Treasury Today Country Profiles in association with Citi

Supply chain finance and credit lines

This month’s question

“I have heard a lot about the benefits of supply chain finance solutions and how these can give suppliers access to cheap finance based on the credit rating of the MNC. But presumably this then uses up the MNC’s credit lines? How can this be a sensible course of action, given the current liquidity squeeze?”

Avarina Miller, Senior Vice President at working capital management specialist, Demica responded:

“SCF will not necessarily work for all supply chains – especially if your suppliers have access to more and cheaper liquidity than you. But where those conditions don’t exist and liquidity is scarce you have to optimise what liquidity there is and that may mean reducing your liquidity requirement and that of your suppliers. If you can free up cash flow and working capital and reduce pressure on your suppliers, you are simultaneously reducing your borrowing requirement and your sourcing/production flow risk. That is good use of liquidity. It is a matter of looking at liquidity from the point of view of your supply chain.”

Richard Sard, Senior Product Manager for Supply Chain Finance, J.P. Morgan Treasury Services, replied:

“The real benefits of a supply chain finance programme for an MNC are unlocked if the implementation of the programme is linked with the renegotiation of terms with their suppliers in order to achieve increased DPO and hence achieving a real cash benefit and improved working capital. If the programme is structured in a way that balances the needs of all parties (the MNC, their suppliers and the financing bank), then their suppliers will see benefits through cheaper finance, even taking into account the increased terms.

“Though supply chain finance makes use of the MNC’s credit lines, the potential improvement in working capital can be seen as more than an alternative to a working capital loan:

  • The benefits are directly related to the amount spent with suppliers, and will continue to accrue with each new purchase order with enrolled suppliers. Rather than a single cash injection, the improvement in cash flow will carry on flowing through future purchase contracts.

  • The use of credit lines is only to the extent that is directly attributable to actual finance paid to suppliers, while the MNC will benefit 100% from the extension of terms from suppliers.

  • If the programme is documented correctly by the bank, there will be no need to reclassify the payments as bank debt, and hence avoid a negative impact on the MNC’s debt gearing ratios.

“Alternatively, a cash-rich MNC may decide to work with their bank to offer supply chain finance to their suppliers in order to strengthen the relationship and add stability to their supply chain. With the current credit squeeze, it is a concern for MNCs that their suppliers have the financial stability to maintain their end of the supply chain. Through supply chain finance an MNC will be able to provide cheaper finance to selected suppliers where this will benefit all parties, and having considered whether this is the best use of their credit line.

“Hence, though supply chain finance makes use of credit lines, it does so in a very efficient way which avoids the MNC showing more bank debt than necessary. Though supply chain finance is not a solution for all MNCs, in the right circumstances it will provide real benefits to working capital and reduce the need for further bank finance.”

Marcus Hughes (Head of Trade Services) and Alberto Amo Mena (Head of Supply Chain Financing Services) of Banco Santander also shared their views on supply chain finance:

“It is true that thanks to supply chain finance, suppliers can sometimes obtain access to lower cost finance. This can arise due to a number of scenarios, such as:

  • MNCs/creditworthy corporates having easier access to lower all-in costs of finance than smaller unrated suppliers, which banks take into account when pricing discounted settlement on approved invoices.

  • Currently some banks’ own funding costs have risen above normal inter-bank market rates, due to the application of a premium. This situation reflects perception of credit and/or country risk and is giving a funding advantage to larger, better rated banks who can pass this pricing benefit on to their corporate customers, including suppliers participating in supply chain finance programmes.

  • Similarly, some corporates find that the only credit they can access in local markets is expensive, due to high interest rates locally and/or the general practice of higher margins than in other more open markets. This local pricing can be greatly improved on by cross-border supply chain finance solutions in which rates can sometimes be less than half the cost of local currency borrowing.

“The credit limit established by a bank to support a supply chain finance programme is marked against the buyer. The buyer does need to bear this in mind, along with its own liquidity needs, when considering launching a supply chain finance programme. But this is a short-term, trade related, self liquidating facility, with a lower risk profile than many other types of finance. Banks with long experience in supply chain finance understand the underlying risks here and know how to manage their portfolio to minimise the potential impact on a buyer’s credit limits.

“It is also important to note that, whilst the bank does mark a notional limit against the buyer, under a well structured supply chain finance programme early settlements made to suppliers do not appear as bank debt on the buyer’s balance sheet. Instead, if properly managed and documented, these trade payables continue to be classified as trade creditors, thereby not impacting negatively on the buyer’s debt gearing. This is because an experienced bank would be purchasing receivables direct from each supplier participating in the programme. Hence before offering an international supply chain finance solution, significant effort has to be invested in understanding legal and accounting issues, such as the importance of perfecting receivables assignment under a suitable legal system for each supplier.

“No bank is suggesting that supply chain finance/reverse factoring is the solution to all trade and supply chain situations. Other solutions, such as pre-shipment finance for exporters, may prove more appropriate, or post shipment invoice discounting. In both these cases, the bank looks to the sales proceeds and the supplier as its principal source of repayment, whereas in supply chain finance/reverse factoring it is the buyer who is the source of repayment, on settlement of invoices at their maturity.

“Let us remember that there are many other advantages to supply chain finance, in addition to the favourable pricing some suppliers will obtain on discounted early payments. Here are just a few examples:

  • Suppliers can obtain non-recourse funds, converting accounts receivables into cash, hence reducing Days Sales Outstanding (DSO).

  • Suppliers not requiring the cash immediately still receive early and accurate visibility of future cash flows.

  • Buyers can, in some cases, at no direct financial cost, negotiate extended payment terms, improving their working capital position (extending Days Payable Outstanding, DPO), in exchange for helping suppliers to reduce their cost of funding.

  • Buyers can use supply chain finance as a lever to negotiate lower pricing on purchases from participating suppliers.

“The old refrain that there is no such thing as a free lunch is highly relevant in supply chain finance, since the large buyer will expect to extract some benefit for using its balance sheet to support its supply chain, as shown in the above mentioned benefits of extended DPO or lower unit cost of purchases. By extending its own DPO, a buyer is in fact reducing its own liquidity needs without paying interest for this cash flow benefit. It is effectively using extended trade credit to reduce its bank borrowing needs. For many large corporates or multinationals, this is highly efficient use of balance sheet strength. However, this collaborative approach should prove to be a “win-win” for buyer and suppliers if properly managed, delivering improved working capital and lower costs on both sides. Hence the hot topic status that this subject currently enjoys.”

Next month’s question

“What sort of size should a company be before contemplating a shared service centre and where does the concept work well? Also, aside from the cost benefits, what other soft benefits are there?”

Have you set up a shared service centre? Do you have any knowledge or experience of the benefits of this model and the best ways of using it? If you have any advice to share, please send your comments and responses to qa@treasurytoday.com