In today’s challenging economic landscape, more and more companies are looking for ways to optimise their working capital. In the past, this meant that large buying organisations would extend payment terms to their suppliers to lengthen their days payable outstanding (DPO) and gain better returns on their cash.
This once made perfect sense when these companies were earning 20% or more annually on their idle cash. However, the 2008-09 financial crisis, along with recent global natural disasters, have adversely affected supply chains worldwide and exposed extreme vulnerabilities within their operations. It was soon realised that the costs of increasing DPO were far worse than the benefits to buying organisations if the impacted suppliers did not have the capital to remain in business. The cost of having a financially unhealthy and unstable supply chain prompted many to look for a better way to balance their need for better returns on their cash with their suppliers’ need to get paid as soon as possible.
This balance has ultimately been found through supply chain finance (SCF), a solution that ends the constant push and pull between buyers wanting to extend payment terms and suppliers wanting to shorten them. SCF, whether funded with the organisation’s liquidity, or that of a third-party, reduces unpredictability within the supply chain caused by unforeseen economic and global events by providing a ‘lifeline’ to suppliers, reducing both costs and risk for the buyers and their suppliers.
A Brief Overview
The language around the financial supply chain (FSC) and how many flows between buyers, banks and suppliers, can very across industries and geographies. For the purposes of this article, a few definitions of commonly-used terms might be helpful at this point:
- Supply Chain Finance (SCF): Expressed simply, SCF is the optimisation of working capital in the FSC. The term ‘financial supply chain’ in this case is used to describe financial flows that run in parallel to the physical supply chain. There are many different flavours of SCF including two that are most widely used; dynamic discounting and reverse factoring.
- Dynamic Discounting: This gives suppliers the opportunity to get paid early on approved invoices in return for a discount. The buyer sets the discount rate and funds the early payment through the same portal that is used for PO delivery, electronic invoicing (e-invoicing) and other purposes.
- Reverse Factoring: Also known as approved payables finance and sometimes even SCF, reverse factoring is similar to dynamic discounting in that the supplier can accelerate payment in exchange for a discount, but where it differs is that the early payment is funded by a third party financial institution, such as a bank.
Finding the Win-Win Situation
With the introduction of numerous accounts payable (AP) technologies, such as workflow automation, optical character recognition (OCR) and e-invoicing, companies were finally able to speed up the process of receiving, approving and processing invoices, leading to the ability to pay their suppliers early. However, even though these invoices were ready for payment on Day 5, large organisations were still waiting until the due date to pay, as paying early meant treasury shortened their DPO without providing a benefit to the organisation.
This is how dynamic discounting came into being. Tom Glassanos, the founder of Xign Corporation, realized that if buyers had an incentive to pay early and suppliers were willing to give a discount on their invoice in exchange for being paid sooner, both parties would greatly benefit from the transaction.
This buyer-funded SCF programme offered suppliers a discount rate that dynamically changed based on the date of payment, meaning the earlier the payment, the larger the discount. By utilising the earlier AP technological advances and new enterprise automation software, buyers and suppliers had the connectivity to easily agree to the discounts being offered. Most importantly, because the programme is optional, suppliers have the choice to utilise the financing opportunity on a per-invoice basis, providing the ability to better manage their cash flow based on their financial needs at the time.
Treasury Takes the Lead
Treasurers have increasingly taken on a more strategic role in SCF as supply chain risk became a priority following the economic downturn. It has become essential for organisations to maintain strong trading partnerships with their supply chain, which primarily means providing them with a source of financing to keep their operations running.
SCF not only encourages collaboration and partnership with suppliers, but it greatly reduces the risk involved with doing business with the supply chain. Due to strict lending requirements and regulatory frameworks, such as the Basel III capital adequacy regime, the majority of medium- to small-sized suppliers (those that make up the majority of the supply chain) have been forced to resort to predatory financing methods such as credit cards, short-term loans or factoring. Although providing access to capital, these financing methods leave suppliers in debt and, in turn, more vulnerable to external change. Because of this, treasury has had to take the lead on strategic supply chain management initiatives to re-inject stability into the supply chain and help make suppliers more resilient.
In terms of optimising working capital, dynamic discounting greatly appeals to treasury as it provides one of the best, risk-free returns on investments they can find in today’s economic environment. Not only can they utilise their idle cash to gain increased profits through early payment discounts, but they can also significantly strengthen the health of their supply chain and minimise the occurrence of production interruptions. It really has become the ultimate win-win situation for organisations across the world. Treasurers are able to turn their supply chain into a revenue generator without negatively affecting the well being of their suppliers, while also enjoying improved working capital management by reducing credit notes and lowering the cash conversion cycle.
The Future of SCF
Ongoing lending constraints, coupled with a still-recovering economy and increased government regulation, ensures that utilising SCF will remain a primary objective for organisations around the world. As needs change, both from the buyer and supplier side, new variations of financing programmes will also be introduced to adapt and fill the gap for boosting the financial supply chain.
For example, one of the main concerns of dynamic discounting programmes is the possibility that the organisation will hit a liquidity threshold, running out of excess liquidity to fund the early payment programme. This problem has recently been addressed with the introduction of enhanced discounting, which provides buyers with the same benefits of dynamic discounting but with the added option to use third-party cash to fund suppliers. This is similar to reverse factoring, but available to the entire supply chain through the same portal that suppliers already use for PO delivery, e-invoicing, and many other tasks. Treasurers are still able to gain risk-free returns by receiving a percentage of the discount share and suppliers receive uninterrupted and predictable financing.
Evolving solutions such as these prove the real market need for SCF and the strategic way in which organisations must find ways to provide it to ensure continued health their most critical asset – their supply chain.
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