This article looks at what Supply Chain Financing is, what are its benefits and what future trends we can expect.
What is Supply Chain Financing?
This term refers to several activities engaged in by companies and their supporting financial institutions. All of these endeavors are aimed at improving the company’s cash flow by moving money faster through the supply chain. They most commonly include factoring, reverse factoring and automated early payment discounts. Many companies will go through a bank for this; others prefer to deal with institutions dedicated solely to supply chain financing.
A factor is a financial institution that buys accounts receivable from businesses allowing them to avoid the waiting period between the time they sell a product and the time they collect their money. The act of buying and selling these invoices is called factoring. It is an old concept that is enjoying a remarkable rise in popularity right now.
Sometimes a purchaser will ask a factor to buy the accounts receivable he owes to his supplier. Usually the buyer wants to extend his payment period for a longer time than the supplier will allow, while taking advantage of early payment discounts. In this case, the factor will charge the purchaser a fee for the transaction. The buyer will be able to hold on to his money longer while the supplier gets his payment right away. This is called reverse factoring.
Early Payment Discounts
With many early payment discounts, the financial institution acts as a dynamic partner with the purchaser, finding suppliers that will discount their goods in return for early payment. Sometimes the institution has a list of suppliers with whom they already do business. At other times they negotiate a deal on behalf of the purchaser. Often these involve sliding scales of discounts depending on when the invoices are paid. The purchaser can then ask for reverse factoring or for assistance in keeping track of what they need to pay to take advantage of the discounts.
What Are the Advantages of Factoring?
Factoring is the buying and selling of invoices to improve the cash flow of a company. Most suppliers will sell their goods to customers using an accounts receivable system that allows the buyer to take from 30 to 120 days to pay for the product. When the purchaser buys in bulk, a considerable amount of the supplier’s cash can be tied up in accounts receivable.
The main benefit to the supplier then is obvious. Factoring allows him to get his money sooner. This is more cash that he can put back into his business allowing it to operate with less debt. Waiting for a customer to pay for his goods can seriously impact the performance of a company.
The financial institution will pay a supplier slightly less than the face value of the debt but often a company will save more by having immediate access to its money than it will lose through factoring. A normal charge for factoring ranges from around .5% up to 2% of the face value of the invoice. Since some businesses factor their invoices every month, people often make the error of multiplying the discount by 12 to get the annual percentage rate. In fact, the discount that a factor takes as its profit does not compound. It remains the same low rate. For example, if a company sells £100,000 worth of accounts receivable every month at 1%, the factor will charge the company £1,000 every month to do so. At the end of the year, the factor will have charged £12,000 for buying £1.2 million worth of accounts receivable. That is still 1% of the total amount of money that has changed hands. Since this is far less than even the prime rate that banks charge for borrowing money, it is clear that supply chain financing is one of the cheapest ways of improving cash flow.
Additionally, institutions that buy invoices will act as credit advisers to the suppliers who do business with them. They often work with many buyers and can tell the suppliers which companies have good credit ratings. In essence they become the credit department for the supplier.
Finally, these institutions can become collection agencies. Once they buy the accounts receivable, they are responsible for making sure these debts are paid. Suppliers who do not have to send their accounts receivable to outside collection agencies can save a considerable amount of money.
What Are the Benefits of Reverse Factoring?
A supplier will sometimes worry that the companies that buy from him will not like it if he sells their debt to a third party or factor. Factoring is so common now that most reputable buyers expect it. In fact, some initiate the factoring process themselves. In this case, it is they and not the supplier who pays the factoring fee. This procedure is known as reverse factoring.
Most of the time, the buyer who initiates the reverse factoring deal is a safe credit risk. The supplier, who may have a lower credit rating, is happy to engage in supply chain financing at no cost to himself. He is, therefore, willing to offer an early payment discount in return for immediate access to cash. The financial institution is taking a very small risk because they are dealing with the buyer, betting on his ability and willingness to pay.
These buyers are also looking for a way to improve their cash flow. They want to take advantage of discounts that are given for early payment of invoices but they still want a grace period before they pay that debt. The money that the factor charges them to pay the debt off immediately is often less than the discount, but even if it is not, having the use of the money for an addition 30 to 120 days is cheaper than borrowing that same amount of cash from a bank.
A supplier is also a buyer. Some companies use both factoring and reverse factoring simultaneously to keep as much cash available for as low of a rate as possible. Analysts feel that these buyer-centric programs will become the dominant type of supply chain financing in the future.
The Benefits of Automated Early Payment Discounts
Early payment discounts can be a complicated process. Even after a company works hard to get the best discounts from suppliers, incorrect billing statements or multiple invoices can leave a payment department unable to get authorisation on time to pay the invoices. Large companies can lose as much as 2% of their total invoice amount in missed discounts. This could mean millions lost annually. Some supply chain financing institutions offer automated programs that are specifically designed to help large companies take full advantage of any early payment discounts that are due them.
Beyond discounts, there is another advantage to automating the accounts payable system. In spite of computer technology, most businesses still manually handle paper invoices. This alone is estimated to cost £400 billion a year globally. Simply automating invoice processing can save any company money before the extra benefits of discounts are added in.
It is not surprising that a correlation exists between lower processing costs and higher percentage of discounts captured. Automated systems can find and mark invoices with early payment discounts and prioritise them so that they will be first in line for approval. Research shows that e-invoicing has reduced processing time from 23 days with a manual system to just five with an automated one.
E-invoicing has made possible “dynamic discounting” whereby discounts are available on a sliding scale based on payment date. These are smaller discounts that remain available after the standard discount date has passed. Trying to capture these discounts with a manual system can be a nightmare, but they can be instantly calculated when the invoice is paid using an automated system.
Supply Chain Financing Trends
Supply chain financing (SCF) came into the spotlight recently with the global economic slowdown. Banks were reluctant to extend any more credit to businesses, and vital loans became difficult to get. This tightening of the money market drove many industries to seek other ways of raising capital. What was needed, they decided, was a way to move money faster through the supply chain. Through SCF, companies can sell their accounts payable for a small discount and get immediate access to the cash that had been tied up in debt owed to them.
As financial markets have become more secure and money is starting to flow again, will companies return to the old system of borrowing the operating cash they need? Of course, but SCF is here to stay. Companies have found that getting faster access to their own cash is much cheaper than borrowing someone else’s money. Analysts have noted that far eastern companies engage in SCF more than those in the west and they expect Asia to continue to lead the way with an annual growth of 18% over the next few years.
It is not surprising that a prominent trend in this field is the move toward automation, since manually processing invoices has proven to be unnecessarily costly to most companies. SCF specialists are providing automated systems for their clients whereby they can both send and pay invoices electronically.
Supply chain financiers are becoming active business partners with their clients. Some have built up relationships with so many buyers and suppliers that they can act as credit departments for their clients, advising them about which customers are good credit risks and which are not. These financial institutions can also negotiate discounts for their clients when they enter the supply chain as buyers and provide tools which help them pay their invoices earlier.
Although some institutions do specialise in SCF, most factoring is done by the very banks that were reluctant to make loans. They are enthusiastic about this type of financing because betting on the willingness of very credit-worthy companies to pay their supply debts is a relatively low-risk venture. Many large banks now have supply chain financing divisions. Banks will remain the most prominent supply chain financiers in the foreseeable future. Analysts expect local banks to gain a larger role in SCF because of their familiarity with local markets and suppliers.