working capital problems for the sellers while at the same time providing credit terms to the buyer.
Trade finance on the other hand has other products such as letters of credit, bank guarantees, and documentary credits. They solve other problems such as none performance and non-payment. They also act as a payment mechanism.
Supply Chain Finance vs Factoring:
The term Factoring relates to a transaction in which a business sells an asset to another company in exchange for money. Factor companies also buy accounts receivable from businesses that are having cash flow requirements, but factor transactions aren’t necessarily tied to supply chain finance. They may be used when companies need cash quickly due to management or other issues. Supply chain finance, however, is a broader term used to describe many activities, including Factoring.
What is sustainable supply chain finance?
Today, we live in a world where sustainability is key to doing ethical business. Global buyers are increasingly driving ethical and environmental practices down their value chains. Therefore, Sustainable supply chain finance relates to lending that is done in a way that doesn’t harm the environment or put an undue burden on the supplier. This approach requires strong relationships between suppliers and finance providers, excellent knowledge of supply chains, and careful risk assessments to ensure sustainable lending decisions.
In conclusion, Supply Chain finance is a valuable tool for any business. Whether you are just starting out or have been in operation for years, supply chain financing can help your company save money and improve cash flow while also helping to grow your bottom line. The process of getting started with supply chain finance may seem daunting at first, but it doesn’t need to be if you take the time to understand what these options offer and how they work before committing to anything. To make sure that this venture goes smoothly from start to finish, you need to consider the tips on ensuring success when using supply chain financing products. My advice is to work with an expert in your area to avoid future problems. Lastly, although I have talked about banks in this article, there are many many non-bank working capital providers out there.
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