Given the recent market news related to certain Supply Chain Finance setups, it is worth to recall what Supply Chain Finance really is and analyze its merits critically.
In a nutshell, Supply Chain Finance (SCF) comprises various structures for the financing of accounts receivable (AR) and accounts payable (AP) of companies, with the aim of enhancing the working capital of sellers or buyers or both in the supply chain.
Accounts payable based programs
There are various types of AP-based programs with differences in structure and purpose.
- Reverse Factoring
Reverse Factoring (RF), also known as Supplier Finance or Supply Chain Finance, is a financing program established by a buyer and a funder whereby the funder commits to accelerate the payment of invoices to certain suppliers. The funder purchases from each supplier its buyer-related AR at a discount. For RF programs to work there must be a credit-arbitrage between the financing rate negotiated by the buyer and the one that suppliers would obtain on their own merits. Typically, the buyer requests the suppliers to extend their commercial terms as a condition to join the program.
If properly structured, RF programs can be of great benefit to both; the buyer obtains longer payment terms and extends DPOs, whilst suppliers, particularly small and mid-sized suppliers, can access financing at a lower cost. However, there are significant inherent risks, such as the use of RF by weaker buyers, as these could become over dependent and might not be able to withstand the cancellation of the facility. Also, its inadequate disclosure in the financial statements might cause that the RF facility remains hidden in the balance sheet of a buyer until enough stress crystallizes, at which point it subsides causing a sudden working capital outflow in a very short period, creating a liquidity hole of the size of the RF facility. As explained in a previous report, rating agencies argue that RF is a risky financing tool which can make bad situations worse and has the potential to push a company to the brink of default.
- Trade Payables Financing
Trade Payables Financing (TPF) is a structure based on confirmed AP, through which a buyer finances the extension of payment terms of its purchases from few key suppliers. The buyer mandates a funder to pay the supplier on its behalf and pays the funder at a later date. The main difference with RF is that the supplier is not legally engaged and that it does not sell its AR to the funder.
When rightly structured, TPF programs allow the buyer to extend DPOs and the supplier to improve cash flow forecasting. For TPF programs, funders carefully select credit worthy buyers with a strong relationship with reputable, industry leading suppliers.
Accounts receivable based programs
AR-based programs such as traditional Factoring and a more comprehensive type of program called Distribution Financing (DF), have a completely different set-up, with different accounting, credit and processing dynamics and therefore should not be mixed with RF type of financings. More information on these AR solutions can be found here.
In DF, a supplier (referred to as vendor) can achieve additional benefits for itself and its buyers via selling its AR to a funder, but with an important enhancement that is the extension of payment terms offered to a portfolio of buyers. DF is therefore a win-win approach for both vendors and buyers. It is a way for vendors to finance sales growth, whilst at the same time reduce credit risk and improve working capital. Buyers benefit too by increasing their liquidity position and DPOs. From the credit standpoint, DF is substantially more complex to handle than RF, but it truly achieves credit risk diversification as it involves the processing of a diversified portfolio of obligors instead of dealing with risk concentration like in RF.
Balance-sheet wise, DF is an efficient way of financing working capital, as it does not impact debt and it greatly improves the cash flow and liquidity of all participants. Companies with RF programs could consider DF as an alternative way to enhance working capital or replace RF, whilst achieving the additional benefits of centralized AR management and credit risk monitoring.
Regardless of the SCF program structure chosen, transparency and adequate credit risk monitoring are essential for the assessment that the risk takers, namely funders and credit insurers, have to undertake. They should analyze elements such as financial strength of buyers, their management and ownership, competitive position, industry dynamics, interdependency of buyer-seller relationship, macro-economic factors as well as country and currency risks.
In summary, well-structured programs processed with adequate technology and comprehensive servicing (that includes credit risk analytics, obligor monitoring and flagging) will remain solid and substantially safe in spite of economic and market turmoil.
Global Supply Chain Finance Ltd. (GSCF) is the leading servicer in the SCF market, with 30 years of successful experience in structuring and managing AR and AP-based financing programs worldwide. With a state-of-the-art processing platform and credit-risk management focus, GSCF ensures that the right program structure is effectively established and managed, providing full transparency to all stakeholders.
To learn more about GSCF Group, please contact us.