Supply Chain Financing Explained

Key Takeaways 

• Suppliers typically pay less for funding through supply chain finance than they would through funding sources such as factoring. 

• Most commonly, supply chain finance is a financing solution that permits suppliers’ invoices to be paid early.

• Buyers can use technological solutions to offer supply chain finance to innumerable suppliers globally.

Historically, investor access to trade finance has been limited, largely because of difficulties identifying suitable investments. Of late, however, investor platforms have markedly broadened opportunities. Supply chain finance (SCF) is the largest segment of trade finance, comprising more than half of grade finance revenues globally in 2020, according to 2022 Finverity insights.  But exactly what is supply chain finance? Here is that and more.

What is Supply Chain Finance?

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.

Essentially, supply chain financing is a type of short-term lending to corporate buyers. With it, such buyers can make early payments to suppliers, leading to better working capital positions for the supplier as well as the buyer. It can also mitigate the possibility of supply chain disruption.

Specifically, the supplier gets cash earlier, and the buyer gains heightened flexibility to place capital where it is most needed.  After paying the supplier earlier at discount, the lender is paid at a later, agreed-upon date the full amount by the buyer. The discount is determined by the lender-generated return.

The ability to pay suppliers early means better-fortified and more dependable supply chains. In turn, this results in improved revenue growth, creating opportunities for investors. Such investors generally seek sectors that are experiencing robust demand. Currently, electronics and hardware distribution are among them.

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.

How Does Supply Chain Finance Work?

Generally, the buyer will contract with an SCF provider and see whether suppliers wish to participate in the program. 

Banks as well as supply chain finance providers and technology entities provide supply chain finance. Technology specialists, through multiple funders via a dedicated platform, also operate some programs.

Rather than targeting dozens of their biggest suppliers, buyers can use technological solutions to offer supply chain finance to innumerable suppliers globally. Such platforms, with their ease of use and streamlined onboarding processes, permit the addition of high numbers of suppliers.

After an SCF program gets going, suppliers can begin submitting invoices early. The ensuing process then goes approximately like this:

• Goods or services are bought from the supplier.
• The supplier submits their invoice with payment due within a specific timeframe.
• The buyer approves the payment invoice.
• The supplier seeks early payment on the invoice.
• The funder sends the payment, minus a nominal fee, to the supplier.
• On the invoice due date, the buyer pays the funder.

Here is an example. Say there is a purchase from a seller of an order of goods. How it normally works is that the goods ship and the supplier submits an invoice with payment due within 30 days or so. 

But imagine the supplier seeks an early invoice payment, or the buyer prefers to put the capital to work. The parties can seek a mutual supply chain finance solution. A lender is then implicated who pays the invoice for the buyer right away. The buyer must repay the lender, typically within 60 days.

Here are the steps of the process:

1. First, the buyer (typically a manufacturer or distributor) issues a purchase order to a foreign or domestic supplier. 
2. The supplier then ships the goods to the buyer and issues an invoice to the buyer.
3. In a supply chain financing arrangement, the buyer then submits approved invoices to a supply chain finance company for processing.
4. The supplier requests discounted payment of its approved invoices from the supply chain finance company. 
5. The supply chain finance company sends the discounted payment to the supplier. 
6. The buyer pays the supply chain finance company the amount of the approved invoice on the negotiated maturity date.

Different Types of Supply Chain Financing

There are varying types of supply chain financing, each of them with their own characteristics and potential benefits.

There are some solutions, for instance, that provide buyers and suppliers with one, centralized platform. There, the parties can manage their finances. Yet other solutions provide more customization, permitting companies to select the best financing options for their needs.

Then there is dynamic discounting, which allows a proffered discount to change based on the supplier’s financial position. This helps mitigate nonpayment risk and renders the supplier more liquid.

With factoring, meanwhile, the supplier submits an invoice then offers a discount for an early payment.

What are the potential benefits?

With supply chain finance, there are benefits for suppliers and buyers alike. Suppliers can use it to optimize their working capital. Because of earlier payments, their days sales outstanding is lowered. In turn, working capital is improved.

• 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.

The Difference Between Supply Chain Finance and Factoring 

Supply chain finance is also known as reverse factoring. The key difference between it and factoring is that with the latter, it is the buyer — not the supplier — that sets up supply chain finance.

Another difference is that funding costs borne by suppliers when gaining SCF are not based on their credit, but the buyer’s. Consequently, the costs to suppliers for supply chain finance are typically less than other financing methods.

Investing in Supply Chain Financing

An increase in digital supply chain finance platforms with matchmaking features has rendered it easier for investors to find suitable SCF investments. Companies make their financing requirements known, and investors can consider varying yields and terms. 

One of the leading alternative platforms, Yieldstreet, on which some $4 billion has been invested to date, offers investment opportunities in supply chain financing with minimums as low as $10,000 and terms typically ranging from four to 18 months. SCF usually pays interest earned at maturity.

Typically, Yieldstreet’s deals are too big for most specialty finance companies, which consequently cannot offer them. By divvying up investment participation through its investment pool, Yieldstreet generally permits larger investments than such companies can provide.  

With Yieldstreet, deal sourcing is vetted and selective. Last year, for example, fewer than 9.11% of reviewed opportunities made it past the company’s stringent screening process and onto the platform. 

With its low correlation to public markets, Yieldstreet’s SCF investment opportunities also serve another essential purpose: diversification. Establishing a portfolio containing varying asset types can lower overall risk, protect against inflation, and even improve returns. 

Alternative Investments and Portfolio Diversification

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

The growth of supply chain finance as a mainstream alternative asset class is likely to continue as investors’ familiarity grows. Yields can vary and are primarily dependent on the sector, size, and geography of transactions. Investors are also attracted to the relatively low volatility of SCF due to minimal correlation to public markets.