Procurement Intelligence Unit

Article featured in the June 2009 edition of the Procurement Leaders Magazine

Seen as a win-win-win trade finance solution that can solve your working capital problems as well as shore up your supply base, is supply chain finance the real deal, asks Francesca Wakefield?

Talk of 'green shoots' is intensifying, positive industrial output figures are emerging and stock markets are rallying. With the FTSE-100 up 26% since hitting a six-year low on 9 March 2009, many commentators are speculating that the worst may be over.

But such thinly veiled optimism fails to mask the trail of destruction the recession is leaving in its wake. The credit crunch is continuing to bite, and hard. According to the Insolvency Service, compulsory liquidations in England and Wales increased 7.1% in the first quarter of this year - a rise of more than 50% compared to the same period last year. And the trend is global. The US car industry is a case in point, with auto giant Chrysler having filed for Chapter 11 bankruptcy on 30 April and General Motors following soon after. According to the US-based Motor & Equipment Manufacturers Association, more than 40 major auto suppliers filed for Chapter 11 last year, with many more expected to be hit hard by Chrysler filing for bankruptcy protection.

In these difficult times, free cash flow and working capital are increasingly the make or break of a company, whether they are a small-scale supplier or a blue-chip buyer. With credit lines still tight, companies must look inward to find the cash. Extending days payable outstanding (DPO) is often the first port of call, but suppliers are already stretched to breaking point. Recent research from Demica showed that while 63% of UK companies and 48% of German companies were trying to extend DPO, 88% and 55% respectively recognised that some of their key suppliers would not be able to sustain such a move.

But does there have to be a trade off between supply base security and improvements in working capital?

Supply chain finance

Supply chain finance (SCF) could be the answer to this seemingly irreconcilable disconnect. Simply put, SCF is a mechanism where buyers can facilitate early payment for their suppliers through the use of a bank, which charges the supplier a fee based on the buyer's credit rating and which does not require the buyer to pay it back until the full term of DPO. A relatively new concept, Peter Stenbrink from Capacent notes that few would have even heard of SCF before 2000. But the past few years have seen a flurry of SCF activity. Drew Hoffler from Ariba, a leading player in supply chain solutions and consultancy, notes that there has been a 75% to 100% growth in its buyer client base for SCF and sees this growth rate continuing.

Meanwhile, Paul Robinson from HSBC's global transaction banking division reveals that most of the major global companies he is speaking to are seriously considering SCF. With interest and uptake having increased dramatically, particularly over the past year, Hoffler sees the credit crunch as a catalyst for SCF. Testament to the tangible and competitive benefits SCF can bring is the calibre of companies that are rolling it out, including Nike, Sainsbury's, Royal KPN and Syngenta.

The process is facilitated by the use of a technology platform which allows the bank, buyer and supplier to view timely financial settlement data - such as the approval of an invoice. While this platform can be provided by the bank or the buyer, it is often provided by an independent technology provider. There are a growing number of companies operating in this space including Prime Revenue, Bolero, Demica, Ariba, Oxygen Finance, Tradecard and Orbian. Among them are some highly innovative solutions, such as the financing platform from Oxygen which has eliminated the need for a bank, or the multi-bank platform offered by Prime Revenue.

In essence SCF is similar to factoring - a receivables financing solution employed by suppliers for years where the sales ledger is sold to a factoring company (commonly referred to as the 'factor') in order to get an advance on the money owed by the buyer. The crucial difference with SCF is that it is a buyer-led initiative, with the risk of default with the buyer and not the supplier - as with traditional factoring. As such, SCF is also "a credit arbitrage play," explains Greg Gorman from technology provider, Orbian, where the supplier can benefit from the difference between its own cost of credit and that of the buyer's - which means that as well as getting paid earlier, suppliers also get a cheaper cost of financing.

Everyone's a winner

Dubbed by many as a win-win solution, the benefits of SCF are manifold. Most crucially, SCF enables the buyer to negotiate extended payment terms and/or an early payment discount. Unlike factoring, where the factor usually has recourse to the supplier in the event of buyer non-payment, with SCF, recourse is to the buyer. This means the supplier can treat the cash advance as final payment and clear the trade debt from its balance sheet, recording the discount fee as an expense. It makes no difference to them whether formal payment terms are 60 days, 90 days or even longer - but the difference to the buyer can be huge. Major global companies that have rolled out SCF with as few as two key strategic suppliers have reported working capital improvements to the tune of hundreds of millions of dollars.

In addition to the working capital improvement, there are real cost savings to be made. There are two main ways this can be achieved. The first is through the negotiation of an early-payment discount - something the buyer is in a strong position to do, having cut the supplier's DSO substantially. The second is through a reduction in unit prices as a result of the reduction in financing costs for the supplier.

Credit Suisse estimates that financing accounts for 4% of the cost of finished goods - more than logistics and transportation. Syngenta's CPO, Hans Elmsheuser, notes that SCF enables him to keep control of his cost base in what is an otherwise outsourced function.

But perhaps most importantly in the current climate, SCF is a way of shoring up the supply base. Most commonly only rolled out to key strategic suppliers, SCF is a way for buyers and suppliers to work together, maximising benefits for all involved. For buyers otherwise faced with the possibility of having to buy out their strategic suppliers, in order to ensure their stability, SCF offers an alternative.

On top of these key benefits, SCF can also lead to improved supplier-buyer relations, better forecasting ability, improved business continuity and improved internal efficiency. In most cases, the financing trigger SCF relies on is the approval of the invoice. As such, it is vital to have an efficient invoice approval system and, more generally, a tight procure-to-pay process, says Capacent's Peter Stenbrink. SCF can often entail the adoption of enterprise resource planning (ERP) systems and a shift to electronic invoice presentation and payment (EIPP), both of which can bring untold efficiency-related benefits of their own.

Slow on the uptake

Beneficial for all involved, the real question is why the uptake of SCF has been so slow? There are many reasons for this, the most obvious being the confusion surrounding what SCF is and how it is different to other trade finance solutions, such as reverse factoring (a selective form of factoring).

Indeed, many mistakenly confuse the two processes as one and the same, or take SCF to be synonymous with the financial supply chain - a term that describes the chain of financial events that take place in any given transaction, rather than the way in which any one of those processes occurs. A chicken or egg situation, this problem is abating as knowledge of SCF spreads and examples of best practice are shared. Already reasonably widespread in the US, SCF is now making successful inroads into the European markets.

Increased uptake of SCF has also been stalled by the complexity of the solution, usually requiring one or more external partners and spanning across a number of internal departments. Of these, SCF most crucially demands open and constant dialogue with finance and the Treasury, says Paul Robinson of HSBC. Although this may not necessarily be an easy thing to achieve, it is important to remember that while SCF may be a procurement-led initiative, it is a finance-based solution.

Revolutionary concept

SCF arguably has the potential to revolutionise trade finance. The US Federal Reserve estimates that there are between US$6 trillion to US$8 trillion in payables outstanding in the US at any one point in time. The effect of a company like Chrysler filing for Chapter 11 is massive for suppliers just in terms of its outstanding payables, let alone loss of future business. Chrysler has now announced that 1,200 of its core suppliers will receive 40% of the money owed to them. Although this is clearly better than those suppliers that will receive nothing, for some large suppliers this still represents a deficit of more than US$30 million in their balance sheets.

So is SCF just a white knight fantasy, a kind of credit crunchcorporate social responsiblypackage? Appealingly, SCF does indeed have an aspect of CSR about it, but, crucially, it has a solid business case behind it. SCF offers suppliers unrivalled receivables security, while enabling buyers to achieve unrivalled working capital improvements and supply-base security. We are living in extraordinary times, ones that demand extraordinary innovation and adaptation. SCF could well prove to be the step-change in strategic procurement thinking needed to keep cash flows in the black and strategic suppliers afloat.