Taking a holistic view of the financial supply chain has become one of the hot topics in the international treasury circuit. During 2007, we will be examining the different issues surrounding the supply chain and the ways in which treasury can add value by helping to manage the supply chain. In this month’s article, we provide an introduction to the core concepts.
What is the supply chain?
The supply chain is a concept which is used to describe the processes involved in trade. This ‘chain’ can be broken down into two different elements: the physical and the financial supply chains. The physical supply chain consists of the processes involved in the physical movement of goods along the supply chain and includes areas such as shipment tracking, inventory management and document management. The financial supply chain meanwhile, identifies the financial flows resulting from the physical supply chain.
The physical supply chain begins with the sourcing of raw materials and ends with the receipt of the finished product by the end customer. While this type of model is most applicable to the manufacturing industry, it can also be applied to a certain extent to companies selling services instead of goods. Virtually all companies will have suppliers who provide raw materials – although in some cases this may simply be office goods such as stationery – and will have customers, even if no physical product is changing hands. Likewise, all companies will have cash flows relating to these transactions. As a result, the principles of financial supply chain management can be applied to all companies to a greater or lesser extent.
The idea of financial supply chain management has been gaining momentum among corporate treasurers in recent months. The onslaught of international competition in the world trading arena has meant that companies increasingly need to cut costs in order to survive. One strategy that companies have historically taken in order to do this is to focus on managing their physical supply chains in order to achieve cost savings and greater efficiencies.
Developments in ERP technology have enabled companies to develop more efficient processes and gain visibility over the movement of goods with great success. This increased visibility has in turn allowed techniques such as just-in-time delivery to become more widespread. In this model, raw materials are not held for any length of time, but are instead purchased on a need-to-use basis, resulting in lower levels of inventory, reduced costs and a more efficient production cycle. The best known example of this is Dell, which has developed a slick direct business model in which computers are built to order and shipped directly to customers.
Working capital management
However, until now the opportunities for other companies achieving similar results have been comparatively few. As a result of the inefficiencies embedded in these processes, an estimated €500 billion is said to be locked up as working capital in the financial supply chain in Europe alone. So in recent years there has been a lot of talk about working capital management, which has always been an area of interest to the treasurer and CFO.
As the evolution of a centralised approach to treasury has enabled treasurers to gain greater degrees of control over their cash – and in turn their working capital – companies have started to realise that the types of techniques used to optimise the physical supply chain processes may also be applied to the financial aspects of the supply chain – with the possibility of achieving similar benefits.
The defining principle of financial supply chain management is looking at processes on a holistic level, rather than as individual processes. Specifically, these are the end-to-end processes which form the purchase-to-pay and order-to-cash cycles, including the processes involved in ordering, invoicing, reconciliation and payment. The goal of financial supply chain management is to obtain visibility over these processes so that efficiencies and cost savings can be achieved throughout the chain. It can be said that working capital management is the part that sits between the purchase to pay and order to cash cycles.
Processes in the financial supply chain
The purchase-to-pay cycle is the trade cycle from the point of view of the company making a purchase. During the purchase-to-pay cycle, the company selects, receives and pays for the materials or other inputs needed in order for it to produce its goods or services.
The order-to-cash cycle is the same cycle from the supplier’s perspective. It begins when a quote is prepared for a customer and ends when payment has been received and reconciled with the appropriate invoice. From a treasury and finance point of view, the key area in this cycle is the accounts receivable function. Once an invoice has been issued, the finance function’s role is to collect payments as efficiently as possible.
Most companies will deal with both suppliers and customers and will therefore need to manage both purchase-to-pay and order-to-cash cycles.
However, there is also a growing realisation that the financial supply chain involves lots of different parties, all of whom can affect the overall efficiencies. Financial supply chain management is therefore characterised by looking at the associated processes, not only from an internal point of view, but also from the point of view of the other parties in the chain. In other words, a multinational should be looking at its suppliers and distributors as well as at itself, and considering how their actions impact on the supply chain overall.
Specifically, companies that are focusing on their financial supply chains are interested in:
Obtaining visibility over all the processes involved in the financial supply chain.
Increasing efficiencies throughout the chain.
Reducing costs throughout the chain.
Freeing up working capital by obtaining a clearer picture of where funds are required.
Adopting a collaborative approach towards other parties in the chain.
As the profile of financial supply chain management continues to grow in the treasury community, so does the number of solutions which claim to fulfil the treasurer’s needs. Many of the banks have moved away from talking about trade finance to describe their trade offerings in terms of the supply chain, while a large number of suppliers are now claiming to offer products which can optimise the supply chain. This can be confusing, as the supply chain is in itself a broad concept which is interpreted differently by different parties. The types of product on offer range from e-invoicing solutions to financing techniques – as well as more holistic solutions encompassing a number of different processes – so it is important to be aware of the different approaches which can be employed to manage the supply chain and the different types of product which can be used to do so.
The role of the treasury
Until recently, many of the processes involved in the supply chain have not been seen as part of the treasurer’s remit. However, as the role of the treasurer has evolved away from being focused simply on cash management to become wider and more strategic, the concerns involved in supply chain management – the relationship between cash management and trade – have moved into the treasurer’s arena. The financial supply chain is by its nature very broad, encompassing accounts payable and accounts receivable, cash management, risk management and procurement. With the role of the treasurer increasingly moving into these areas, the treasurer is well positioned to be involved in the management of the financial supply chain, whether on an advisory or a hands-on basis.
The diagram below shows how the role of the treasury has evolved in relation to the financial supply chain:
Historically, the treasury has been focused on managing the company’s cash, but this has gradually expanded to include a number of other areas of the supply chain. The traditional treasury model evolved to encompass some of the processes at the very beginning and end of the financial supply chain – ie the company’s payables and receivables arising from the sale and purchase of goods. For many treasuries, the first step into financial supply chain management was taken by looking at the credit terms enjoyed by the company and offered to suppliers – ie the processes at the beginning and end of the financial supply chain.
“Managing the financial supply chain to optimise working capital, is a core focus for treasuries nowadays. This is a natural evolution since supply chain management is something that industrial companies have focused on for years. Although finance is important, it is not core business for the corporates, and therefore it has not been prioritised until now. Working capital projects have historically not been part of the treasury mandate – this is however changing, allowing treasuries a much broader mandate than they have had in the past. For many treasurers, this is a new and difficult challenge, because they do not yet have the ‘hands on’ experience. The role of the banks is also changing, supporting companies with a wealth of experience in this field, from all kinds of industries.”
Erik Zingmark, Global Head of Cash Management, SEB
More recently, with the growing emphasis on working capital, the treasury has become more involved in the processes at the centre of the financial supply chain. Working capital management is concerned not only with payments and collections, but also with the turnover of inventory. The longer inventory is held, the longer the company’s cash is tied up, directly impacting on the company’s available working capital.
As an extension of this, a treasury which is looking at the financial supply chain holistically, will also include areas such as cash flow forecasting and financing arrangements. The scope of treasury’s involvement in these processes is widely acknowledged to be expanding, continuing the ongoing trend of the treasurer taking on additional responsibilities and developing expertise in a wider range of areas.
While the concept of the financial supply chain is not new, the past 18 months have seen a significant and sustained burst of interest in this area. So why is this topic sparking so much discussion now? There is a consensus that the development of technology has played a big part in this – as greater levels of automation become possible, corporates are becoming more ambitious in considering how technology can be used to smooth out processes throughout the business. Meanwhile, the stricter regulatory environment post Sarbanes-Oxley has naturally led to higher expectations regarding the levels of automation and visibility that must be achieved in order to make accurate reporting possible. Using this to obtain cost savings is a natural extension of this.
The rise of open account trading has also had an impact. The use of letters of credit has been falling as companies become more comfortable with trading on this basis. As a result, the role of the banks in international trade has had to change in order for the banks to maintain their position as intermediaries in the trade process. Many of the solutions being developed by banks are therefore being influenced by this shift to offer products more suited to today’s trading environment – such as supplier finance.
In our new research report on Managing the Financial Supply Chain, due to be published later this year, we will have a more detailed look at the latest techniques available to companies looking to optimise their supply chains.