The Implications of Globalisation for the Financial Supply Chains of UK SMEs
Over the last few years, the increasing trend towards globalisation has resulted in a large part of the UK’s manufacturing base moving overseas, particularly to China. Official UK trade statistics show a steady increase in the volume and value of imports from Asia, with imports from China (including Hong Kong) growing from £10.7bn in 2000 to £22.6bn in 2006.
This change in global product flows has resulted in many small and medium sized businesses (SMEs) having to become importers for the first time. They find themselves needing to source from overseas finished products or intermediate components (it is estimated that 60% of all imports coming into the UK are used in some form of value-added processing). For many SMEs whose principal business is not trade, buying goods from abroad is both daunting and potentially risky.
One of the challenges for small businesses that are importing from, for example, China, is how they can pay for the goods they are sourcing. Practically, they can only do it in two ways: by using traditional – and for them arcane – documentary credits or documentary collections or by payment in advance. The complexity of the documentary credit process is, for many SMEs, too much for them to manage and most will opt to make an advance payment to the supplier.
Although a proportion of these companies will use banks to make their international payments, the majority are likely to be using foreign exchange companies because they perceive them to be more competitive, both on rates and especially on fees.
The issues facing a small importer working with suppliers on the other side of the world are the same as for a large one. However, the risks they present are proportionately greater. All importers have to work with suppliers in other parts of the world. This produces operational risks due to language and time-zone differences. There are product risks around quality and delivery and financial risks from foreign exchange, cash-flow and working capital management.
Large companies have treasury and logistic departments to manage these risks. SMEs, for the most part, do not. Often it is the owner/manager who negotiates the purchase and juggles the logistics and financial management of its imports, whilst at the same time keeping the business going on a day-to-day basis. One can begin to understand why it is easier for them to send the payment with the order, rather than have to grapple with the complexities of trade finance as well!
But payment in advance brings more risks into the equation. There is the risk that the importer will be defrauded and the goods will not arrive at all, although, in my experience, most exporters – especially those that buyers meet through trade and government organisations and trade visits – are legitimate businesses. More likely is the risk that the goods will not arrive on time or will not be to the specification ordered. In all three cases, the exporter has the importer’s money and redress in a foreign jurisdiction is going to be difficult to achieve.
However, the risks for the importer do not stay with the importer. Most, if not all, SMEs will be financing their imports with bank lending, in the form of either loans or overdrafts. Despite these loans being secured against assets, many of these assets will be either worthless, as can be the case with debentures, or prove difficult to recover if, for example, the seizure of the family house to pay-off the debt would lead to poor public relations for the lender.
So, the complexity – and cost – of traditional trade instruments encourages SMEs to make advance payments to their overseas suppliers. This practice increases the risks to the bank that its SME customers will not be able to repay their loans, leading to increased impairment. In order to reduce those risks, banks need to find ways to become more deeply involved with quite small customers’ businesses – customers that may be served by a call-centre – and understand their financial supply chains better.
SMEs make up the bulk of many financial supply chains. Large corporates rely on them to supply components and to distribute their finished products. Yet SMEs are very vulnerable to working capital shortages. They tend to be under-capitalised in the first place. When they find themselves, for example, with the need to import raw materials and intermediates from Asia and faced with pressure from their customers to extend payment terms, their finances are stretched to the limit and, in some cases, beyond it.
Banks have an important role to play in assisting SMEs manage their cash flows and keep their working capital requirements to a minimum. Getting paid on time should be an SME’s first concern. SMEs need cash to pay suppliers and employees. They can survive without sales or profits for a time – but they cannot survive without cash.
This is one place where the banks can really help. Asset-based lending, in the form of invoice discounting and factoring, enables SMEs to access up to 90% of an invoice’s value within a very short period, often just 24 hours. Reverse-factoring – sometimes called supplier finance – allows a bank to discount a supplier’s invoice based on its large corporate customer’s ability to pay. The SME supplier invoices the corporate on, say, 60 day terms. The corporate agrees to pay the bank the value of the invoice on the due date. Because the customer has guaranteed the payment of the invoice, the bank can now discount the invoice for the supplier. This is usually at a better rate than the supplier would obtain otherwise, because of the financial strength of its corporate customer.
By getting close to their businesses, banks have been able to come up with new ways to help SMEs import goods. Here are two real-life solutions.
One company that I know of imports goods from the Middle East for resale to UK stockholders and processors. It buys the goods with a letter of credit at sight, so the exporter can get its money immediately. The goods are delivered and held in trust for the bank. The letter of credit is paid and an import loan payable in 120 days is raised. The bank then releases the goods ‘in trust’ to the importer, which delivers and invoices on the same day. The invoices are discounted and used to pay off the import loan. Without this solution, the importer would not have been able to trade. With it, it is trading and growing.
Another company imports capital equipment, which it installs for a major UK retailer. Using the order from the retailer as collateral, the importer’s bank was able to provide flexible credit lines. These allow it to draw down letters of credit to give it the working capital to fund the purchase and import of the machinery before it is sold to the retailer. In this case, the importer went to a number of banks for credit lines, but was turned down as they considered the trade to be too risky. It was only when their current bank agreed to use the blue-chip retailer’s order as collateral that the deal could go through.
We have seen that globalisation is presenting obstacles and opportunities for UK SMEs in equal measure. It provides them with an opportunity to source goods cheaply and compete in their home market. At the same time, it exposes them to risks from payments – particularly payments made in advance to overseas suppliers – and extended supply chains. These risks are also the banks’ risks, as they are providing the SMEs with their working capital in the first place. By understanding their SMEs’ financial supply chains, the banks can help them manage their cash flows better through the use of asset-based lending products such as factoring and invoice discounting. In addition, the banks should look at ways that they can demystify trade finance and help smaller businesses use traditional documentary credits and collections.