In many senses, present market conditions have created the perfect opportunity for supply chain finance to thrive: buyers want to pay their suppliers later, but suppliers need to be paid earlier to stay in business. In this article we examine how supplier finance works and what the benefits are for both parties. We also look at the supplier finance implementation process and provide a checklist for companies considering such a programme.
During the financial crisis, suppliers’ working capital management has been hindered by a number of new and existing threats, which have in turn affected suppliers’ ability to fulfil orders and stay in business. These threats include:
Buyers extending their payment terms.
Increased cost of supplier credit.
Reduction in the availability of credit.
However, with high-profile instances of supplier failure impacting the high street, buyers have become increasingly aware of the need to support their suppliers in order to maintain their own supply chains. For example, in the UK the collapse of major high street retailer Woolworths led to its entertainment arm, EUK, going to administration. EUK was one of the major suppliers of CDs and DVDs to entertainment retailer Zavvi, formerly Virgin Megastores, which subsequently went into administration as the company ran out of stock to sell, due to the broken link in its supply chain.
A solution that allows the buyer to play a role in providing support to the supplier is supplier finance, which is sometimes referred to as reverse factoring.
Unlike traditional receivables financing techniques, the supplier finance arrangement is instigated by the buyer through its own bank. The bank is able to do this because the buyer’s acceptance of the invoice is an intrinsic part of the supplier financing arrangement, as illustrated in the sequence below.
The process has the following key stages as shown in the diagram:
Bank approaches suppliers nominated by the buyer and offers supplier finance terms.
Supplier ships goods to buyer.
Supplier sends invoice to buyer.
Buyer communicates acceptance of invoice to bank.
Bank pays supplier the discounted value of the invoice.
Buyer pays bank on agreed payment date.
In a supplier finance arrangement the supplier receives early payment for the approved invoice from the financier. The sum is paid up front, less a fee due to the bank. The fee, known as a ‘discount’, is a financing cost, usually based on the value of the invoice. The buyer then pays the face value of the invoice to the bank on the due date.
If the buyer chooses to pay the bank before the due date, interest would be accrued as the buyer’s account would be in credit. If however the buyer pays after the due date, interest would be charged as though the buyer had exceeded an agreed overdraft limit.
The details of the solution will vary depending on the financier, but may include the following:
Supplier finance may be offered on a non-recourse basis – ie the supplier is not held liable for the debt if the buyer fails to pay.
Some banks offer solutions whereby the supplier has the option of agreeing supplier finance terms with the bank while reserving the option not to discount its receivables, or to pick and choose which receivables are financed. Alternatively, it may be able to choose to have invoices discounted at a later date, providing that there is still enough time until maturity to make this worthwhile.
Alternatively, a fixed arrangement may be preferred in which finance is provided automatically for each receivable. This has the advantage of reducing the cycle time and processing costs.
Supplier finance can be particularly beneficial for SME suppliers, or those in emerging markets, who need cash quickly and are reluctant or unable to extend credit terms to their customers. Ian Armstrong, Head of Financial Supply Chain Solutions, Santander Corporate Banking comments, “With the right commitment from the buying organisation and the right partner, it can make a real difference to suppliers.”
Types of arrangement
Like traditional factoring or invoice discounting, supplier finance is usually arranged on a bilateral basis, between the buyer and its nominated bank. Before the financial crisis, some financiers began to offer a multilateral approach to supplier finance, taking additional participants in the chain into account. In some instances, a procurement utility would be used as an intermediary providing liquidity at multiple levels of the supply chain following invoice acceptance. The middle layers of the supply chain would then receive inventory financing based on the creditworthy buyer’s cost of capital.
However, as Armstrong remarks, “In my experience, the multilateral platforms that are available have had limited take up, particularly in the UK. The common platform approach may be suitable in some instances for major buying organisations such as government departments, for example, but in reality the multilateral approach is adding a layer of middlemen, which of course means more costs. That said, e-invoicing platforms can add real value to the supplier finance proposition, as they speed up the invoice approval process, meaning that suppliers can be paid even earlier.”
Benefits of supplier finance
From the buyer’s point of view, supplier finance represents an opportunity to maintain or improve their working capital position and strengthen their supply chain. The buyer does not have to pay the invoice early, meaning that cash can be used for alternative purposes.
In some cases, the buyer may also be able to negotiate price reductions with their suppliers in light of the improved payment conditions for the supplier and the supplier’s reduced cost of credit. Buyers can also manage supplier relationships more effectively, reducing the impact of extended payment terms and reducing the administrative burden of investigating late payment queries from the supplier.
Supplier finance should also provide softer benefits such as increased goodwill between buyer and supplier and increased supplier loyalty. As supplier finance provides support to the wider SME community, it improves the buyer’s corporate social responsibility (CSR). Given that, in most instances, there is no cost involved for the buyer, this in turn means that stakeholder value is increased as CSR policy targets can be met without added expense.
For the supplier, the main benefits relate to improvements in cash flow and reduced risk as the funds are received more quickly. There is less need for working capital as days sales outstanding (DSO) is decreased and there is also a reduced need for credit insurance. As this type of arrangement is typically non-recourse it normally qualifies for off-balance sheet treatment, meaning that the arrangement will have less effect on the supplier’s access to other lines of credit.
In addition, the cost of financing is typically lower than the cost of finance arranged independently. This is because the cost is based on the buyer’s credit rating rather than the supplier’s. Supplier finance is also generally cheaper than other, more traditional, forms of supply chain finance such as factoring or invoice discounting. In addition, the supplier does not lose control over its accounts receivable in the same way that it might do in a factoring or forfaiting arrangement.
From the point of view of the lender, supplier finance again represents the opportunity to improve relationships with both the buyer and the supplier. “There is of course a financing cost for the number of days early that we are making the payment to the customer, although this will typically be significantly cheaper than other financing methods,” comments Armstrong. “The charge is applied because we as the bank are using our balance sheet to make the early payment and taking on the risk, albeit a reduced risk against the buyer.”
Interest in supplier finance programmes has increased significantly with the financial crisis. As Armstrong notes, “The whole supplier finance model really works in the current environment.” Supplier finance is no longer something that buyers are just talking about; it is something they are starting to use.
There has also been increasing interest in such schemes from suppliers, with suppliers actively signing up to the programmes, often for 100% of their invoices. In addition, some suppliers are going on to arrange finance for their own suppliers in a similar way, leading to the creation of an ecosystem that provides end-to-end support to the supply chain.
Evidently, corporations and governments alike are beginning to understand the benefits of the supplier finance schemes that are available.
For organisations that have decided to set up a supplier finance programme, there are several steps to the implementation process. The first is to decide on the right solution for the company. Although pricing may be a significant factor in this decision – for instance, some banks will offer the service to the buyer at no cost, whereas others will charge a fee to both buyer and supplier – there are other factors to consider.
One of the main elements of the programme is of course the banking partner. In times of crisis, reliable bank relationships are crucial and the choice of bank alone may be a decisive factor in choosing the right solution for the company. The bank’s ability to service suppliers in other countries may be an additional factor.
Once the banking partner has been chosen, the buyer needs to decide which suppliers it wants to offer the solution to. Typically, a buyer would choose suppliers that are both reliable and regular as these would fit well into the supplier finance framework. The buyer then needs to approach those suppliers and notify them that the scheme is going to be available to them.
In a typical arrangement, the supplier would then have a specified amount of time to revert to the buyer’s bank, should they wish to participate in the programme. “At Santander, once we receive notification of interest from the supplier, we send them a live approved invoice from the buyer stating the amount and current payment terms,” explains Armstrong.
“We then explain that we would pay that invoice early for a specified fee. In the same communication we include a contract for the supplier so that they can fully sign up to the scheme and have that invoice paid today. The contract also covers future invoices of course.” Usually, the supplier will have the option to ask for 100% of its invoices to be paid via the programme, or it can select invoices for early payment one invoice at a time.
Bringing suppliers on board
Although there will be some suppliers who will join the programme straight away, there will inevitably be some who will be unsure how to proceed, as the schemes are only just becoming publicised. Fear of the unknown may be at the root of this uncertainty, so thoroughly explaining the solution to the supplier may help to motivate suppliers to join. Banks should be able to provide literature for suppliers to help with this ‘onboarding’ process.
There will be some suppliers who cannot join the supplier finance programme even if they wish to. For instance, a supplier who is currently involved in an invoice discounting or factoring arrangement may not be able to release individual invoices to have them paid early. There are of course some factors who will allow certain invoices to be released, but others will hold the supplier liable until maturity.
Challenges and considerations
Depending on the chosen solution, corporates should be aware of changes that may need to be made with the introduction of a supplier finance scheme. Such changes may include IT infrastructure and administration procedures.
The interface is an important element of a supplier finance programme, in particular when operations are carried out across several geographical regions and therefore in different languages. More often than not, the supplier finance platform will be web-based, and as such there will be minimal disruption to both buyer and supplier. Some banks will accept invoice data in spreadsheets and carry out the format conversion in-house, lessening the burden on the corporate. Some platforms also offer buyers direct SWIFT access, allowing them to submit a file of data (via FileAct), from which the bank unpacks the individual payments.
Interaction between the supplier and the bank is another area to consider. For the scheme to work well, the supplier should have the option to view all forthcoming invoices on the bank’s system. Some banks also offer value added services such as email alerts to let suppliers know when invoices have been paid and remittance advices explaining the payment detail.
From an audit point of view, it is important to make sure that the financial reporting for supplier finance is carried out correctly. On the liabilities side, a relevant accounting question is whether trade payables that are subject to supplier finance arrangement should be presented as trade payables or as bank financing, potentially affecting ratios and covenants. This is dependent on whether the obligation between the buyer and the seller is legally extinguished and this may vary between solutions. Professional advice should be sought when considering such a programme.
When looking to set up a supplier finance programme, buyers should:
Decide what they want to get out of the programme.
Make a commitment as a business that this is a scheme they want to invest time in.
Choose the right solution for the company, which is not necessarily the one that looks best on paper. Relationships will also play an important role in the decision-making process and choosing an experienced provider should be a key consideration.
Put together a project team. This should include people from finance, IT, audit, treasury and procurement to ensure that every angle is covered.
Communicate the details of the scheme as widely as possible, both internally and externally.
Ensure that the benefits of the proposed scheme are fully explained to suppliers.
Supplier finance is frequently offered to suppliers at the same time as payment terms are extended. However, from the point of view of business ethics, it may not be deemed best practice if a supplier finance programme is offered simply as a way of extending the buyer’s payment terms. Ideally, the scheme should be established because the buyer has realised that its increased payment terms have begun to squeeze its suppliers too far, meaning that the supplier needs cash earlier in the cycle to be able to fulfil its orders.
In other words, a supplier finance programme should be a solution to a problem, not simply a method for increasing days payable outstanding (DPO).