Supply Chain Financing: Liquid Inventory That Keeps Things Moving

I had an opportunity to interview Craig Weeks, one of our faculty advisors for the Supply Chain Resource Cooperative this week, at the NC State Football Stadium recording studio.  Craig is a wealth of information on this topic, and we will be presenting the insights from this video soon.  I thought it would be useful to present some interesting insights for those who are new to the term “Supply Chain Financing”.

As defined by the Global Supply Chain Finance Forum in its standard terms and definitions, Supply Chain Finance is defined as the use of financing and risk mitigation practices and techniques to optimize the management of the working capital and liquidity invested in supply chain processes and transactions. SCF is typically applied to open account trade and is triggered by supply chain events. Visibility of underlying trade flows by the finance provider(s) is a necessary component of such financing arrangements which can be enabled by a technology platform.  It is essentially the flow of funds that keep the supply chain running – think of it as “liquid inventory”, in that it frees up working capital and free cash flow that ensures things don’t grind to a halt.

The world of supply chain financing (SCF) has grown significantly in the last five years, and as an asset class, the returns on these capital investments have fallen considerably.  The growth of the industry on the one hand has increased the appetite of large multinational enterprises (MNE’s) to increase their payable timelines, and has also increased the level of access of many smaller suppliers to access quicker payment on their receivables.  Software companies like SAP and Ariba have made it increasingly easy for small and medium enterprise (SME) suppliers to access immediate payment of invoices through “click” buttons available in these systems.  In a sense, this has created a “race to the bottom”, as the basis points associated with supply chain financing have gone lower and lower.

Another big change has been the introduction of the “Basel 3” accord regulations.  Prior to this requirement, a bank might be able to lend money to a large retailer such as Walmart and charge 2%, and concurrently lend funds to Sears at a higher rate of 10% due to increased risk.  The bank could hold a single tier 1 capital reserve for losses that would cover both loans.  With the introduction of Basel 3, the reserve has to be aligned with each account.  In this case, the reserve for Sears might have to be eight times as large as the reserve for Walmart, which requires significant amounts of capital to be set aside.  This has made it increasingly complex for banks to calculate the right return and to forgo many of the more risky lenders in the ecosystem.  The “capital adequacy” rules render it more difficult.  Another factor is that the credit risks for larger suppliers are readily available to assign financing rates, but as large companies seek to create financing options for large numbers of smaller suppliers (through the “click” functions mentioned previously), banks are struggling to calculate the credit risks and assign ratings to these much smaller accounts.

Suppose that three major MNEs, (for the sake of example companies like Procter & Gamble, Coca-Cola, and Airbus), have 20,000 suppliers each in their supply base.  About 12000 or 60% of this supply base have credit scores that enable them to access SCF.  However, this leaves another 8000 smaller suppliers (as well as tier 2 suppliers) that would like to gain access to SCF, as they are often subject to greater payment terms (say 120 days).  Current commercial paper loan rates are perhaps 35% per annum, so although the risk profile of these smaller suppliers is greater, they have a larger company (say Coke) as their buyer, which has a superior credit rating.  If Coke vets that supplier, and has done some due diligence, they would gain access to a better capital rate.  It would make sense that suppliers in this category (that receives a lower rate of financing) would have a lower chance of bankruptcy than a similar-sized company in a similar industry, that did not have access through a large corporate customer to improved financing terms.

The value of extending credit to a larger swath of the supply base would result in significantly lower risk to MNE supplier risk profiles, and would enhance the ability of supply chain managers to target suppliers that fall outside of the identified parameters of low risk suppliers. This would provide a significant financial benefit and risk reduction profiling of suppliers, that could enable improved risk management and fewer supply chain disruptions.

These and other topics were discussed in our recorded interview, as the SCRC begins to explore the Wild West of supply chain financing.