Supply chain finance, also known as supplier finance or reverse factoring, is a set of solutions that optimise cash flow by allowing buyers to extend supplier payment terms. Increasing the time it takes to pay a supplier improves several financial metrics (e.g. days payable outstanding or DPO), and most importantly, frees up cash that would otherwise be trapped inside the supply chain. A buyer can use increased cash flow to invest in operational, competitive and innovation initiatives that will drive additional growth. They can also return cash to shareholders in the form of dividends or stock repurchases.
Simultaneously, supply chain finance offers suppliers a way to mitigate the effect of payment term extensions and to accelerate their own cash flow. Suppliers who participate in a program have the option to get paid early – typically as soon as an invoice has been approved by a buyer. The supplier can accelerate payment on some, all or none of their receivables, depending on their financial position and funding requirements. For those receivables that are paid early, the supplier will pay a small finance charge or discount. All of this occurs without negatively impacting either companies’ balance sheet. Accounting treatment for supply chain finance, when done properly, does not count as additional debt for a buyer or supplier.
Since the buyer is the obligated party, financing is offered to the supplier at rates that are typically more favourable because they are based on the buyer’s credit history and rating. For many suppliers, this access to a lower cost of funding is exceptionally important. Supply chain finance thus creates a win-win situation for both buyers and their suppliers. The buyer optimises working capital because it has more time to pay suppliers, while suppliers can generate additional operating cash flow by getting paid early without affecting their balance sheets.
The benefits of supply chain finance
Supply chain finance is one of the few financial health improvement tactics that works for organisations on both sides of the supply chain. Buying organisations can extend their payment terms, and suppliers can get paid earlier. It’s a true win-win solution for both trading partners. A meaningful increase in working capital can be transformative for today’s global supply chains, many of which operate with razor-thin margins.
Suppliers also realise substantial gains in cash flow as they now have the option to get paid early on each invoice they submit to the buyer. This working capital can be used by both buyers and suppliers to fund new innovation or competitive initiatives. It can be used to weather economic or industry volatility, and protect or grow margins. Money that has traditionally been tied up in accounts payable/receivable can now be used to generate income and gain strategic advantage in the marketplace.
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Supply chain finance also strengthens supplier health and relationships. Not only does it minimise or negate the impact of extended payment terms, but suppliers can also receive near-immediate payment for invoices at an interest rate often many times lower than other financing approaches. This increase in cash flow can protect suppliers which are often more vulnerable to marketplace dynamics. Growth, stability and innovation – these are three tenets of a successful supply chain. Supply chain finance is an elegant way to unlock working capital that serves each of these elements for buyers and suppliers alike.
In two simple definitions, here is what happens if you get your supply chain finance right:
- Increasing the time it takes to pay a supplier improves several financial metrics and most importantly, frees up cash that would otherwise be trapped inside the supply chain.
- Supply chain finance offers suppliers a way to mitigate the effect of payment term extensions and to accelerate their own cash flow.
What supply chain finance is NOT
The world of trade finance is complex and varied. There are numerous ways to increase business capital on hand and, in many cases, the differences are slightly nuanced. Given this landscape, it’s not just important to understand what supply chain finance is, it’s also important to understand what it is not.
It is not a loan. Supply chain finance is an extension of the buyer’s accounts payable and is not considered financial debt. For the supplier, it represents a non-recourse, true sale of receivables. There is no lending on either side of the buyer/supplier equation, which means there is no impact to balance sheets. It is not dynamic discounting or an early payment program. Early payment programs, such as dynamic discounting, are buyer-initiated programs where buyers offer suppliers earlier payments in return for discounts on their invoices. Unlike supply chain finance, buyers are seeking to lower their cost of goods, not to improve their cash flow. Dynamic discounting and early payment programs often turn out to be expensive for both suppliers (who are getting paid less than agreed upon) and buyers who tie up their own cash to fund the programs.
It is not factoring. Factoring enables a supplier to sell its invoices to a factoring agent (in most cases, a financial institution) in return for earlier, but partial, payment. Suppliers initiate the arrangement without the buyer’s involvement. Thus factoring is typically much more expensive than buyer-initiated supply chain finance. Also, suppliers trade “all or nothing” meaning they have no choice to participate from month-to-month to the degree that their cash flow needs dictate.
Finally, most factoring programs are recourse loans, meaning if a supplier has received payment against an invoice that the buyer subsequently does not pay, the lender has recourse to claw back the funds.
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