Managing Risk in the Financial Supply Chain
The phenomenon of globalisation has had an enormous impact on the way in which commerce is conducted. In the past, companies had a preference for manufacturing as many of their products’ components as possible in house, or at most only sourced them from relatively local suppliers. No longer, as low cost sources of supply have emerged across regions such as Asia and supply chains have expanded dramatically both in terms of geographical length and complexity. This transformation of the physical supply chain has been accompanied by a similar revolution in the financial supply chain.
The changes that have taken place within the financial supply chain raise considerable risks that, if not managed efficiently, may result in significant damage to the corporation. The art and science of managing these risks were major talking points at a recent Hong Kong meeting of senior Asian treasury personnel. Much of the discussion focused on the importance of ensuring that all the supplier links in the chain remained intact by ensuring they were continually lubricated with sufficient working capital.
In the days when supply chains stretched little more than the length of the street, the concept of ‘just-in-time’ manufacturing had particular implications. In a world where supply chains may reach around the planet, those implications are very different. More specifically, and particularly where the manufacture of components involves significant intellectual capital, the margin for error is now miniscule and the implications of a link in the supply chain failing can be extremely severe.
From the perspective of corporate treasury, the financial health of the corporation’s suppliers is of paramount importance and self-interest. In some respects, treasurers’ concerns about their suppliers’ working capital health may be nearly as acute as for that of their own organisations. This concern extends beyond just the working capital needed for a supplier’s continued existence; the supplier that, while technically solvent, cannot pay its own suppliers on time is at obvious risk of having its supplies suspended, so the end customer still suffers supply disruption.
This natural self-interest has driven a huge expansion in supply chain finance. It is now relatively commonplace for larger corporations to approach their banks for a supply chain finance solution that will keep their suppliers well furnished with working capital. In effect, this forms part of the corporation’s business continuity planning in much the same way as contingency planning for natural disasters.
To some extent, the risks of supplier failure can be offset through multiple sourcing. While this also has the attraction of facilitating competitive pricing, attendees at the Hong Kong meeting were clear that this in itself did not obviate the need to take a keen interest in suppliers’ working capital situations. If this was neglected and a key supplier failed, there was still a risk of major disruption, as there would be no guarantee that the surviving suppliers could immediately assume the additional workload. The net result would still be a major impact on the corporation’s ability to deliver a finished product, with negative implications for its own profitability and working capital position.
A few corporations are almost reaching the point where the robustness of the relationship is so business critical to them that they effectively feel a duty of care to their suppliers. They are, therefore, extending their paternalistic interest in their suppliers’ working capital into other areas. For example, some are becoming closely involved in their suppliers’ strategic business plans, such as the location and financing of new production facilities. Others are starting to provide key suppliers with advice on working capital best practice.
In corporations where treasury has the responsibility of managing all corporate risk, this involvement with suppliers extends even further. In these situations the treasurer is not just concerned with his/her own corporation’s corporate responsibility programme, but that of their suppliers as well. The logic of making this part of supply chain relationship management has been borne out by the brand damage suffered in recent years by several large corporations whose suppliers had been guilty of sub-standard employment practices.
A critical element in efficient working capital management is information flow. Streamlining this involves the use of compatible technology, or at the very least compatible data formats. However, in Asia there is very little natural systems synergy, particularly between larger corporations and their smaller suppliers. While the large corporation is likely to be using an ERP system from one of the major vendors, its suppliers are more likely to be using small business accounting packages. This frequently results in a data format mismatch.
This situation has prompted some corporations to ask their banks to act as a middleware layer in the supply chain. The bank is expected to collect an electronic invoice from the supplier, provide financing for that invoice and then charge it back to the buyer in a format compatible with its ERP system.
An extension of the bank’s role as electronic information interface is especially valuable in situations where the local clearing system has insufficient free character fields to carry remittance information, so such information is truncated or lost. In some countries in Africa, Asia and the Middle East there may not even be a clearing system at all, or if there is, it may not offer functionality such as direct debits. Again, the expectation is that the bank will act to bridge this sort of information gap (typically by bilateral exchange) so that the data element of the supply chain does not grind to a halt.
Some of the most appreciable potential efficiencies in the financial supply chain arise when both buyer and supplier use the same bank. However, this situation does not often occur. Where the buyer is a large multinational, it will typically be reluctant to use local Asian banks due to concerns over credit risks. (Furthermore, few such banks would be capable of providing the required supply chain financing products.) As a result, multinationals will usually turn to one of their global banks when looking for supply chain financing. However, it is highly unlikely that small local suppliers will be using the same global bank; they are far more likely to use local banks instead.
In this situation, several opportunities are being missed. Firstly, the issue of data loss/truncation in clearing will have to be addressed. Secondly, assuming standard ACH payments are being used, three/four days of working capital are being lost in clearing. By contrast, in those rare situations where a bank is both of sufficient credit standing to satisfy multinationals and also has sufficient local branch footprint to service smaller suppliers, a virtuous circle results. All transactions become internal book transfers, so the issue of data format incompatibilities no longer applies and transfers all have same day value. Add these ingredients to a supply chain financing scheme provided by the same bank and further benefits emerge. The suppliers issue invoices upon confirmation of delivery, then draw against those invoices up to an agreed percentage and receive the cash immediately – without any clearing delays. From the perspective of the buyer, its supply chain has been both streamlined in terms of data flow and made more resilient by accelerating the working capital cycle of its suppliers.
A topic discussed at length at the Hong Kong meeting was the amount of cash that should be held on the balance sheet. In a robust economic climate, publicly quoted corporations are typically under pressure from shareholders and analysts to keep this to a minimum. In tougher conditions, (such as at present) and for privately held companies, the situation is rather different.
Holding substantial amounts of cash on the balance sheet as a defensive mechanism to guarantee the availability of sufficient working capital in hard times is a well-established concept, but there is another important potential benefit to this. One of the core concepts of a supply chain finance scheme is leveraging the credit rating differential between a highly rated buyer and a group of lower rated (or unrated) suppliers. Using their invoices to a highly rated buyer as collateral, suppliers are able to raise working capital at a cost significantly below that achievable if they attempted to raise finance against their own balance sheets. But this begs the question of what happens if the buyer’s credit rating deteriorates? From the supplier’s perspective, financing costs may increase to the point where the scheme becomes valueless. In exceptional circumstances, a proposed financing scheme might have to be aborted. As a result, larger corporations keen to sustain the financial health of their suppliers are starting to realise that there is an additional reason for maintaining sufficient cash on their own balance sheets – namely to ring fence their existing credit ratings.
In a sense, the involvement of corporate treasury in supply chain finance represents yet another step in its evolution from purely a finance function to a finance/business one. Ensuring the resilience of the financial supply chain imparts a similar resilience to the physical supply chain. In addition, the increasingly consultative role of treasury becomes apparent in the provision of working capital education to suppliers and advice on matters such as location and financing of production facilities. Yet elements of the traditional treasury role still remain; the treasurer is still the ‘guardian of the balance sheet’, although in the world of supply chain finance the implications of that responsibility have notably expanded.