Chapter Fourteen

Financing the Supply Chain

IN THIS CHAPTER, we take on the concepts learned earlier in Chapter 11, and look at some of the solutions available for financing the supply chain today. We start by looking at financing across various legs of the supply chain, and the elements of risk associated with each. We look at creating a supply chain risk index and conclude with a case study on assessing credit risk of the suppliers, an area in which Treasury teams are now getting more involved.

PHYSICAL AND FINANCIAL SUPPLY CHAINS

Technological advancements and service sector capability growth has begun to fully integrate the physical and financial supply chains. For each leg or element of the physical supply chain (see Figure 14.1), there is a corresponding equivalent arm of the financial supply chain that provides support, liquidity, and communication to enable the physical supply chain to work more smoothly and seamlessly than in the past.

FIGURE 14.1 Integration of the Physical and Financial Supply Chains

The growth of value-added services apart from regular banking products and the long-term thinking of institutions and the trade have resulted in a number of pioneering activities and processes to reduce uncertainty and processing effort, and increase visibility and speed financial settlements for all concerned parties. These span the areas of financing, processing, regulatory, compliance, and risk management.

Some of the determinants of smooth flow in the evolution are:

• Credit risk. The innovation and documentation in the field of credit risk management has driven a number of solutions regarding credit risk assessment, measurement, tracking, transfer, and mitigation methods.
• Technology. Imaging, data transfer speeds, reliability, and integration across systems have accelerated the inclusion of technology into the supply chain. Instruments now do not have to travel physically for scrutiny or verification, and transactions can be processed without paper at the click of a few buttons. With different vendors and customers on the same platform (such as in an electronic invoice and bill payment), or with different systems being integrated, the participants in the supply chain can verify, negotiate, execute, and pay quickly and seamlessly.
• Outsourcing and business process efficiency. Bank and specialised institutions have made processing a core competency—handling huge volumes with amazing accuracy and cost efficiency driven by economies of scale. Many processes that were tedious to execute, expensive to staff, and provided multiple opportunities for error, owing to specialisation or scale required, have now become candidates for outsourcing or automation, or both.

DIFFERENT FINANCING SOLUTIONS

The world of banking, markets, and finance has evolved considerably over time. This evolution presents a number of alternatives for firms to consider, based on the market, need, cost, and credit.

Basic Processes and Considerations of Financing Type

Depending on the process followed and various parameters, the type of financing can be determined. Some of the processes and considerations for financing the supply chain are provided in Figure 14.2. These include:

FIGURE 14.2 Processes and Considerations for Financing the Supply Chain

• Sale. The underlying transactions themselves and the location and access of both buyer and seller as well as the source and destination of the goods or services
• Documentation. Which document is going to be used as the underlying for the funding, and what incremental documentation is necessary for the purpose of funding itself?
• Funding. Who provides the funding, whether it is partial and whether it is discounted, and in which currency it is paid?
• Ownership (title). Who has ownership of the goods, is there a transfer of ownership itself?
• Assumption of credit risk. Who assumes the credit risk: the funding entity, the seller, or a third party, and is the funding with recourse to the seller or without recourse?
• Accounting treatment. Does the funding and transfer of ownership cause the receivable to move off the seller’s books, or can there be a setoff of the asset with the corresponding liability?
• Responsibility for collections. Does responsibility for collections of proceeds against which the funding is being done remain with the seller, or is it transferred to the funding entity or a third party?
• Value-added services. Are any value-added services provided by the entity—for example, reconciliation or ledger entry posting?
• Pricing.

We now explore the various funding alternatives.

Funding Alternatives

Figure 14.3 depicts various funding alternatives in the financial supply chain. Depending on the type of end use, the recipient of the financing, the kind of risk and underlying, regulatory environment, and techniques involved, the various alternatives are classified as shown in the figure. Financing may be in the following categories.

FIGURE 14.3 Funding Alternatives

• Trade based are of different types depending on export or import, pre- or post-shipment for export.
• Receivables based conceptually use existing receivables or documents to raise cash prior to settlement.
• Entity based are specifically chalked out programmes for specific entities, such as suppliers, distributors, customers, etc. based on the recipient, companies, or banks.
• Inventory comprised of warehouse (bonded or non-bonded) and inventory can be financed based on requirements and types of inventory.
• Securitisation use a stream of similar receivables that are purchased by financial institutions with or without recourse, title, and collections responsibility.
• Specialised transactions can be of different types, such as factoring, forfaiting, and ECA financing, covered in detail in the section “Some Alternatives in Detail.”

There are various sources to fund the supply chain. These include:

• Commercial banks
• Governments and government agencies
• Export credit agencies
• Financial institutions
• Trade associations
• Factoring houses
• Development banks
• Multilateral agencies

Some Alternatives in Detail

Some common funding alternatives that have developed over time are discussed next.

Bill Discounting

Bill discounting is the type of financing when the legal holder of a bill (a commercial bill, such as a banker’s acceptance draft or commercial acceptance draft) transfers it to a funding entity (such as a bank) to obtain cash (at a value discounted for the interest for the period) prior to its maturity date (see Figure 14.4).

FIGURE 14.4 Bill Discounting

Bill discounting is usually with recourse, with the drawer of the bill (the entity that is receiving the money) having the responsibility for collections. A bill may be discounted several times, but each discounting is for that bill only (i.e., each transaction involves one bill and not a group or set of bills). Discounting also does not assign ownership and keeps the asset on the balance sheet of the drawer.

Factoring

Factoring of receivables is the purchase of a receivable or bill from the seller of goods or services, where the paying entity (“factor”) assumes responsibility for the collection of receivables (see Figure 14.5) and in some cases the credit risk as well.

FIGURE 14.5 Factoring

Factoring can be done on a portfolio of receivables or assets and can be both on a recourse and nonrecourse basis, where the assignment of debt happens in the name of the factor. The item then could move out from the balance sheet of the seller.

Table 14.1 shows some of the differences between bill discounting and factoring.

TABLE 14.1 Differences Between Factoring and Bill Discounting

Factoring Centre

The factoring centre is a credit management tool used by companies with intercompany sales or closely monitored sales and collection processes (see Figure 14.6).

FIGURE 14.6 Factoring Centre

The process flow for the operations of the factoring centre, which is typically a subsidiary at a central location, is described next.

• The factoring centre buys the receivables from the manufacturing subsidiary after the invoice has been issued.
• The factoring centre immediately pays the manufacturing subsidiary the discounted amount in the currency of invoice (invoice of the manufacturing subsidiary); this could include the cost allocation of funding (liquidity) and risk management.
• The factoring centre collects the full payment from the sales subsidiary (buyer) in the currency of the buying entity on the due date.

Factoring centres offer several advantages. These include:

• The factoring centre allows sales and manufacturing subsidiaries to run their own manufacturing cycles and cash conversion cycles while concentrating liquidity risk centrally.
• Coupled with a Treasury centre, the foreign exchange risk management also gets addressed. Both subsidiaries in the channel are made immune to currency risk with the centre taking on all responsibility.
• Any sudden liquidity on the buyer’s side can be handled with delayed payment without impacting the manufacturing subsidiary.

Forfaiting

Forfaiting, a term derived from the French word for “forfeit,” is a transaction-based funding operation where a seller or exporter sells one of its trade bills or promissory notes without recourse. In a forfaiting transaction, the evidence of debt will always be endorsed to the paying party as a holder in due course, which allows the seller recourse to the payer at maturity under most laws.

The key difference between forfaiting and bill discounting is the recourse element—discounting is with recourse to the drawer. Also, the discounting usually happens for a specific period, and the seller pays the bank maturity of the bill.

Supplier Financing

Supplier financing is the general term used for the early settlement to the suppliers of a large company’s payables by a bank that acts as a lender by buying over the receivables of the supplier (and hence payables for the company). The company will then settle the payment on the due date directly to the bank (see Figure 14.7).

FIGURE 14.7 Supplier Financing

Different forms of supplier financing are available, and many banks run supplier financing programmes with pre-approved credit limits for weaker suppliers of large corporate clients. Supplier financing enables the corporate to reduce its days payables outstanding and cash conversion cycle and hence its need for working capital.

The suppliers hence get provided with more liquidity at possibly more favourable terms and cost since the bank has effectively substituted the suppliers’ credit rating with the superior rating of the large corporate.

Many banks offer incremental value-added services, such as automation with suppliers, payment order processing, reconciliation, tracking, and payment services along with the regular supplier financing solutions.

Export Credit Agency Financing

Export credit agencies (ECAs) are private or quasi-governmental financial institutions set up to encourage and support exports from a country by providing financing linked to exports by entities from that country. ECAs act as intermediaries between national governments and exporters to facilitate the financial supply chain.

Depending on the agreement with the government, ECA financing can be of three different forms:

The funding is generally provided to an importer at market or better-than-market prices in order to incentivise the importer to buy from the exporter in the ECA’s country.

ECA Credit

ECAs employ three different funding methods:

ECA Credit Insurance

ECA credit insurance covers, to an extent, commercial and political risk of nonpayment of the underlying transaction.

Commercial risks covered include:

• Buyer insolvency
• Failure to pay by due date (including a grace period)
• Importer’s unwillingness to fulfil contract terms although exporter has complied

Political risks covered include:

• Changes in trade regulations and laws
• Bilateral or multilateral political issues, such as cancellations, embargoes, sanctions, and other aspects outside the control of the buyer and the exporter.

ECA Guarantees

ECAs are generally meant for banks in the country that are providing financing to support exports. These guarantees encourage banks to take on additional risk for situations where they might have been reluctant to extend credit, such as for small companies (see Figure 14.8). Such guarantees are especially useful during credit or liquidity squeezes, such as during the Asian crisis in the late 1990s.

FIGURE 14.8 ECA Guarantees

Re-Invoicing

Re-invoicing, although not technically a component of supply chain finance, is an interesting addition to the value chain. Its aim is to reduce overall group outflows and thereby increase profitability (see Figure 14.9).

FIGURE 14.9 Re-Invoicing Centre

The re-invoicing centre buys the product and takes ownership from the manufacturing subsidiary, which makes a small profit on the transaction. The re-invoicing centre does not take possession of the goods but pays the manufacturing subsidiary immediately and simultaneously invoices (or re-invoices) the sales subsidiary (which is selling the product to the end customer). The goods are shipped directly to the sales entity on instruction from the re-invoicing centre, the customer of the manufacturing subsidiary.

The payment to the manufacturing subsidiary is in the invoice currency (currency of the manufacturing entity). The invoice and payment from the sales subsidiary could be in the sales currency, with the residual risk being managed by the re-invoicing centre.

The re-invoicing centre uses the tax arbitrage between locations, since the re-invoicing is done from a location that is more tax efficient than the manufacturing location. This method is obviously not viewed favourably by the tax authorities in the country of manufacturing, and must be implemented with care owing to regulatory and compliance sensitivity.

CASE STUDY: SUPPLY CHAIN RISK INDEX (SUPPLIER SIDE)

This case concerns how a company can start its own supply chain risk index. Although the case discussed is on the supplier side, the same approach can be used to develop intelligence on the customer side.

The concept of risk across its four areas—business risk, financial risk, operations and technology risk, and event risk—is discussed in detail in Part Four of this book. Here we discuss the points relevant to the supply chain index in the context of identifying and monitoring risk on the supplier side (see Figure 14.10).

FIGURE 14.10 Risks Relevant to the Supplier Side of the Supply Chain

The risks that are circled on Figure 14.10 are those most relevant to the supplier side of the supply chain. They can be captured through four input channels (see Figure 14.11):

FIGURE 14.11 Input Channels and Structure of Risk Index

1. External survey of finance team and management of suppliers

2. Internal feedback of members of the procurement team

3. Market factors that are measurable inputs derived directly from market sources

4. Supplier intelligence through banks, industry sources, and market reports

The index can serve as a useful input to management by providing early-warning signals and visibility into the situation on the ground. It uses objective inputs along with behavioural and subjective inputs from the supplier, buyer, and neutral sources to obtain an optimal and balanced quantitative assessment of the situation in each market, country or environment. Typically, a segment in a country will have its individual scores.

Figure 14.12 shows the various inputs across the channels.

FIGURE 14.12 Inputs to Each Channel in the Index

The inputs are fed and scored on a scale of −2 to +2 as follows. The scores for each input/question from the external survey, internal feedback, and market intelligence can be:

• Very negative (score of −2)
• Slightly negative (score of −1)
• Neutral (score of 0)
• Slightly positive (score of +1)
• Very positive (score of +2)

Inputs from market factors can be normalised to a scale based on the numbers.

Each input is weighted, and a score obtained between −100 and +100. A score less than zero indicates a heightened risk level. A score close to −100 indicates an impending market disaster. A positive score indicates confidence with the environment and a low risk level.

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SUMMARY

This chapter discussed the linkages between the physical and financial supply chains and their funding alternatives. We also explored the creation of a supply chain risk index and how it can be used to assess the credit risk and potential needs of the supplier.

While many alternatives exist in the supply chain financing suite, the intelligent use and the documentary elegance of the solution chosen determines the efficacy and final profitability impact of the method used.