The Keys to Effective Financial Supply Chain Management
Though financial supply chain management is not an entirely new concept, interest in the discipline has increased dramatically over the past year with the focus shifting from theoretical discussion to the practical implementation of programmes with tangible benefits. Interest has been driven by banks seeking to adapt their transaction banking product offerings to new market conditions, as well as buying corporates looking to squeeze added value from their existing procurement arrangements.
The physical supply chain can be defined as the activities involved in planning and executing the movement of goods and their documentation, while the financial supply chain describes the activities involved in planning and executing payments between trading partners – what could be described as the order-to-cash and the purchase-to-pay cycles for suppliers and buyers respectively. For every physical movement of goods between supplier and buyer, there exists a financial flow travelling in the opposite direction. Financial supply chain management involves taking a holistic approach to these processes in order to achieve a range of benefits that include improved efficiency and visibility across the supply chain and a more favourable working capital position.
A distinction should also be drawn between what can be defined as ‘supply chain services’ and ‘supply chain finance’. The former refers to the realm of providing services in order to increase supply chain efficiency – services that are not necessarily finance related such as the dematerialisation of paper invoices or an increase in straight-through processing (STP). Supply chain finance (SCF), on the other hand, relates more specifically to providing the appropriate financing facilities at the relevant points in the physical supply chain.
From the buyer’s perspective, offering financing in this way represents an opportunity to more effectively manage relationships with suppliers and increase payment terms without damaging goodwill between trading parties. And from the perspective of the supplier, the main benefits relate to improved cash flow as reduced days sales outstanding (DSO) mitigates the need for working capital during the production process.
While traditional trade finance offerings tend to be focused around individual transactions and the strength of participants’ balance sheets, SCF takes a more holistic approach. Rather than looking at transactions in isolation, SCF considers the entirety of a trading relationship and is altogether more encompassing. This approach has been determined in no small part by the changing nature of global trade flows – in particular the growth of trading on open account.
With many emerging market economies fully recovered from the financial crises of the 1990s, trade between the developed and developing world is currently growing at around 13% a year according to SWIFT. However, documentary supported trade has only been growing by around 3% a year, meaning that the bulk of the increase is taking place on an open account basis. In addition to this, the trend towards production taking place in countries that are traditionally considered less credit worthy has added a new level of risk and complexity to procurement arrangements. These developments have established a need for new approaches to mitigating risk and financing suppliers. SCF seeks to address this by taking an approach that looks beyond the strength of an individual supplier’s balance sheet and any associated country risk, and instead considers the strength and depth of the relationship between buyer and supplier, and buyer and bank.
In common with traditional factoring or invoice discounting arrangements, the supplier receives a percentage of the due payment up front. However, with a supplier finance approach, the process is initiated by the buyer through its own bank and, thanks to the buyer’s stronger credit rating, the terms are likely to be more favourable than the terms on offer to the supplier through a local bank. Indeed, in this respect, SCF schemes represent a form of credit arbitrage that capitalises on the gap between the price at which a buyer can finance a product between production and payment, and the price at which a supplier could finance itself for the same period.
Financing suppliers in this way is heavily dependent upon the relationship between the trading parties. In order to accurately price products, banks need to be supplied with data from their clients detailing the history of the relationship with the supplier, and will also need to be notified at the first sign of any problems with a supplier meeting its obligations. In this respect, a track record of problem free production will be the ideal scenario.
Banks should also see some regulatory benefits to financing trade in this way. By transferring the credit risk to large, well-rated buyers, banks are also able to lower their capital reserve requirements with respect to the Basel II accords. Indeed, Deutsche Bank research shows that trade related finance carries a lower risk of default than equivalent non-trade related instruments – even if those instruments were used to finance trading. And this data should allow for the more accurate pricing of risk on SCF products.
Recent discussions on financial supply chain management have often focused on developments in information and communications technology that have made initiatives in this area more practical. And though operating a successful electronic trade finance platform is a necessity for any bank wishing to offer SCF to its client, the importance of IT and electronic processing should not be overstated. Many corporates – in both the developed and developing world – will still be operating paper-based systems for commercial documents such as purchase orders and invoices, and will be unable or unwilling to switch to electronic systems in the short term. By only offering SCF packages on an electronic basis, banks will be excluding large numbers of small to medium sized exporters that would benefit from financing opportunities.
In order to offer the best possible service to their importing clients, trade finance banks need to be flexible when it comes to dealing with exporters. An example of this is the Asia Centralised Processing Centre (ACPC), which was established by Deutsche Bank in Mumbai. The ACPC was established in 2003 in order to process trade transactions originating in Asian countries and allows for the manual imputing of paper documents. It thus provides a bridge between those corporates that use electronic systems and those that use paper based systems, allowing SCF packages to be offered to more suppliers.
Regional differences in the way that trade is transacted can offer some significant challenges to both trading corporates and their banks. For example, while some US banks and corporates have made significant advances in terms of SCF and implementing reverse factoring structures, there are potentially still advances to be made in terms of improved supply chain services. The number of payments between corporates in the US that are still settled by paper cheque, for example, is an indicator of the progress that could potentially be made in terms of dematerialisation and electronic invoicing.
The situation in Europe is somewhat different. With process efficiency being relatively advanced the bigger focus is on providing appropriate financing opportunities along the supply chains of European corporates.
Yet in all regions, the situation can differ significantly from sector to sector. Industries that are particularly dependent on a tight network of supplier relationships – automotives or chemicals, for example – will generally have more sophisticated and efficient structures in place than those with looser supplier relationships, such as retail.
There will also be legal and cultural differences- both between and within regions- that affect the approach taken towards financial supply chain management. The early payment culture in Germany, for example, will necessitate a certain approach to receivables financing, while legislation regarding electronic signatures varies across jurisdictions and thus affects how corporates and their banks address paperless invoicing.
However, despite regional differences within Europe, and between Europe and the US, addressing the Asian market remains the key challenge for those wishing to implement SCF initiatives. And even though this region will be the most important growth area for some time to come, banks and corporates should be wary that Asian economies are undergoing rapid change. The Asia of tomorrow will certainly look very different from that of today. Indeed, the nature of North/South trade has already changed significantly, with capital goods now increasingly likely to be produced outside of OECD economies.
Another common problem in this region is that developed world banks often underestimate the depth and sophistication of local bank offerings in countries such as India and China. Financial institutions in these areas are now well established and have considerable experience in providing trade finance and related services to their domestic corporates. European and US providers will often find that opportunities for offering packages attractive enough for local suppliers to accept are more limited than anticipated. Yet despite these ongoing issues- and the rapidly changing economic profile of the region- the large number of small to medium sized exporting firms means that Asia is set to remain a key area for implementing SCF packages.
The overall message here- and, indeed, across the whole of the financial supply chain – is that the approach from banks and buying corporates should be flexible enough to accommodate different approaches towards trade across different sectors and regions.