Safeguarding Your Financial Supply Chain

After years of streamlining the physical supply chain, organisations are now looking to the financial supply chain (FSC) to push the boundaries of efficiency and security. There is a growing awareness of the need to safeguard business against the elevated levels of fraud and risk that firms have been exposed to during the recent crises in the financial markets.

With suppliers already operating on squeezed margins, further downward price pressure could lead to serious instability or even supply chain failure, while the risk of factoring fraud can also have devastating consequences in an age where supply chains are complex and often closely interlinked.

Supplier Survival

In order for corporates to keep levels of supply chain risk to a minimum, they must ensure all suppliers in a chain have a solid cash flow. Historically, supply chain financing has involved lengthy disputes over the stretching of payment terms taking place between buyers and suppliers. On one hand, buyers look to extend terms; on the other hand, suppliers look to reduce them. The situation appears to be reaching breaking point, as supported by Demica’s latest research revealing that 88% of UK firms and 55% of German companies identified their key suppliers as unable to sustain further lengthening of payment periods. This situation raises the spectre of the possible failure of essential suppliers, which would have a serious knock-on effect throughout the supply chain.

Effective FSC management requires an understanding of the wider implications that failure can cause in the supply chain. Pressure may be mounting on major firms at the end of the supply chain to free up cash, but if that means putting essential suppliers out of business, then the whole chain risks collapse. In the UK, the collapse of the high street chain Woolworths had a wider impact as its music arm was the largest wholesale provider of music and film products in the country. If firms are to ensure that they are not stifling their suppliers’ access to working capital, they must find intelligent ways to access it without making unsustainable extended payment demands.

One major study of supply chain management trends1 identified supplier failure among its top 10 risks. The same organisation also estimated that risk associated with ‘volatility and supplier failure’ had increased 54% between mid-2007 and mid-2008 (the early stages of the recent financial markets crisis). Yet many supply chains rely on a set of specialised suppliers who cannot be easily replaced, if at all. This has led to firms taking a much greater interest in the financial performance of their suppliers and encouraging standard best practice to include preservation of supply chain health as well as maintaining pressure for economies and efficiencies.

Fraud Protection and Prevention

The recent downturn has also brought another risk to the supply chain professional’s agenda. When a supplier struggles with cash flow, there is an increased likelihood of fraud being committed. A supply chain can be particularly damaged by a phenomenon known as ‘factoring fraud’. A fabricated or inflated invoice is raised by a customer and forwarded to a factoring company which pays the face value of the invoice upon receipt, allowing the supplier to generate short term cash flow before their outstanding invoices are due for collection. A lack of communication and transparency between a factoring company and its client is the key culprit here, as factors have no other option in an invoice discounting arrangement but to assume that a customer will truthfully and adequately report information. Moreover, reporting routines in invoice discounting arrangements tend to be at the aggregate level and are not reconciled item by item – until, that is, the factor decides to perform a random audit. By this time fraud can often have escalated to involve large sums.

When a firm’s outstanding invoices are due for collection, the firm is faced with the dilemma of satisfying the false invoice. This is normally covered by a ‘lapping’ scheme, creating and factoring a new false invoice in order to hide and cover an earlier one. Since the collection of the old and reporting of the new invoice occur simultaneously, the factoring company effectively nets off the invoices, giving the false impression that the previous false invoice has in fact been settled. This leads to a continuous (and often growing) cycle of fraudulent debt and lapped invoices, with the ironic consequence of leading a factoring company into believing that its customer is increasing its turnover and therefore safe.

The ‘improved’ performance often reduces the importance of having spot audits with that particular customer, only serving to encourage the customer to create further lapped invoices, possibly for larger amounts. By the time a factoring company runs a random audit of the customer and the fraud is discovered, it is often too late to recoup any losses as the number of falsified invoices tends to be colossal – leading the supplier into administration and the factoring company to lose substantial amounts it had previously thought were based on real invoices.

In supply chain terms, a supplier being closed down for fraud can be just as devastating as a business failure. The underlying source behind factoring fraud, other than those directly responsible for initiating it, is therefore the lack of control and knowledge surrounding the collection of outstanding invoices.

Mitigating Risk and Fraud: A Solution

Firms that are experiencing elevated levels of risk are looking at intelligent supply chain finance (SCF) platforms in order to optimise and safeguard their FSC.

Firstly, SCF reduces the risk of supplier failure by ensuring the supplier has a healthy flow of working capital. The solution is usually secured on outstanding invoice debt in the supply chain, where the risk is transferred from the supplier to the financier. For example, in a supply chain with 75-day terms, it is possible for the supplier to receive payment on day five at a low cost, while the buyer is able to pay the financier on day 75 in exchange again for a margin to the bridging financier. This allows a supplier to access working capital while also extending the buyer’s payment terms.

Secondly, SCF dramatically reduces levels of fraud through detecting and deterring the creation of false invoices. Total invoice transparency is made possible so that it is easy to differentiate between real and false debtors through the precise monitoring of when each payment was collected and the matching of each payment to its corresponding and real invoice. With a supplier’s ledgers captured on a daily basis, the financier gains an immediate view of invoice information at the item level, effectively matching invoice records with payment records.

The process is becoming increasingly popular with corporate treasurers as it becomes virtually impossible to hide false invoices, preventing any lapping scheme from developing and growing out of control. The process begins with the supplier sending an invoice to the buyer, who then approves it and uploads it to the SCF platform, thereby creating an irrevocable payment obligation. The supplier is then able to sell the invoice to the financier at an attractive rate, based on the buyer (rather than supplier) credit rating.

It is clear that all supply chain professionals have a duty to implement effective mechanisms in order to safeguard themselves against rising levels of supply chain risk. Buyers face significant risk, as a single essential supplier failure sees the buyer struggling to source an alternative – indeed, such a failure may have devastating repercussions throughout several interlinked supply chains. The risk to suppliers is great. Under constant pressure to sustain further lengthening of payment periods from buyers, suppliers are experiencing unprecedented cash flow squeeze and are struggling to stay afloat. Finally, financiers who are involved with several companies in a supply chain – or maybe all participants if they are offering an SCF facility – could face losses far wider than those resulting from a single fraudulent failure.

1AMR Research, Managing the Biggest Supply Chain Risk of All: Constant Change, November 2008. See also Supply Chain Top 25, 2008.


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