Supply chain finance – some thoughts about fundamentals
With recent events (Greensill, Carillion and Abengoa before), supply chain finance (SCF) got in the spotlight. Accountancy bodies (both IFRS and FASB) are looking into disclosure requirements, rating agencies (such as Fitch) into debt reclassifications, various government inquiries questioning its use, etc. While it appears so far knee jerk reaction was mainly avoided, it makes sense to see the fundamentals of why the product exists and what its purpose is, explains Igor Zaks, CFA, President, Tenzor Ltd and TRF News Editorial Board Member.
Working capital management- not just financing
Unlike bank debt, working capital components (accounts payable and inventory) are a complex intersection of operational and financial issues. For example, some companies hold large inventory because of forecasting quality, reporting deficiencies, etc. – not just a conscious decision to keep it. Similarly, an essential part of accounts payable (AP) is a long and complex approval process – the company often simply does not know which invoices should be paid until later (something one can see when looking at the AP function of many companies).
Then and only then (i.e., when the buyer completed three-way matching and all other relevant processes) ‘true’ financial decision is happening – i.e., how supplier should use the cash to finance working capital. On the opposite side of the balance sheet, there are inventory and accounts receivable, which together with accounts payable form the cash conversion cycle. And payment terms accommodate both – process delay (approval) and extra time negotiated to finance operations.
Bringing technology and efficiency
Here comes technology and process management. There were many new developments in procurement, supply chain, and AP technology (anything from e-invoicing to sophisticated machine learning tools). As a result of these changes, companies can reduce the approval times radically. Suddenly the company does not need to wait 30-60 days to know that invoice is valid- this can be establish in days, or even instantly. Many companies will also communicate the approval to their suppliers on their portal without affecting payment terms (that are contractually determined).
So, the company that used to have let’s say 60 days payment terms with 45 days to approve the invoice and 15 days to have a payment run, can suddenly do all of it in less than a week. It made investments, implemented best practices, got top management focus, and achieved such massive operational improvement – now how can it benefit? Paying suppliers in 1 week instead of 60 days without deriving benefits will disincentivise the company (unless they are forced to do so under the regulatory regime).
Company choices after invoice approval
The first thing any working capital manager learns is never to pay invoices before they are contractually due. Ensuring the company does not pay its AP before the due date is the first thing any AP audit will do. This is why many companies (disorganised enough to confuse invoice approval with contractual payment day) get into trouble. So this is not an option. Other options are:
Do nothing.
Once the invoice is approved, ensure the AP system is set up with the correct payment day and sit on the invoice until due. No impact on the buyer/or supplier working capital. If a supplier has a high cost of capital, this may be very expensive to them. In many cases, a supplier can finance the invoice (through factoring, securitisation, etc.). This will, however, have significant pricing implications as short of some type of buyer communication, the financier bears dilution and fraud risk that they have to price in. On top of this, small supplier financing options are often fairly limited. There are also separate accounting considerations affecting the seller (true sale, etc.)
Pay early at a discount.
Early payment discounts existed for ages; however, modern technology allows to move it into dynamic discounting. This allows the buyer to make money efficiently, however it affects its working capital negatively. It can also be unstable as the buyer may not have cash available all the time (meaning it will gladly discount at one time, but not another one), creating instability to the supplier.
SCF.
Once the invoice is approved and payment is irrevocably confirmed (a process that often happens irrespectively of financing), the credit risk is moved on the buyer – something that financial institutions can price very efficiently especially in case of investment-grade buyers. There are two clear economies of scale SCF delivers comparing with buyer’s financing. One is buyer ERP integration that only needs to be done once for many suppliers. The second is program structuring costs (legal costs, etc.) are proportionally much higher for a small facility.
Platform-based confirmed payables financing.
Once the invoice is approved and the payment confirmation is available, it becomes a tradable asset. Various platforms allow to extract such information from a buyer and then enable multiple parties to bid on such assets.
Today, many platforms allow mixing of the three products, combining dynamic discounting with either single or multiple financiers to ensure optimal capital allocations.
Conclusion
To a large extend, modern SCF is a reaction to increased process efficiency and better procurement/accounts payable technology, allowing to accelerate the approval process. SCF and dynamic discounting play a critical role in improving such efficiency while incentivising both buyer and supplier in the process. Unfortunately, recent abuses either relate to the misleading use of the term or using the technique for a completely wrong reason- these issues need to be dealt with, but not at the expense of a perfectly reasonable tool for increasing supply chain efficiency.