Supply Chain Financing, Explained
Approximately $1.5T of the trade finance market is subject to a funding gap driven by the retrenchment of banks from lending markets due to regulatory considerations, according to Insight Investment. Sectors that typically utilize high levels of supply chain finance include consumer goods, transportation, and manufacturing.
But what is supply chain financing?
Supply chain finance is a term used to describe a set of technology-enabled solutions that are designed to both lower financing costs and improve cash flow for buyers and sellers of goods across the globe. Supply chain finance automates invoice approval and settlement processes, from initiation to completion. Buyers agree to approve their suppliers’ invoices for financing by a bank or finance company. Supply chain financing optimizes working capital and provides liquidity to both parties in the trade. Specifically, suppliers gain quicker access to money that they are owed, while buyers get more time to pay off their balances. On either side of the equation, the parties can use the cash on hand for other projects to keep their respective operations running smoothly.
Supply chain finance generally works best when the buyer has a better credit rating than the seller, and can consequently source capital from a bank or other financial provider at a lower cost. This advantage lets buyers negotiate extended payment schedules and the sellers can receive immediate payment from the intermediary financing entity.
Supply chain finance is often referred to as “supplier finance” or “reverse factoring,” because it encourages collaboration between buyers and sellers. This thinking counters the competitive dynamic that typically arises between these two parties. Under traditional circumstances, buyers attempt to delay payment, while sellers look to be paid as soon as possible. With supply chain finance arrangements, however, it is a win-win for buyers and sellers.
So how does it work?
- First, the buyer (typically a manufacturer or distributor) issues a purchase order to a foreign or domestic supplier.
- The supplier then ships the goods to the buyer and issues an invoice to the buyer. In a supply chain financing arrangement, the buyer then submits approved invoices to a supply chain finance company for processing.
- The supplier requests discounted payment of its approved invoices from the supply chain finance company.
- The supply chain finance company sends the discounted payment to the supplier.
- The buyer pays the supply chain finance company the amount of the approved invoice on the negotiated maturity date.
What are the potential benefits?
- The suppliers benefit from access to funding based on the buyer’s credit profile, which often is at a lower cost than what the supplier can obtain on its own. If the supplier accessed financing for these receivables on their own (i.e. factoring as an option), they would likely pay more for that financing than what it costs them to participate in a supply chain financing program.
- The supplier can be paid faster under a supply chain financing arrangement and even though their invoices are paid at a discount, having the cash sooner enables them to generate more product for sale so the selling cycle can repeat more quickly.
- The buyers benefit from extended payment terms negotiated with the supply chain finance company.
- The buyers can then better forecast and manage their working capital needs, reduce their borrowing needs and the related interest expense while maintaining good relationships with suppliers because they are getting paid timely.
What are the potential drawbacks?
- Supply chain financing is available to large global manufacturers and distributors and their suppliers. Middle market buyers and their suppliers haven’t been able to take advantage of the benefits of these programs because they are often too small and not as credit-worthy as larger rated companies.
- This method of financing requires the negotiation of a confirmed payment amount between buyer and supplier up front and limits deductions, setoffs, counterclaims against billed invoices that typically occur in trade transactions. However, these constraints must be weighed against longer payment terms by the buyer and quicker receipt of payment by the supplier.
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