Supply chain financing (SCF) through banks has been present in sub-Saharan Africa for many years, although in a different and unstructured manner. Previously, various local banks across the continent have been engaged in financing the supply chain of key companies without the direct involvement of their distributors. Now the industry is fast moving to a direct engagement model where the financiers play a key role in selecting, growing and even churning the supply chains.
So what is SCF? Simply put, it is lending money to parts of the supply chain that need access to financial assistance in order to continue producing and distributing their goods. Not all of a company’s business partners have access to steady and cheap sources of financing. The ability of the business partners to source these funds effectively is central to the ability of companies to grow their sales and market share in a given location. If companies fail to arrange smooth financing solutions for business partners, dependence on the business partners’ own ability to meet its financial needs may lead to persistent problems. This model certainly has limitations and can be detrimental to companies’ growth plans.
The key objective of treasurers is to ensuring that all cash in the company or group is actively invested and earning the best possible return. A SCF solution takes treasurers closer to this goal by releasing cash tied up in working capital, as this limits the cash that can be used to obtain better returns or increase the scale of the business.
Structured Supply Chain Financing
Any physical supply chain, starting from procurement and ending with collections, will be more efficient if the financial requirements at its various stages are met in a suitable manner, thus linking the financial supply chain to the physical supply chain. If the financial supply chain is also able to mitigate the risks associated at the various stages, such as supply risk, production risk and credit risk, then the treasurer can achieve optimal benefits. This can be achieved through structured SCF.
A structured SCF programme through a bank benefits companies as well as their business partners. The medium/long term goals of a company adopting a structured SCF solution are to:
- Achieve higher sales with lower credit risk.
- Achieve lower bank borrowing.
- Free cash and make it available for other strategic investments.
- Reduce costs.
- Improve the balance sheet.
Cost Reduction
One of the key aims of SCF is to reduce the cost of the supply chain rather than shift the costs elsewhere. Ultimately, this will have an impact on the pricing of the products, giving companies a competitive advantage.
The cost benefit to the supply chain should be viewed with respect to the cost of ad-hoc financing that some distributors have to pay, which either reduces their margins or pushes up the goods’ retail price. This is similar for the vendors who need to continuously fund the procurement of raw materials, sometimes outside the credit period and at higher costs.
Financing a company’s business partners through a SCF programme, with the involvement of the company, enables banks to offer competitive pricing because the underlying risks are reduced.
Figure 2 above lists the key risk factors that drive most banks’ pricing models and compares pricing using two lending scenarios, bilateral lending and SCF. In the case of vendor financing, the payment risk reduces because this is passed on to the company that the vendor supplies. The bank, however, carries the performance risk if pre-shipment finance is provided to the vendor.
In both vendor and distributor financing, the transaction risk is reduced because the SCF programmes are restricted to transactions between companies and their business partners. The biggest risk of all, the counterparty risk or the credit risk to other business partners, is reduced because the bank gets comfort from the historic track record and the relationship between a company and its business partners.
Working Capital Management
The key and immediate benefit to a company that adopts the right SCF solution is an improvement on its working capital.
Figure 3 depicts two scenarios:
Scenario 1
A company is financing its business partners and also enjoying a credit period from its suppliers. In this example, the company has an inventory conversion/holding period of 90 days. The company also allows its buyers a 90-days credit period and enjoys a credit period of 60 days from its suppliers. The working capital gap is 120 days.
The working capital gap equals days inventory outstanding (DIO) plus days sales outstanding (DSO) minus days payable outstanding (DPO). So in this case, it would be 90 days plus 90 days minus 60 days – this means the working capital gap would be 120 days.
Scenario 2:
The company has adopted the right SCF solution. The bank provides finance to the distributors of the company. The company can also get its receivables from direct customers financed from a bank. This practically reduces the DSO to zero. The good news for suppliers is that the bank can actually extend the company’s credit period depending on the time it takes to convert the raw materials to finished goods ready for delivery. This could be more than the contractual credit period that the company has been enjoying from the suppliers.
The working capital gap in this case therefore becomes negative. For example, 90 days plus five days minus 100 days means the working capital gap would be minus five days.
Shareholder Value
The benefit of cost reduction of the supply chain coupled with improvement in the working capital of the company eventually increases the economic value addition (EVA). An analysis of the impact on the income statement and the balance sheet of a company is illustrated in Figure 4 above.
Income statement
Under a structured SCF solution, the company is able to reduce its overall cost of goods sold (COGS). This is achieved through obtaining discounts on procurement or negotiating better pricing, since the suppliers are now able to pass on part of the cost benefits to the company. The impact is an increase in the net operating profit after tax (NOPAT), which is a function of the profit before interest and tax.
Balance sheet
SCF helps to reduce the working capital on the balance sheet. This is achieved because the distributors are financed directly by the banks, and in most cases without financial recourse to the company; similarly, the bank can also finance other receivables.
The capital charge, which is directly related to net assets and the weighted average cost of capital (WACC), sees improvement because the net assets are reduced. The impacts on NOPAT and the capital charge, in opposite directions respectively, results in an increase in EVA.
Challenges in Sub-Saharan Africa
While all the above benefits of a right SCF solution are there for the taking, getting there is a challenging journey. The challenges facing companies and banks are not too different from those experienced by other markets during the evolution of this product, but there are still some challenges that are unique to Africa.
Too early, too fast?
As discussed earlier, many multinational companies, which have realised the benefits of this programme elsewhere, are trying to implement this product into their businesses in Africa. Many companies have not sufficiently developed their distribution chains, meaning that they have been selling their products largely on a ‘cash and carry’ or ‘cash-on-delivery’ basis, not wanting to carry the credit risk. This would have left their distributors arranging financing on their own and the sales in some of the regions where distributors do not have easy access to finance would have suffered. However, the greater damage, with respect to the new requirement of adopting a SCF solution, is that these companies do not have a ‘credit track record’ of their distribution. Neither have they had a chance to proactively churn their distributions based on credit performance.
Banks are able to provide a ‘without recourse’ SCF solution to companies and finance distributors based on certain fundamental comforts. The comfort primarily comes from the following factors:
- The company has a good track record with the business partner.
- The partner’s business depends largely on the products of the company.
- The partner has done business with the company for a reasonable period of time.
Companies need to evaluate, churn and consolidate their distributions, as well as segregate and categorise their buyers. They also need to have growth strategies for their top distributors and should have clear plans as to how they would support and groom these buyers so that distributors participate in achieving the goals of the company. It is only when distributors become true business partners and these synergies are achieved that a bank will structure a supply chain solution for a company. It is only then that the structure will be sustainable and generate benefits for all the parties.
Today, many companies operating in Africa have not understood this prerequisite for a supply chain solution, and have been hunting for a bank that will take away the credit risk from them and give them an opportunity to grow their sales. This, as explained above, is a short-term and unrealistic approach for this product.
Educating the Distributors – a Major Change Process
One of the challenges in Africa is to change the mindset of some distributors and encourage them to appreciate the philosophy behind SCF. Many distributors are averse to giving up the free credit period they have been enjoying from their suppliers and replacing it with interest-bearing borrowing. Rightly so, but again this is a short-sighted approach. These business partners are ignoring the following benefits:
- Even if the business partners have been enjoying a free credit period, the interest cost is built into pricing. They can actually negotiate a discount for paying upfront.
- The tenor of the free credit period is contractual. When this is replaced by bank finance, the bank endeavours to match the facility tenor with the actual working capital cycle. Business partners, therefore, need not arrange costly funds for the balance period from other sources.
- The bank takes care of distributors’ requirements during peak seasons, as it takes a portfolio approach and works out the lending strategies along with the company.
Some business partners have been in the habit of delaying payments to companies without facing too much pressure from them because they are reliable customers and have been responsible for selling the company’s products. This can be even worse when distributors are not exclusive. With the bank becoming involved, a change in payment discipline is not really welcome.
Many distributors are averse to changes that take place on the operational front, as they are reluctant to give up the complacency of the delivery and payment processes. Sometimes the hurdle comes in the form of computer literacy in remote locations, when automated payment and tracking solutions are put in place. In fact, distributor profile inconsistency is a major setback when any automated channels solution is structured for a particular supply chain programme.
Conclusion
SCF solutions are catching up in sub-Saharan Africa. The product brings with it great benefits to all concerned, but it also comes with risks that need to be addressed for a successful launch as well as its sustainability. It will take some time before the benefits and issues are realised and interested companies begin positioning themselves and their businesses to benefit. The race has started, but it is a marathon rather than a sprint.