Companies in the modern globalised environment exist to add value, through the provision of raw materials, through manufacturing processes or through the provision of services. It is a mistake to think any company exists in a vacuum all companies are linked and those links continue to become more complex.
Traditionally, the banking industry has tended to consider suppliers, manufacturers, service providers and end customers independently. However, as working capital management has become more important to companies, the inefficiencies inherent in this approach have become more obvious.
"For example, in an interaction between a supplier of components and a manufacturer such as an auto company, the stronger party which might be the auto firm can push the pressure of financing and delivery on to the supplier," explains Dermot Canavan, Regional Trade Product Head EMEA and Trade CAO, RBS. The auto company might seek to pay the supplier after 60 days rather than the current 15 days. As the supplier depends strategically on the buyer, it has to accept these terms.
However, the extension of the terms by an additional 45 days creates inefficiency in the value chain. The buyer is effectively borrowing money from its suppliers through the extension of terms. The inefficiency occurs because the cost of funds for the supplier is higher than the cost of funds to the buyer. This increase in supplier costs is likely to be passed back to the buyer in higher prices for materials and, ultimately, that higher cost will be passed on to the end consumer.
A holistic view
In the past, banks looked separately at funding for suppliers and buyers. Now they look at the entire value chain rather than at individual customers. By taking a holistic view of lending across the value chain, inefficiencies can be spotted and eliminated.
In the example above, the auto firm is rated higher than the supplier and has a lower funding cost. The solution? To provide funding to the supplier but at a funding cost that reflects the rating of the buyer.
This solution provides value for both parties. The supplier might have a borrowing cost of 6 per cent (compared to the buyers funding cost of just 3 per cent) and get paid after 30 days. The buyer might want to extend its payment terms from 30 days to 60 days.
Rather than paying 6 per cent for that 60 day funding, the supplier using supplier finance can fund itself at 3 per cent. Consequently, there is no additional financial disadvantage to the supplier of extending terms. While the invoice now states terms of 60 days, the bank can discount it to the supplier so it can receive payment on day zero for just 3 per cent.
For suppliers, there are multiple benefits from a supply chain finance solution. Suppliers credit lines are not used, which releases pressure on their balance sheets. The solution also strengthens the strategic relationship between buyer and supplier, providing greater security. Finally, the supplier is able to agree to extended terms from the buyer at no additional cost to itself and gets a lower cost of funds than would normally be achievable.
For the buyer, the benefits are straightforward. It can extend payment terms and improve its liquidity position. Moreover, in a well structured programme the payment is classified as a trade payable rather than a bank or capital markets debt, which helps to improve its balance sheet.
For the bank provider, supply chain finance is advantageous because it creates the opportunity for additional business. Moreover, the risk associated with lending is reduced because by establishing a supplier finance programme with self-liquidating transactions there is an increased incentive for the buyer to pay its invoices promptly and there is a much lower risk of payment not being made at all. "The buyer, supplier and bank all win," notes Anil Walia, Head of Trade and Supply Chain Advisory, EMEA and UK, RBS.
Supplier finance can be extended up and down the value chain without changing the relationship between parties. The only change that takes place is a greater willingness between parties to cooperate to add value. "Historically, there was little concern among buyers about where suppliers' liquidity comes from as long as their terms were improved," says Canavan. "Now there is recognition of the competitive benefits of engaging with suppliers through supply chain finance."
Benefiting the entire company
In the past, many companies adopted a silo approach to purchasing, finance and sales, with little consideration of the value chain within the company. For example, the Key Performance Indicators (KPIs) of functions within a company may have been starkly different: the finance function may have been focused on liquidity and balance sheet management while purchasing focused on gross profit. In practice, the misalignment of different functions' KPIs can have a considerable negative impact. Many invoices have terms of 45 days but offer payment at 15 days with a 2 per cent discount: a supplier that wants payment at 15 days is effectively giving up 24 per cent a year. Given the higher cost of funding to a supplier (relative to the buyer) this is extremely inefficient. In addition, these higher costs are likely to be passed on to the buyer. The purchasing manager is happy to pay the supplier early because the gross profit target has been achieved. However, for the finance function, early repayment adversely affects the balance sheet target: its preference would be to pay later and retain the additional 30 days' liquidity.
Traditionally, these contradictions in KPI targets were difficult to reconcile. A more efficient way to address this situation would be to recognise that if a supplier is willing to absorb costs of 24 per cent a year, a better real cost for those supplies is achievable (improving gross profit and helping purchasing achieve its KPI). Furthermore, supply chain finance makes it possible to deliver liquidity to those suppliers that need it at an attractive cost. A bank can discount invoices at a cost of just 3 per cent a year compared to the 24 per cent the supplier was paying previously or the 7-10 per cent, maybe, payable through the suppliers own lines of credit, explains Canavan. That differential between rates facilitates the renegotiation of the commercial contract, allowing the buyer to reduce its purchasing cost. This way both the finance and purchasing departments are able to achieve their performance targets.
Combating the financial crisis
Just eight years ago, many of the ideas that underpin supplier finance were just that ideas. Now many thousands of companies both buyers and suppliers have benefited from supply chain finance: there is conclusive proof that it works.
Indeed, supply chain finance has proved especially beneficial in the turbulent period since 2008 when many small companies have found it difficult to get liquidity from their bank providers. Inevitably, some companies have faced bankruptcy and been forced to seek protection from the courts. By using discounted receivables as part of a supplier finance solution which can be kept out of any bankruptcy proceedings those companies were able to continue to operate until restructuring could occur.
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