Supply chain finance is a relatively new way of providing liquidity to businesses. But what is it and why do it? How is it different from the more traditional approaches of factoring and invoice discounting?
To access working capital finance, businesses have traditionally used short-term trading assets such as stock or trade receivables as security. The most liquid of these assets from a lenders perspective is the accounts receivable ledger. They will secure their loan using this asset as the primary collateral, or even purchase the complete ledger. The lenders repayment source is the collection of these accounts receivable from the end customer (i.e. the debtor).
In broad terms factoring is transactional, with the lender purchasing and then taking over the collection of each receivable. Even purchasing just a single invoice is now common via peer to peer platforms. Invoice discounting on the other hand is a more wholesale arrangement. This is usually based on selling the complete debtor’s ledger but allowing the borrower to manage the receivable collection themselves.
Factoring and Invoice Discounting Downsides:
The amount of funding available at any point in time can vary tremendously. It is dependant on the invoices being funded and the lenders view on the end customer.
Lenders typically earn most of their income through the application of fees rather than the interest rate on the funds lent. As such, they can have a high fixed cost.
They can also be quite invasive for the borrower, with audits, reporting and requirements to disclose (non-confidential) arrangements to customers.
For companies with few customer invoices (e.g. retailers), or those operating in sectors unpopular with lenders, factoring and invoice discounting are obviously not an option.
What is Supply Chain Finance and How Does it Differ?
From the borrower’s perspective, factoring and invoice discounting look up the supply chain to a company’s customers and use these debts as security. Supply chain finance on the other hand looks down the supply chain to the suppliers.
Whilst some providers of supply chain finance try to dress it up as something else, supply chain finance is a form of working capital finance and provides liquidity in a similar way to an overdraft. The main difference being that funds are only used to pay suppliers.
From the security perspective, there is obviously no advantage for a lender to take security over a supplier invoice. If the borrower does not honour the debt, the supplier is unlikely to step in and help! Rather, supply chain finance lenders such as TradeBridge take comfort from the overall strength of the borrower. A position that is often backed up by credit insurance.
How Does Supply Chain Finance Work?
There are two broad types of supply chain finance in the market. They can be described as “supplier initiated” or “buyer initiated”.
Supplier initiated programmes (including reverse factoring) allow suppliers to sign-up to the programme and request early payment on approved invoices before they are due. The supplier receives the early payment from the lender (less the finance fee) and the lender gets repaid by the borrower on the due date.
Buyer initiated programmes (sometimes called purchase finance or supplier finance) involve the buyer instructing the lender to make payments directly to the supplier. These payments can be made early or on the due date. The fee is usually charged to the buyer who repays the lender on the agreed date (may be after the due date).
The simple diagrams on our buyer-initiated vs. supplier-initiated blog show how each form of supply chain finance works in practice.
Why Use Supply Chain Finance?
Despite what you might read elsewhere, few companies use supply chain finance for the sole benefit of their suppliers or ‘to secure their supply chain’ as it is usually put. In our experience, more common reasons to use supply chain finance include:
Where the buyer requires additional working capital to fund their growth (or manage seasonal cycles), supply chain finance can provide a valuable source of new liquidity, enabling the borrower to increase their sales.
Some buyers choose to improve their own balance sheet by extending supplier payment terms before offering supply chain finance (see reverse factoring below).
In supply chains where the supplier struggles to access finance (or finance is expensive compared to the buyer) both parties can benefit from this credit arbitrage by sharing the savings.
Where shortages exist, buyers can gain an advantage by using supply chain finance to attract the best suppliers without impacting their own working capital.
Is Reverse Factoring Supply Chain Finance?
Reverse Factoring is a type of supply chain finance, typically practised by specialist banks and very large companies. It is called ‘factoring’ because in order to avoid this facility being classified as debt on the large company’s balance sheet, the bank must actually purchase the supplier’s invoice from them. A separate contract between the bank and the large borrower covers the repayment obligations which allows the lender to offer suppliers cheap pricing based on the very high credit rating of the borrower once the invoice is approved (hence the “reverse” part).
If this seems unnecessarily complicated, that’s because it is. It is done for one purpose only; to allow the larger company to borrow many tens of millions without it being called “debt”.