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What is supply chain finance?

This is part of the AskWaves series from FreightWaves. If you have a question for our editorial team, click here. For more AskWaves articles, click here.

Supply chain financing, or reverse factoring, is a short-term loan agreement that buyers enter into to pay for goods and services provided to them by suppliers.

According to these agreements, a customer engages a financial institution to pay his outstanding invoice to a supplier. Typically, the bank makes the payment before the due date and at a discount to the supplier on behalf of the buyer. The buyer then pays the bank at a later time than allowed by the billing terms of the invoice.

A standard invoice of 30 or 60 days can be paid by the bank at short notice after approval by the buyer, with the repayment to the bank extended to six months or even one year.

The transaction can be as simple as the bank pays the invoice at a discount and the buyer pays the bank the full invoice amount at a later date. Or, in more elaborate supply chain funding programs, suppliers are invited to participate.

Once in the program, the supplier can choose which invoices to trade or sell at a discount to financial institutions in exchange for early payment. In some cases, well-capitalized buyers self-fund the program by paying invoices early in exchange for a discount on the face value of the invoice.

This scenario is set in many manufacturers’ supply chains to free up money. Many chain stores also use supply chain financing programs with their suppliers and vendors.

At first glance it is simple. Suppliers are paid early, albeit at a discount, buyers receive longer payment terms and the bank deserves a fee. Both suppliers and buyers can optimize the cash flow by using the balance sheet of the financial institution. In addition, many buyers have strong credit profiles, essentially allowing smaller suppliers with higher credit risk to access financing at a lower cost.

In comparison, factoring is initiated by the supplier. Under a factoring agreement, the supplier delivers the supply and then sells its invoice or account receivable to a third party or financial institution known as the factor. The supplier receives a discounted portion of cash prior to actual payment for goods by the buyer. The factor receives a fee, usually the difference between the gross value of the invoice ultimately paid by the buyer and the discounted portion it has already paid to the supplier.

In the past, most buyers only had their top suppliers in a supply chain financing program. But improved technology platforms allowed buyers to open financing programs for all suppliers, regardless of size.

Supply chain financing research

Research into disclosure of supply chain funding programs has increased following high profile insolvencies such as Greensill Capital’s. Supply chain financing arrangements are recorded with other payable items under current liabilities on the balance sheet, or that mature within one year.

Most leverage measures and valuation methods used to value a business and its equity include only debt and finance leases. Creditors are not included in these calculations. Also, extended payment terms can increase the amount of cash flow from operations that a company generates, potentially inflating cash-flow-based valuation metrics.

The lack of required disclosure for supply chain funding programs has drawn the attention of credit rating agencies and the Securities and Exchange Commission. The groups argue that investors may not fully understand a company’s indebtedness as the extension of payment terms through a supply chain financing program is not recorded as debt. There is also some concern about the possible consequences if financial institutions were to suddenly withdraw from these financing arrangements.

Some have pointed to the lack of supply chain financing disclosure requirements as contributing to the demise of the UK’s second largest construction company, Carillion. Project cost overruns and an extension of payment terms to subcontractors from 30 days to 120 days were cited as reasons for the company’s downfall in 2018.

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