Treasury and banking professionals will be aware of the market excitement about streamlining the financial supply chain and improving working capital management. However, a little known fact about the new generation of supply chain finance structures is that a number of these trade payables backed financing models have been widely used by leading banks in Spain and Latin America for 20 years, usually under the generic name of Confirming. During this time they have gained a deep expertise in this field, for the benefit of their corporate customers’ domestic and international supply chains.
Indeed, the Latin countries do have a long track record of developing financial instruments in pursuit of improved working capital management: As long ago as the 15th and 16th centuries, bills of exchange were being accepted, endorsed and discounted as a form of commercial credit at the large Spanish trade fairs in Medina del Campo and Seville. In the modern era of e-commerce and web-based technologies these same principles still hold true regarding the tremendous benefits of bridging the timing and funding gaps between a buyer wanting a reasonable period of trade credit and a supplier wanting to accelerate his inbound cash flow.
In this context, Spanish banks were generally ahead of the pack in developing a financing product which recognised that in providing any kind of invoice finance to a supplier it greatly helps a bank to mitigate risk and reduce the customer’s financing costs if it knows that the invoice has been approved by the buyer. This basic premise is at the root of the wave of financing instruments currently being developed by international banks. Today’s buzz words include reverse factoring, vendor financing, payables financing, receivables purchasing and trade payables backed financing, which all tend to be variations on the theme of the umbrella term supply chain finance.
Drivers for Supply Chain Finance
Corporates are increasingly purchasing their supplies from overseas markets, in order to benefit from lowest cost country sourcing, ie purchasing goods and services at the lowest possible cost. With the globalisation of supply chains, large corporates are realising that they need to be more collaborative and supportive in managing these extended trade relationships. In place of the traditional arm-wrestling relationship between buyer and supplier, where the buyer simply squeezes the most advantageous terms out of his suppliers, collaborative supply chain management is becoming widely accepted as best practice.
Even with the growth in long distance global trade, the traditional trade finance tool, the documentary letter of credit, is on the decline in terms of market share. Notwithstanding the tremendous security and financial flexibility of this trade finance instrument, letters of credit can involve high administrative costs and manual processes. This has been a driver for initiatives at industry level and within individual businesses to simplify trade processing and reduce costs. According to the World Trade Organisation, more than 80% of global trade is now in the form of open account, whereby a supplier simply invoices his customer who then settles the invoice after a period of trade credit. So despite the enormous value of letters of credit in specific circumstances (such as the beginning of a trade relationship with a new supplier or buyer in relatively unknown overseas markets), it seems that the trend towards increased open account trade is set to continue.
In this expanding open account environment, creative banks are finding a useful role for themselves in delivering supply chain finance and other value-added services to help their customers improve their working capital management. These initiatives respond to the challenges being laid down by national and super-regional governments to drive commerce and economic growth. Many EU countries have introduced laws to help promote a culture of prompt payment in order to alleviate the problems of small and medium enterprises (SMEs) suffering from late payment of their invoices. Similarly, banks are responding to encouragement from the European Commission and national governments to develop e-invoicing solutions in order to reduce processing costs and improve the flow of working capital along supply chains, with benefits for buyers and suppliers.
Basic Supply Chain Finance Structuring
The basic process for efficient supplier payments and supply chain finance can be summarised as follows:
- The buyer sends to the bank a Confirmed Payables file specifying the dates on which invoice payments are to be made.
- Suppliers are advised by the bank of the amounts and dates on which payments are to be settled on behalf of the buyer.
- This communication can be by email, fax, post, or preferably on the bank’s web-based portal.
- In addition to informing the supplier of future payment dates, the bank offers the supplier early settlement of these payments. This financing is negotiated with the suppliers separately from the supplier payments which the bank undertakes to make on behalf of the buyer.
- If the supplier decides to accept the early payment and completes the short form documentation, funds will be received by the supplier at an account with the financing bank or any bank of his choice.
- At maturity of each invoice the bank either makes settlement to the supplier on behalf of the buyer (if early settlement has not been taken by the supplier) or is reimbursed for the discounted payment using the buyer’s funds in those cases where supplier finance has been drawn down.
- This structure works equally well for both domestic and international trade.
Migrating from Paper to Electronic in Supply Chain Finance
As can be seen in the simple structure described above, this valuable supply chain finance can be, and indeed in Spain was for many years, successfully structured in a paper-bound world, whereby the bank sends by mail to suppliers forward dated payment advices and finance offers. Suppliers then sign the receivables sale contract and return this to the bank. Upon receipt of this documentation, a bank would send the discounted payment to the supplier, either electronically or even as a banker’s draft. However, this supply chain finance process can be greatly streamlined using web-based technologies. Accordingly, leading Spanish banks have already migrated their customers onto secure and robust web-based portals, where suppliers can access the latest invoice status and financing offers and have the opportunity to accept early settlement of selected invoices or indeed all invoices.
Benefits for Suppliers
- Opportunity to obtain early settlement of invoices from the bank, improving the cash flow of the supplier.
- The value of funds obtained is the full face value of the invoices settled minus a discount charge for the period until maturity.
- Thus the supplier receives a higher percentage of invoice face value than under a factoring or invoice discounting arrangement, where typically only a pre-agreed percentage (eg 70-80%) of the invoice face value will be advanced.
- The funds raised through supply chain finance will usually be non-recourse for the supplier since the discounted payment is structured as a receivables assignment.
- Being non-recourse early settlement, this funding is off balance sheet for the supplier and therefore does not eat into their existing credit limits. This structure may enable the supplier to access more funding than would be possible on a standalone basis.
- The simple documentation signed between the bank and the supplier is usually a short form contract by way of a sale/purchase of receivables, whereby the bank becomes the holder of the trade debt.
- Where the supplier is a small or medium enterprise (SME) and the buyer is a large credit-worthy corporate, the discount cost will often be lower than the SME might achieve through conventional borrowing.
- Even if the supplier decides not to take early settlement of invoices, he still has the benefit of early visibility of cash flow which helps with cash forecasting.
Benefits for the Buyer
- Creates a more collaborative, stable and financially robust supply chain which functions more efficiently for the benefit of the buyer and his suppliers.
- The bank works with the buyer to inform the suppliers of the new supplier payment arrangement, outlining the operational and financial benefits.
- Cuts the cost of processing supplier payments and gives the buyer improved visibility of its outbound cash flow, by outsourcing the supplier payments process to a bank.
- Reduces ‘chaser’ queries from suppliers regarding the current status of invoices, ie have invoices been received, processed and approved? Suppliers can obtain the status of invoices and discounted early settlement offers on the bank’s supplier portal.
- Importantly, where properly structured and documented, arms-length finance for suppliers can be delivered in such a way that trade payables on the buyer’s balance sheet continue to be classified as commercial outstandings due to trade creditors, instead of being converted into bank debt which would otherwise impact negatively on the buyer’s debt gearing ratios.
- As a separate arrangement, the buyer may be able to negotiate improved terms (eg cost of goods or longer trade credit terms) with his supplier base, in the light of the improved working capital management the suppliers enjoy under the bank’s supplier payment programme.
Value-added Supply Chain Finance Services
Beyond the vanilla supply chain finance structure described above, there are a number of variations on this basic model. In some cases a different percentage of the contract value can be advanced on completion of the various stages of the trade cycle, so that part of the funds are advanced at each step when the purchase order is issued, once raw materials have been manufactured, when goods are actually in transit and finally on receipt and approval of invoice. This financial structuring allows the supplier to fund the sourcing and manufacturing of the goods.
In cases where a buyer finds he has cash surpluses these can be used to make early payment to suppliers, as part of the supply chain finance programme. The buyer can be remunerated for using his treasury surpluses in this way. A bank may also be willing to help the buyer extend payment terms by providing finance at the normal maturity of the invoices.
Supply Chain Finance and Factoring/Invoice Discounting – What’s the Difference?
The supply chain finance instruments described above sit very comfortably alongside factoring and invoice discounting solutions. Each of these cash flow instruments is different and is individually suited to a particular set of circumstances. One fundamental difference is that, while supply chain finance benefits from buyer data (ie knowledge that invoices to be financed have been approved), factors and invoice discounting providers are generally reliant on information solely from the supplier at the point when funds are advanced.
Factors provide an extensive range of services of which finance is just one aspect. Typical factoring services include:
- Outsourced management of the client’s entire sales ledger (ie the company assigning its invoices to the factor)
- Credit assessment of the client’s trade customers which results in the factor establishing approved credit limits against individual trade debtors
- Bad debt cover of approved trade debtor limits
- Collection of debts
- As regards finance, factors are typically prepared to make pre-payments of up to 80% of invoices covered by approved debtor credit limits. Although there are some exceptions, this is generally less than the level of finance made available under supply chain finance, in which the supplier can receive early payment of the full face value of the invoice minus financing costs.
- All factored invoices will specify that invoices have been assigned to the factor and that the buyer/trade debtor must make payment direct to the factor. The factor is in direct contact with the trade debtor and has a comprehensive range of procedures for collecting debts, such as reminders and even legal proceedings to pursue debtors where necessary.
Invoice discounting (known as receivables financing in the US) is similar to factoring in that trade debts are also sold to an invoice discounting specialist or bank who is prepared to advance a percentage (normally up to 80%) of the invoice. However, unlike factoring, the supplier/client of the invoice discounter is responsible for managing its own sales ledger and collecting the trade debt, which is then used to reimburse the financing. Thus the buyer/trade debtor is generally unaware that the supplier is obtaining invoice discounting facilities, whereas a factoring arrangement will typically be fully disclosed to the buyer/debtor.
Supply chain finance is generally without recourse to the suppliers and factoring is also without recourse for approved debtor credit limits where bad debt protection is included in the service. However, invoice discounting is generally with recourse, supported by a third party credit insurance policy. Typically, invoice discounting is designed for larger more creditworthy clients than factoring which tends to more suited to smaller, fast growing companies wishing to improve their cash flow.
The Way Forward for Confirming and Supply Chain Finance
When originally developed, Confirmingwas particularly well suited to industries with trade cycles with relatively long credit terms, eg 90 to 180 days. However, in some markets trade terms are quite short (eg only 30-45 days). This presents a problem in many corporates, since unless invoices are processed quickly and efficiently it can take so long to approve an invoice (typically 15-20 days and in some cases even longer) that the window of opportunity to provide financing is lost, which in turn has a negative impact on the supplier’s cash flow.
The natural way to enhance a supply chain finance solution is for a bank to deliver value-added solutions that assist buyers in the invoice approval process. These accounts payable solutions and e-invoicing initiatives help the buyer to streamline his processes and approve his invoices more quickly. This in turn enables the bank to offer finance to suppliers earlier in the trade cycle. Banks experienced in supply chain finance are therefore working their way back along the trade cycle in order to bring their customers value added services to facilitate the efficient receipt and processing of invoices. This in turn will enable the creation of greater volumes of approved payables, which will permit suppliers to get early settlement on more invoices, hence releasing increased working capital from the financial supply chain.
Conclusion
Whereas many international banks are still deciding how to structure supply chain finance and who within their organisation should manage these new solutions, major Spanish banks are already delivering value to their clients using a range of supply chain finance techniques. In conclusion therefore, a long-standing ‘Spanish custom’ (which strangely in the international context usually means a peculiar local practice) has in the field of working capital management pioneered the way into a valuable and flexible form of supply chain finance. This situation is, I believe, a powerful example of a valuable local practice that is now ideally positioned for globalisation. The targeted deployment of this supplier payment and finance tool can help a buyer ensure a stable and robust supply chain which is competitively advantaged, for the mutual benefit of buyer and suppliers, with improved visibility and working capital along the supply chain.