How Supply Chain Finance Eases the Strain of Rapid Growth
Around the world, increasing levels of interconnectedness and complexity within supply chains have driven growing interest in supply chain finance (SCF). SCF refers to a collection of processes that enable transactions to occur through the provision of short-term credit by financial institutions to the parties involved in transactions within supply chains[1]. SCF provides a solution to the problem of delayed payments between different stages of the supply chain, which can feed into larger market-wide liquidity issues[2]. Within the market, the widely-used term for this is “unlocking working capital”.
An Ideal World Supply Chain
To illustrate how SCF works, let’s use a simple example of a clothing supply chain with no SCF available, in an ideal world.
The chain is comprised of four parties: at the top, a creditor; then a cotton farmer; followed by a factory which spins the cotton into garments; and finally, a clothing shop that sells the items to consumers.
Firstly, to pick a cotton harvest, the cotton farmer needs to finance investment in machinery, labour, etc. To do so, they take out a loan from the creditor, agreeing that repayment plus interest will be made in 4 weeks. The farmer uses the money to invest in the necessary equipment and manpower needed for picking cotton, and completes the job within 1 week, allowing 3 weeks to sell the cotton in order to repay the creditor.
In this ideal world, the factory buys the cotton from the farmer immediately and receives an invoice to be paid within 3 weeks. The factory spins the raw material into garments, which are ready to be sold to a retailer, and this takes 1 week, leaving the factory 2 weeks to deliver on the invoice.
The clothing retailer immediately buys the stock of clothes from the factory and receives an invoice from the factory that is to be settled within 2 weeks. In this ideal world, the retailer manages to shift their stock to customers within the fortnight.
Using this income, the shop settles the outstanding invoice with the factory. The factory now has the funds to settle their invoice with the farmer, who uses that money to repay the initial loan taken with the creditor.
A Real-World Supply Chain
However, the real world works quite differently.
The prevalence of uncertainty in terms of when a party will receive money from the next party along the chain means that there is a need for SCF. In our example, there are many problems that each party in the chain may encounter that could prevent them from settling their outstanding invoices in time.
For instance, the farmer’s harvest might take longer than anticipated due to poor weather conditions or machinery unreliability. The factory might face a temporary slowdown in demand for their clothing stock from retailers due to fashion tastes changing or general conditions in the adjacent market changing. Retailers may face issues of competition from other stores or problems with customer demand for their products.
All of these reasons and more have the potential to affect the settling of invoices between parties. Additionally, in the real world, there are significantly more stages to the supply chain, each of which increases the likelihood of payment issues between parties. As such, there is liquidity risk in markets as one failed or delayed payment impacts other transactions at different stages in the chain.
Supply Chain Finance to the Rescue
The aforementioned problems with invoice settlement deadlines can be rectified with SCF. If a party who owes another money knows that there is a chance that they will be unable to settle their outstanding invoice by the deadline provided, they can turn to a supply chain financer. A financer steps in and takes care of the outstanding invoice on behalf of the party, for a price that is determined by the invoice cost plus a fee that reflects the projected market value of the collateral[3]. The collateral, in this case, is the party’s assets – in our example, this would take the form of the farmer’s cotton and the factory’s and store’s stock of clothing. The financer projects the value of this collateral in order to cover themselves in the case of the party defaulting; they will then be able to sell the party’s assets (which is now their own asset) at a market rate, should the party default.
This might sound similar to regular debt. However, as explained by Omar Al-Ali, partner at Simmons & Simmons, “SCF is different to bank debt”. Debt causes huge liquidity fluctuations on specific repayment days, for example, if a firm has to pay £100m, whereas SCF allows that firm to overcome this liquidity issue by repaying in smaller amounts over a number of repayment days[4].
Taking It Further
SCF takes benefitting firms who require credit to cover impending invoices to the next level; smaller firms can draw upon the superior credit ratings of other, larger, agents that operate along the supply chain in order to cover their outstanding invoices at a better rate than if they utilised their own credit rating, which would be poorer due to a number of reasons such as firm size, length of operation in the market, reputation, etc.
To go back to our aforementioned example of a clothing supply chain, if the factory which spins cotton into garments is relatively young within the market and thus has a poorer credit rating than the retailer, who is a large worldwide department store, the factory would be able to settle their outstanding invoice to the farmer by telling the financer that their impending payment is due from a large, well-respected client, with a better credit rating; thus, the financer will provide SCF at a more reasonable rate for them. This mentality is prominent within traditional SCF and is a major contributor to rising rates of adoption of the practice in recent years.
Advancements in Supply Chain Finance Technologies
The majority of SCF providers (which include large banks as well as non-bank financial institutions) fund their programmes by acting as a principal investor, using their own balance sheets to procure the finances for clients seeking SCF. However, although this was initially the industry-standard method of funding programmes, new innovations in the market have meant SCF continues to revolutionise working capital and improve transactional efficiencies.
One of these steps forward is the use of capital markets to optimise balance sheet figures, which in turn allow SCF providers to cater to more clients, take care of more outstanding invoice settlements, and overall, facilitate higher levels of growth. Essentially, financers are able to reach deeper levels of funding by using capital markets to their client’s advantage. An example of one of the ways that markets can be used is through bond issuance; a financer essentially trades on bond markets in order to raise additional funding for its clients. The largest SCF player on bond markets is Greensill Capital, a firm that became the largest issuer of bonds in Europe and is preparing to do the same in the Australian market too[5].
The Impact of Supply Chain Finance
Numerous key global industries, including automotive, manufacturing, and retail, have experienced a surge in popularity for SCF. Financial experts attribute the growth in popularity of SCF as one of the reasons why globalisation continues to escalate at an impressive pace. SCF unlocks the issues surrounding working capital and provides inventory finance solutions in order to combat these problems and accelerate growth and development.
Without SCF, the coordination required to ensure the smooth running of increasingly complex supply chains would be too brittle to be sustainable, and without a doubt, SCF is a leading contributor to why world markets continue to take strides in developing ways of optimising supply chains. In the past, investment in working capital was limited to traditional banks. However, with industry innovators such as Greensill, Oracle, and Taulia, SCF and associated technologies constantly developing methods to disrupt traditional SCF, a growing pool of investors is able to invest in short-term capital instrument.