Corporate Payments: Opportunities for Value-added Services
Over the past 20 years or so, the two most dramatic corporate trends have been globalisation and outsourcing, the latter creating what is now commonly referred to as platform companies. A platform company outsources its manufacturing and distribution to third parties, typically located in low-cost jurisdictions in the case of manufacturing activities, leaving it to focus on research and development, marketing and supply chain management.
Combined with globalisation, this has created huge growth in the volume of cross-border transactions and a reliance on a global supply chain ‘eco-system’ involving small and medium-sized enterprises (SME) whose ability to access financing at a reasonable cost is often a limiting factor to the velocity of trade. In addition, an outsourced distribution network is heavily reliant on relatively small distributors operating on very low margins.
The result is an awakened sense of the need for platform companies, often of blue-chip credit standing, to support their eco-system partners in order to ensure continuity of trade and manage the risks inherent in a business model where they are heavily reliant on the supply chain participants’ financial strength. This brings into question the traditional methods used when companies focus on working capital optimisation, namely pushing out supplier payment terms and trying to incentivise customers to pay more quickly, a high days payable outstanding (DPO) and a low days sales outstanding (DSO) being the holy grail and traditionally a good measure of how well a company is doing in managing its working capital. As performance metrics, however, DPO and DSO only tell the balance sheet side of the story and pay no attention to the true impact on the profit and loss (P&L) statement.
If an SME supplier has to finance a higher accounts receivable (A/R) balance at a cost of finance that is significantly higher than the platform company that it supplies, it is going to result in, at best, a higher cost of goods. At worst, the SME supplier cannot access sufficient financing to support a higher working capital need and goes out of business. The resulting impact on the platform company’s business could be significant if the supplier is providing strategic components.
In a sense, the platform company is outsourcing its financing to a company of lower financial standing. This, unlike other outsourcing decisions, is not necessarily a conscious decision because, if it were, it is doubtful that it would ever be approved. That being said, many companies still focus on DPO and DSO as key metrics to benchmark their working capital efficiency. In addition, more and more companies are beginning to focus on inventory levels.
Another trend in recent years is the shift of ‘horizontal, infrastructure’ functions such as finance processes, including A/R and accounts payable (A/P) to global shared service centres (SSCs), often located in low-cost jurisdictions such as India. This process offshoring has typically been coupled with the deployment of global enterprise resource planning (ERP) platforms, which has enabled the set-up of payment factories and facilitated the move for many corporates to a single global payment bank.
The remote nature of these process centres and the move to create standardised global processes has driven a requirement for banking partners to provide centralised customer support and online self-service for payment queries. The very nature of intra-bank and inter-bank systems and the lack of integration of corporate messaging standards, however, still means that payment files are often submitted by corporates, only to enter a ‘black hole’ until such time as funds are either received by beneficiaries or the beneficiary claims non-receipt, usually several weeks after the date of original payment submission. In other words, the fragmented payment systems in place today are not designed to support the evolving needs of corporate customers operating in a global SSC environment.
One of the downsides of the global SSC approach is the creation of vertical silos and fragmented processes in, for example, the end-to-end procure-to-pay (P2P) process. The recent focus on compliance and controls via Sarbanes-Oxley has forced many companies to piece the jigsaw back together in order to create end-to-end visibility. It has also highlighted the effect of several years of focus on siloed processes, which has led to disjointed and often conflicting performance metrics, as well as ignorance as to upstream and downstream processes within a single organisation. This has prevented companies from fully benefiting from the advantages of global standardisation and the ability to take advantage of value-added services.
In the SSC world, most companies have focused on creating a high level of straight-through processing (STP) and operational efficiency within their own company’s internal boundaries. This is in stark contrast to the level of efficiency that has been achieved in the way that financial supply chain (FSC) transactional data is exchanged with suppliers, outsource partners and distributors. The exchange of information with supply chain partners is often paper-based, resulting in the requirement to re-key data manually. In the past, the argument would be that these manual processes could be done in low-cost countries and would therefore have little impact on the cost base. With salary inflation spiralling in ‘low-cost’ jurisdictions, this argument is becoming somewhat outdated. There are often bigger issues, however, that are created by manual intervention that are not necessarily so visible as salary costs. Staff turnover is extremely high in many of the locations that have successfully attracted companies’ back office processing centres. Even when procedures are well-documented and repetitive in nature, the costs of hiring and training people to manage tasks that could be automated is an unnecessary waste of money.
There is an even greater impact, though, when upstream and downstream functions are affected by the inefficiencies created by manual back office processes. For example, the credit control department requires timely identification of customer receipts and closing of open invoices in the A/R ledger, in order to free up credit capacity and ensure continuity of customer shipments. This is often impaired, owing to the lack of efficient A/R reconciliation procedures that, in turn, is often caused by the lack of remittance advice information supplied by customers. Where it is supplied, it is often paper-based and needs to find its way to an offshore location in order for the information that it contains to be beneficial. Paper-based information does not marry well with the global, virtual world of the SSC. Think, too, of the treasury function’s inability to readily access accurate cash forecasting data. One would think that, when supplier payment terms are 45 days, there would at least be 45 days’ worth of daily payment information available from the A/P ledger system. This is often not the case, however, owing to the inefficiencies of the receipt and matching procedures required before invoices can be flagged for payment on the A/P system. This can lead to sub-optimal liquidity and funding decisions that can far outweigh the costs associated with creating more efficient upstream processes.
The corporate world is evolving rapidly, with the resultant impact that supply chains have become global and supply chain partners are integral to the success or failure of platform companies. There is a constant drive for cost reduction in the form of operational efficiency and the need to focus on the elimination of paper-based financial supply chain data. As these two areas merge, there is a growing realisation that there is tremendous value to be unlocked if a broader view is taken on the end-to-end supply chain with the objective to optimise the financing costs in every layer (see Figure 1).
Figure 1: Operational Efficiency and Beyond
One of the biggest technology trends in recent years has been the move toward software-as-a-service (SaaS), which has rapidly overtaken traditional client server-based applications. There are many reasons for this shift:
One of the most important features of SaaS, however, is the ability to create a wide range of customisation and different business logic on top of common applications. This enables the delivery of products that meet customer needs much more closely, even in a rapidly changing environment. Not only that, but customers do not have the upfront costs involved in the purchase of large ERP applications but instead on a usage basis, making the cost/benefit economics in the form of a payback period much more attractive.
One of the more recent examples of SaaS in action in today’s financial marketplace is SWIFT’s new corporate access solution, Alliance Lite. Designed to be a lower cost alternative to existing corporate access options such as MA-CUG, Alliance Lite is aimed at mid-size to large corporates. In addition to providing secure, non-bank proprietary connectivity for account balance reporting and domestic and international payment initiation, the success of Alliance Lite has prompted solution providers to integrate the solution alongside a range of services that provide enhanced value to corporate treasury operations and A/P departments, such as cash forecasting via integration with existing ERP applications.
As already discussed, many companies are heavily focused on improvements in DSO, DPO and inventory. In addition, they are also beginning to focus on the impact of their initiatives in these areas on their supply chain partners, recognising that, in the main, the traditional products used to manage working capital have a ‘squeezing the balloon’ effect rather than optimising financing costs along the entire supply chain.
Recent technological developments, combined with corporates’ desire to eliminate process inefficiencies and associated costs, are beginning to drive adoption of e-commerce platforms designed to exchange invoice and other financial supply chain data. Forward-thinking companies are planning to take advantage of the availability of such data and recognise that, in capturing both buyers’ and sellers’ information, there is an opportunity to layer supply chain financing programs on top of these platforms.
Supplier financing has been one of the first areas on which corporates and financial solution providers have focused, with structures designed to allow suppliers to get paid early by a third-party financier based upon the creditworthiness of the buyer. One of the key requirements is the ability to get the buyer’s acceptance of the invoice in order to separate performance risk from credit risk. One of the largest opportunities for buyers in the supplier financing space is the ability to take advantage of early payment discounts (EPDs) offered while simultaneously extending DPO. This can create a win-win situation for buyers and suppliers when the EPDs offered are a set at a rate that is lower than the supplier’s cost of funds but higher than that of the buyer (Figure 2). The ability to manage these types of programs on a dynamic basis is predicated on the use of technology that captures the trade flows on a near real-time basis and is able to disseminate the information to multiple parties in the form of financiers and credit insurers.
Figure 2: Working Capital Management Versus Supply Chain Finance
Alongside the globalisation of supply chains, there has been a significant shift away from the use of letters of credit (LCs) to open account trading, which has led to an increased focus on alternative methods of A/R risk mitigation. While factoring and securitisation both provide some level of risk mitigation, they are costly, and advance rates can be low. In addition, when compared with other asset classes such as mortgages, leases, etc., the proportion of A/R that are directly financed in both the US and Europe is only a small fraction.
There are opportunities to create new receivables financing products and achieve a much lower cost of funding, especially for SME companies, once again using technology platforms that can seamlessly interact with multiple parties in order to create a more dynamic exchange of trade flow information and credit enhancement techniques. The use of a platform also enables an audit trail and eliminates the potential for fraud that is highly prevalent in the current world of factoring.
Developments in the physical supply chain world over the past decade have far outpaced those in the FSC world. The investment in the physical supply chain and the implementation of programmes designed to manage physical inventory levels more effectively, however, have created the opportunity for the focus now to shift towards the financial aspects. The very nature of platform companies means that inventory ownership typically shifts to outsourced manufacturers and distributors and, once again, little thought is given to the relative financial strength of the parties involved, with the focus being on balance sheet metrics alone. Typically, there are underlying purchasing and sales contracts that cover the issues, such as excess inventory, buy-backs, etc. In addition, inventory tracking and management tools are available, which should mean that shifting inventory from one company’s balance sheet to another’s should truly be a simple decision around financing capacity over and above anything else.
While the corporate community is marching towards its goal of operational efficiency in a world of ever-increasing complexity, driven by evolving business models and globalisation, and while private equity groups are moving the goalposts of business economics, banks have been facing their own challenges.
Payment processing has largely become a commodity business with low margins and high infrastructure costs. At the same time, large corporates have been driving down pricing on traditional payment products and have become increasingly resistant to banks’ proprietary solutions and interfaces, preferring to keep their options open and costs down by insisting on standardised formats. With regulatory changes in the form of the single euro payments area (SEPA), many banks are being forced to consider whether the investment required to stay in the payment game is justified, given little opportunity for incremental revenue in the traditional product areas.
As banks seek to offer value-added services to their customers in response to the erosion of margin from their traditional product areas such as payments and trade finance, they are beginning to recognise the influences of automation in the supply chain as opportunities to create substitute revenue flows. There are a number of challenges, however, that they need to overcome.
It is fair to say that large, global banks are, in general, as siloed as their platform company customers, the cash management relationship managers often dealing with treasurers and finance process managers, while the trade finance teams typically deal with credit managers. In addition, cash management services are often aimed at large, blue chip companies, while trade services are aimed at distributors and manufacturers who have a requirement for financing. Banks are slowly beginning to connect the dots within their own organisations, but this is taking time and creates issues around cannibalisation of existing business lines.
The IT departments within banks are often remote from their customers and are engaged in trying to manage myriad legacy internal systems. The traditional methodology of in-house development of applications based upon a pre-specified set of criteria is not supportive of a dynamic environment where financing and payment products are evolving continuously, and they have been slow to adopt the SaaS model.
The emerging supply chain financing techniques and products require visibility of upstream trade information, not just at a single company level but up and down the supply chain, which could have multiple layers. Banks have typically offered supply chain financing solutions at a single company level based upon that company’s creditworthiness, so the new multi-layered approach requires them to re-think not only their product offerings, but also their approach to credit allocation and solution deployment. Most companies are – and want to remain – multi-banked, not least because a bank’s ability to price and take risk varies. This, combined with alternative sources of financing and risk mitigation, means that optimal pricing is achieved when supply chain financing is managed on a dynamic, distribution basis rather than on the traditional bilateral approach.
The structuring of supply chain financing programmes requires a deep understanding of complex corporate business models and processes in addition to the accounting, tax and legal implications. Every company is unique and requires an almost ‘investment bank’ type approach in order to ensure that the programme meets its individual needs. This, in turn, requires a technology platform that can remain flexible and easily adapted to ever-evolving requirements.
In light of the recent and ongoing tightening of liquidity in the financial markets, large corporates will focus even more heavily on working capital optimisation and are becoming more aware of the impact of the credit crunch on their SME supply chain partners. With opaque investment vehicles out of favour, there is likely to be a ‘back-to-basics’ approach, with A/R, A/P and inventory flows representing a real opportunity for transparent, structured solutions designed to maximise both the balance sheet and P&L at multiple levels of the end-to-end supply chain.
Payments are simply not seen as a value-added banking product by the majority of corporates, yet at the end of every supply chain transaction, a payment needs to be made. Supply chain financing represents a huge opportunity to marry existing payment products with offerings that are truly perceived to be of value to banks’ corporate customers.
Banks are very well placed in this regard, owing to their existing customer relationships and position of trust, especially in emerging market countries. In addition, market awareness and adoption of innovative supply chain financing solutions has, to date, been somewhat slow, and therefore opportunities for banks to play a leading role in this space still very much exist. With adoption set to accelerate, however, banks should focus on tackling the barriers to timely solution development and deployment.
There is a need for banks to develop a deep understanding of corporate business models, processes and underlying terms of trade. The adoption of SaaS and the use of niche third-party software combined with the ability to seamlessly integrate with legacy applications will be key to the acceleration of solution deployment. And finally, success will require the breaking down of silos across departments such as cash management, trade finance, credit, asset securitisation and IT.
Whether liaising internally with other departments or externally with customers and third-party specialists, there is no shortage of opportunities for all in the ever-developing world of supply chain financing. With more opportunities than threats, collaboration represents the key to unlocking the tremendous value that is currently trapped in the global, virtual world that represents the corporate financial supply chain.