Innovative Supply Chain Financing for a New Landscape
In the age of globalisation, the purchase of goods by European and North American companies from suppliers in the Far East, eastern Europe or Latin America is now the rule rather than the exception. The lengthening of the supply chain, accelerating pace of such cross-border trade, and subsequent growing need for faster and more efficient payment and debt collection methods have led to the creation of new sophisticated tools for financing such purchases.
Until the latter part of the 20th century, trade was generally funded by either a direct line of credit from the seller to the buyer, or a letter of credit extended by the bank to the buyer to ensure on-time supplier payment. In today’s faster-paced world, however, those models have been supplemented, and at times even supplanted, by other financing instruments. These methods involve a bank or factoring company’s early payment of receivables or payables, owed to the supplier or buyer respectively, for improving cash flow at both ends of the supply chain. Two increasingly popular methods are invoice discounting and reverse factoring.
In invoice discounting, a supplier unlocks the funds it is owed by ‘cashing in’ on its receivables. Unlike traditional factoring, however, the supplier, not the factoring company, is responsible for debt collection.
The use of invoice discounting has benefited from its improved perception as a means of financing trade in comparison to traditional factoring. Buyers often interpreted the use of a third-party intermediary in traditional factoring scenarios as a red warning light; if a factor’s client, or seller, needed to borrow money against already issued invoices, the buyer could view this as a sign of financial instability. Other buyers felt that the involvement of a third-party intermediary made this financing process cumbersome and preferred maintaining a direct relationship with the seller.
Invoice discounting’s combination of full confidentiality and a direct buyer-seller relationship has helped increase its popularity. And since debt collection for this type of instrument remains the seller’s responsibility, which ensures confidentiality, it is considerably less expensive, albeit at a higher risk to the factor, than traditional factoring – a factor’s invoice discounting fee is about half that for conventional factoring transactions.
With reverse factoring, the initiative for paying the debt through a factoring agent is taken by the buyer, upon whose credit the transaction is based. When the buyer orders goods from a supplier, the factoring company pays for them; in order to take possession of the goods once they arrive, the buyer pays the factoring company the bill plus a finance charge. This instrument is particularly useful for solid companies capable of covering their debt when dealing with suppliers from the developing world, where business is typically conducted in cash and therefore the goods must be paid in full prior to shipment.
Reverse factoring, along with payables financing, receivables purchasing, vendor financing, and trade payables-backed financing, fall under the supply chain finance umbrella, offering flexibility that was never available through the traditional letter or line of credit. These instruments are based on the assumption that account receivables financing of any kind, in which a bank or factor pays an invoice with the knowledge that it has been approved by the buyer, is a win-win situation for both sides: it mitigates the bank’s risk on the one hand, while reducing the financing costs of the bank’s customers on the other.
Given that the emerging economies of Asia, eastern Europe and Latin America feature a multiplicity of international borders, currencies and languages, their increased volume of trade with buyers in the West has had an impact on several financing areas. In addition to making invoice preparation and the payment of receipts more complex and burdensome, this development has increased the need to manage risk effectively. Since new financing instruments such as invoice discounting and reverse factoring, together with traditional factoring, often give the client access to local information sources, they enable the buyer or seller to know more about the company at the other end of the supply chain. This, in turn, helps improve risk management.
As more supply chain finance instruments have entered the market, an unprecedented amount of data has become available to banks and factoring companies. This has led to a growing need for advanced software solutions that can integrate, organise and present this plethora of information for internal and external purposes.
Over the last decade, the advent of these solutions, together with improved online connectivity, have enabled lending institution clients to access their trade data via a simple but secure Internet connection. The client is able to follow trade payments in the same way that private consumers monitor their bank accounts, knowing exactly what funds are available for use. After checking availability, the client can electronically request funds in real time. And since everything is integrated, payment can be made quickly and funds can move into the client’s bank account.
These solutions are currently used by most banks and other companies engaged in trade financing – and in some cases, even by companies with large-scale purchasing operations. Take, for example, Carrefour, the French-based retailing chain with revenues of over €92bn in 2007, and over 100 supermarkets and other outlets in Europe, Asia and Latin America. The company uses in-house developed software within its trade financing department, which acts like an independent bank or factoring company. Similar software systems, which are sometimes called distributor finance rather than supply chain financing, are in place in other companies including IBM and Dell, where the department handling financing is, in essence, a financial institution.
The growth of these instruments and their integration into everyday trade practices makes it safe to say that the separation between traditional trade financing and factoring is fast disappearing – if not already gone. This blurring of the boundaries has led to the rapid entry of an unprecedented number of new instruments. However, software solutions that specialise in a limited number of alternatives are likely to saturate their markets very quickly at the cost of competitiveness. As a result, today’s solutions should accommodate both new and traditional instruments, as well as integrate with a comprehensive array of financing methods.