Supply Chain Finance in Context of Working Capital Management

Igor Zax, MD, Tenzor Ltd.

Talking about supply chain finance in a broad definition (including a whole range of products, including factoring, invoice discounting, supply chain and distributor finance) we often miss a wider context of overall working capital management (and even wider of its place in global supply chains and industry structures). Better understanding of this context should be beneficial in product design, as well as go to market strategy for the financial services community to address these markets.

Working capital management in changing industry structure

Speaking about working capital, first thing we need to recognise is enormous change in the industry structures since the concept firs come to play. A “traditional” model of integrated manufacturer buying raw materials, manufacturing goods and selling it to consumer is now virtually extinct- we are in a new world of “platform companies”, supply chain collaboration, etc.

In 1991, Richard Coase received a Nobel Prize in Economics for a theory of the firm based mainly on the concept of transaction cost, (i.e., the overriding reason for a firm’s existence is because there are costs of putting together different market participants, costs that might be lower within a single firm structure than in the broader market). With this realization, supply chain management and co-operation become much more important, with better technology and information facilitating the change. In fact, many industries have developed a model where Original Equipment Manufacturers ("OEMs") have become “platform companies”. A “platform company”, as a concept, was defined by GaveKal in 2005 as a company that: "produces nowhere but sells everywhere...Platform companies know where the clients are and what they want and where the producers are. Platform companies then simply organise the ordering by the clients and the delivery by the producers (and the placing of their logo on the product just before delivery)."

Modern technology applied to supply chain collaboration arguably makes it possible for many companies to operate without significant negative operational consequences.

However, as became particularly clear at the time of recent financial crisis, a company which has a high degree of consolidation in either sourcing or distribution (that is often the best arrangement from an operational point of view) represents a high concentration in terms of both credit and operational risk. While the platform company model in theory (and normally in contractual terms) should provide substantial risk mitigation, the reality is that often most of its business partners would not have enough capital to absorb a material shock.

In practice what we can see in many industries is that companies that look good based upon their own, stand-alone financials may be almost fully dependant on a few players on the supply side (such as contract manufacturers) as well as on the distribution side. (Even supposedly diversified companies can have massive exposure to companies operating under very similar business models with expected high default correlation.)

In fact, consciously or unconsciously, “platform companies” have outsourced their own financing up and down the chain...

While in “traditional” model shifting financing up and down looks like a sensible strategy (and for long time companies that were good it measured by working capital cash conversion cycle and measures such as DSO, DPO and DIO were considered exemplary), there is more and more recognition that if a resulted cost throughout the chain increases as a result, even putting strong hand and retaining larger share of diminishing industry profitability may be unsustainable (as, for example no major OEM would be able to sustain its channel collapse – there was a well-known story on a dot com crisis when one of the major industry player have to spend billions effectively bailing up the channel after loading it just before the market collapse).

Key components of working capital management and role of financing products

For a company, working capital management principally consists of three elements:

1. Risk management2. Financing3. Operational aspects

Risk Management

As a company, three risks are principally important on receivables- default risk, late payment risk and fraud risk. Relative importance of these risks massively depends on diversification and funding structure of the company.

Credit risk surprisingly in often the least of the worries, particularly on a well-diversified multi industry portfolio, as default rates are quite predictable. It is also may be better and cheaper addressed through insurance market rather than financing products. Very significant exception would be highly concentrated portfolio, where single default (even if a buyer is relatively good) can lead to catastrophic consequences. In this area there is a general lack of available products- for both insurance and factoring single risk programs for medium risk buyers are relatively scarce and often disproportionally expensive, supply chain financing is heavily focused on top credits, and still very uncommon in the mid-market space. As a product, this put supply chain financing is a very strange position – it isolates credit risk from others (performance and fraud) but then only

deal with the cases where this risk is very low (most of bank funded programs) or on occasions where it is very high with corresponding yield (example will be Abengoa transactions funded on a non-banking market).

Late payment risk is very important for companies with tight capital management (such as many owned by private Equity). For example, just couple weeks delay on 30 day terms increasing working capital consumption by 1.5 times and can have far larger consequences for return on capital than fraction of percent default rate (particularly for companies with relatively fat margins). Often this risk is indeed the main driving force for use of tools-factoring and even more so supply chain finance.

Fraud risk is important but there is always a question if outsourcing of it to a finance company is effective way of managing it. One of the core questions is if systems used for supply chain finance and dynamic discounting actually help to mitigate such risk to both buyer and supplier (i.e. by the time invoice is approved all risks are eliminated and controls are done) or it merely protects third parties.

There is also a direct impact of payment terms on both buyer and supplier credit risk. Part of the chain having a mismatch in their working capital (i.e. buyer who pays to early or supplier who is paid to late) have to finance it making it (in addition to cost implications) dependent on third party financing. In case (as it often is in highly interdependent chains) they cannot be easily replaced platform company may be facing significantly increased risk.

Financing

As a general principle, invoice financing (with exception of some large securitization programs) is rarely the lowest cost way of financing (supply chain financing is in some cases, however it often addresses need that did not exist before the program as it covers forced terms extension). Supply chain finance is also very rarely cheapest form of financing for the buyer, however may have cost advantage to some sellers. The driver is normally either accounting/covenants (i.e. IAS39 or FAS 140 compliant program with financing not being treated as debt, ability to structure programs around covenants restrictions, etc.) are often driving force- however this area is constantly changing- example would be rating agencies adjustments in SCF programs treatment post Abengoa. . Another core distinction that unlike general funding receivable fiannce is specific to product sale and therefore it may be treated as just additional product to sell at a margin (i.e. it cost me say 0.5% to finance the extended credit but I can charge the customer 0.75% for the same making 50% margin on sale of financing vs say 5% on sale of corresponding physical product)- in which case the whole view shifting from wholesale purchasing of financing by a large company and “retail” sale to its smaller chain counterparts.

This leads to several competing views on such finance programs and different views of accessing the value.

1. Supply Chain Finance as general financing. If the difference in accounting treatment is ignored one needs to compare all in costs with alternative forms of financing. There WACC (weighted average cost of capital) will often be used as a benchmark.

2. Supply Chain Finance as balance sheet management tool. So far as it is allowed by accounting standards and third parties relevant to company (rating agencies, equity analysts/investors, etc.) supply chain finance can be seen as a way to fund the business without showing it as a bank debt.

3. Supply chain finance as a product. From a supply chain prospective, terms are a product, same as goods and services. If one can buy them cheap and sell them expensively this makes profit, often higher than accompanying products. To look accurately one needs to consider all elements of financing (funding, risk and administration) against profitability of getting price advantage by either offering customers’ longer terms or paying suppliers early.

4. Supply Chain Finance vs. dynamic discounting. This is a difficult comparison that very much depends on the capital structure and the way company is evaluated. If company has cash on balance sheet one may argue the benchmark shall be return obtainable on such cash, while other argument would be that keeping this cash is a business choice, while WACC is a relevant measure. One core distinction there is timing- if discounting is an option (for example the company only does it between reporting periods, so no implication is seen on its balance sheet) or it is essential to suppliers (i.e. they constantly rely on it as source of liquidity) where it is essentially just form of commercial negotiations (such as asking supplier for longer payment terms for free and then negotiating discount to pay earlier- but if company is able to do so it may well ask for straightforward price reduction without changing the terms).

Operational aspects

Third aspect where both factoring and supply chain finance is utilised in working capital management is process outsourcing (partially on collections). With factoring, this may be valuable to smaller companies (as factoring company will have more efficient systems), but such arbitrage rarely exist for larger clients that can have efficient internal system or outsource collections to specialised providers. Supply chain financing often delivers larger operational efficiencies by broadly eliminating the whole process (i.e. once invoices are approved there is full predictability and visibility), however it does not address fundamental processes (three way matching, dispute resolution, etc.) that have to be dealt with outside of such system. This questioning the whole idea of separate system for SCF- instead we are likely to see more conversion with procurement management, e--invoicing, etc.

Conclusion:

Better understanding of industry structure, processes and priorities of corporate customers are likely to significantly improve both product development and targeting for all parts of working capital finance industry. Finance providers need to recognised that they are just a supplier of (valuable) commodity and need to find their place in a globalised and integrated supply chains of today.

Igor Zax, Managing Director, Tenzor Ltd.

www.tenzor.co.uk

e-mail: igor.zax@tenzor.co.uk

tel +44 777 5708426