Why You Need to Know About Your Supplier's Money Flow
There has been a dramatic move in supply chain financing in the past two years from documentary credit to open account payments – that is, importers are directly paying suppliers, instead of using guaranteed payment notes issued by banks. Here are a few reasons why. At first, globalisation of trade saw many business relationships spring up between buyers and sellers who had never met, didn’t speak the same language, and lived a dozen time zones apart. Letters of credit (LCs), which involve banks as neutral third parties guaranteeing payment against the confirmed receipt of goods, meant that lack of trust was not a deal-breaker. Because guarantees always come at a price, LCs are expensive and banks made a lot of money from them.
But now, after a decade of Americans and Europeans becoming accustomed to the things that they sit on, turn on, watch and wear to be made on the other side of the world, longer lasting relationships between buyers and sellers many thousands of miles apart have become established, therefore the trust factor is not so much of an issue. Hence, in an effort to save money on bank fees and in response to the recession that had a disastrous effect on the banks’ willingness to lend money in the first place, most companies, if they had not already, moved to open account payments, or plan to do so as fast and as completely as possible.
It seems like an obvious move. However, there are pitfalls. Perhaps the most important thing to bear in mind is that a company will need to get a deeper knowledge of its supplier than their simple ability to deliver the goods to specification and on time. It is important to know more about their financing arrangements.
Broadly, there are three factors a company needs to consider before moving from documentary credit terms to open account payments. First, it needs to ascertain whether it has the technology and operating processes in place to shift the task of paying suppliers from the bank to internally within the company. Second, and crucially, it needs to figure out if its suppliers are willing. Third, it needs to consider if the move to open account payment terms would have an inadvertent impact on its share price.
Perhaps the biggest obstacle is resistance from suppliers. Suppliers will often decline open accounts, not just because payment terms tend to stretch out beyond 30 days, but because commercial LCs (also known as documentary credit) are often used as collateral against which to borrow money from banks to buy the raw materials or to cover ongoing overheads needed to produce goods. In Bangladesh and Pakistan, local law requires these documents. Banks are simply less comfortable lending against an open account than a commercial LC, which has very specific information about the quantity of goods and a guarantee of how much money will change hands when they are delivered. Thus, a supplier’s willingness to move to open account terms is often linked to their working capital position. Those with strong cash positions will welcome open account payment terms as a means to reduce their expenses, including bank fees and interest; those with weaker balance sheets will want to retain the documentary credit because it provides access to financing.
Be warned: most buyers have a mix of suppliers that can derail the process. When companies ponder the move to open account terms, they quite sensibly start by approaching their sourcing or merchandising groups, to communicate their intentions and gather feedback. But many companies do not have a homogeneous supplier pool. Typically there are a few suppliers providing the majority of the goods to an importer, with many more suppliers providing seasonal or specialty goods. It is not uncommon to see an 80/20 or even 90/10 ratio where 10% of suppliers are selling up to 90% value of goods to a customer. All too often, the sourcing managers are contacting the largest suppliers, who would gladly move to open account at the expense of the smaller suppliers, who still rely on documentary credit. It is only when the company starts to broadly implement an open account payment system that they experience resistance and find that they are in trouble with small suppliers that provide those hard-to-source yet essential products.
Basically, you need to know how your supply base gets access to necessary working capital to manufacture the goods you are buying from them. Also, it helps to know whether funding, or pre-shipment financing, is required for acquiring raw materials. Or does the supplier want post-shipment financing to accelerate its receivables to improve its cash flow? Or both?
For pre-shipment financing, the supplier can use a commercial LC as collateral against which to borrow money from its bank, which is often know as packing credits. Or it can legally ‘transfer’ the LC to a second tier supplier of raw materials to provide that supplier with not only a payment guarantee but, in turn, collateral for their own financing. In this case, you can offer alternative documentation against which the bank will feel comfortable lending money to your supplier. For example, if you have detailed records of what goes on in your supply chain and how this supplier fits into it, some banks are comfortable lending against that. Furthermore, such collaboration can often mean that a manufacturer in China, for example, who would normally be restricted to raising capital from a Chinese bank at huge expense, can get access to credit from a foreign bank at more favourable rates.
However, borrowing money for raw materials might not be the main reason a supplier wishes to stick to LCs. Commercial LCs can also be used for post-shipment financing where, by presenting the LC, the supplier can ask the customer’s bank to advance payment on the accepted draft, also known as the banker’s acceptance. This money comes with a discount on the face value, which is how the bank makes money from the deal, but it means the supplier gets paid sooner than it would if it waited for the buyer to pay. In this case, it might be effective to negotiate different payment terms on an open account. Time is money, after all, and it might make more sense for you to pay earlier, but pay less. Often, suppliers will offer a discount for a shorter payment term, or they might be willing to accept payment later in exchange for the money they’ll save on the bank’s cut.
The main thing to remember is that when a buyer moves to open account payment terms, the payment guarantee on which supplier finance traditionally depends disappears. Suppliers and banks look for other forms of guarantees. Most banks require the buyer to sign agreements with the bank to guarantee that any invoice the buyer approves for payment is irrevocable, thus creating a payment obligation (much like a LC without the fees and line of credit); or to send payment instructions to the bank at the time the invoice is approved (thus letting the bank know that the buyer intends to pay the invoice) instead of a couple of business days before the payment due date; or both. Suppliers, on their part, want something to counteract the fact that their payment is not as secure as it was before. The challenge is that that the buyer is forced to take a more active role in supplier finance than before.
As if that wasn’t enough to worry about, moving to open accounts can inadvertently hurt a company’s reputation in the financial markets because once a company pays on open account, it requires much lower lines of credit to sustain its existing payment programme. If a company is viewed as proactively managing reduced credit, investors will most likely view it positively. But if the move is seen as being forced on the company, that reduction in credit can be viewed negatively, leading to the share price taking a significant hit.
For example, Talbots, a Massachusetts-based retailer of women’s apparel, shoes, and accessories, saw its stocks tumble 32% on 16 April 2008 after it announced that two lenders, HSBC and Bank of America, would not renew lines of credit totalling US$265m. As it turned out, these credit lines had been used to support import LC payments to Talbots’ suppliers and the company had come to agreements with its major suppliers to move to open accounts. But the furore was sufficient to force Talbots to issue a press release explaining its financial arrangements with banks and suppliers, pointing out that the revised terms extended the settlement period to 45 days from approximately 22 days, adding an estimated US$4m to the retailer’s 2008 operating cash flow.
In this case, Talbots most likely made the change in payment terms in response to notice from its banks that these lines of credit would not be renewed, and so the stock market reaction is understandable. But what if a company were to proactively move to open account payments with extended terms? Whatever the impetus, a move from LCs to open account allowed Talbots to improve its working capital to the tune of US$40m. Even for a company not at risk of its lenders reducing their credit lines, this seems like a smart move.
Many companies have already made the move to open account and extended payment terms. As a lesson learned from Talbots, some treasurers have been keen to retain lines of credit, or at least reduce them in small increments, in order to ensure that reducing LC payments is not perceived by market analysts or shareholders as a symptom of underlying financial weakness. Obviously, management will not do its shareholders any favours if, in the process of improving its working capital, a reduction in credit lines is perceived as a weakness in the company’s financial position. Therefore when moving to open account payments, companies should exercise caution to ensure that the reasons for doing so are not misinterpreted.
Banks, meanwhile, are eager to keep their corporate customers, so they’re investing in educating importers in supplier financing and the benefits to the buyer’s supply chain of having a well-funded, liquid supply base that’s available to the supplier. Banks say they’re experiencing mixed reactions. Some buyers are actively pursuing supplier financing programmes with their banks, while other buyers have adopted a position that the supplier needs to find its own financing sources. Those buyers who support supplier financing programmes are using the changes as a means of negotiating other terms in the supplier contract, including adopting a new supply chain process, such as agreeing to join and embrace a new supply chain technology platform, or agreeing to extended payment terms, which help the buyer’s working capital position. The open account financing education process and the opportunities it brings in terms of redefining the supply chain is on-going and will take several years to gain critical momentum in market, but the relentless increase in international trade means the move towards open accounts – and a more fluid supply chain – seems irreversible.