Topic 7 Why supply chain finance?

Introduction

In this topic we explore why a company might use supply chain finance. There may be a
finance requirement in relation to working capital but supply chain finance is not the only
solution. The need to finance the working capital cycle might not be the main reason for
using supply chain finance. In practice, there are a number of possible drivers depending on
the size, maturity and type of company.

Learning objectives

By the end of this topic you will understand:

• the reasons why a company might decide that they require a supply chain finance
solution; and
• how a company would select a supply chain finance solution that best addresses a
problem or realises a benefit.

Think...

Why do you think a company might need a supply chain finance solution?

What problem are they trying to solve?

What benefits are they trying to realise?

7.1 Recognising differing client needs

Differing needs of parties in the physical supply chain

As noted in Topic 2, a physical supply chain involves multiple parties. With the exception of
the end consumer that buys the finished products for their own use or consumption, each
party in the physical supply chain is both a seller and a buyer. A company’s role in the supply
chain will be determined by the stage in the supply chain at which they operate. A producer
of raw materials, for example, has needs which are different from those of a manufacturer,
a wholesale distributor or a retailer. Size, maturity and credit standing also make a
significant difference to a company’s supply chain finance needs.

© The London Institute of Banking & Finance 1

Funding and liquidity management

As we have seen in Topic 6, a company is exposed to financial consequences whenever they

buy, sell, make or move their products through the physical supply chain. In particular, as
they incur costs and receive payments, their funding and liquidity management
requirements will be impacted. If they pay out cash before they receive cash, their liquidity
will be reduced, possibly creating a funding gap which they would need to address.
Conversely, if they receive cash before they pay out cash, their liquidity will be enhanced,
allowing them to reduce debt or invest surplus funds to optimise returns. Addressing a
funding gap is a primary supply chain finance benefit, but may not be the only driver.

Circumstance and objectives

A company’s needs are affected by what they wish to achieve and their circumstance. In the
context of supply chain finance, we consider these drivers by recognised turnover bands as
shown below.

7.2 Small and medium-sized enterprises (SMEs)

SMEs are predominantly owner-managed, family-run businesses. As such, they typically do
not have strength in depth in their management teams, with each manager having
accountability for multiple disciplines. They may not have a dedicated, full-time, qualified
finance director or treasurer, for example, and will probably be relatively ill-informed
regarding banking generally and supply chain finance specifically. They are more likely to be
sole-banked, but may have additional specialist finance providers to meet specific needs (eg
factoring). Debt pricing tends to be relatively high for SMEs, reflecting their generally poorer
credit quality.

FACTFIND

SME segment in emerging markets: gaps in availability of trade finance

Although this brief refers to gaps in the availability of trade finance, it applies equally and
more generally to supply chain finance. The fact that there is such a significant gap,
particularly in the SME segment in emerging markets, is one of the reasons why supply
chain finance is the subject of so much innovation and development right now.

ADB Briefs: Trade finance gaps, growth, and jobs survey

© The London Institute of Banking & Finance 2

Check your understanding

Referring to the ADB Briefs report.

The percentage of trade finance applications made by SMEs is 23%. What percentage are
rejected?

a) 20%
b) 30%
c) 40%

Answer

SMEs struggle to access traditional funding from banks. They are generally seen as a riskier
prospect, requiring greater collateral against any lending. The high cost of technology and
lack of digital expertise in smaller firms also prevents banks engaging with them via
innovative fintech solutions, creating a further barrier.

7.2.1 Financial strength

The financial strength of SMEs is also typically a problem, with relatively weak balance
sheets. Many SMEs manage with relatively low levels of capital, especially if they operate in
the wholesale distribution sector where there is no need for expensive capital equipment
and their only significant fixed asset may well be a warehouse. The asset side of their
balance sheets is often comprised mainly of stock, debtors and cash, much of which may be
funded by debt.

Growth is constrained as access to working capital facilities is typically limited. Many SMEs
will operate without debt by managing their terms of trade with suppliers and buyers very
carefully to avoid funding gaps. This has the effect of slowing down their rate of growth, but
may well be a conscious decision by the owners of the business who are not willing to risk
their financial health by becoming more highly leveraged. In some cases, the decision to
operate without debt, or with minimal levels of debt, is effectively forced on an SME
because they simply cannot access the working capital facilities that they need to optimise
their growth potential.

© The London Institute of Banking & Finance 3

7.2.2 Bargaining position

SMEs do not generally have a strong bargaining position relative to their suppliers and their
buyers, so they are usually required to accept whatever terms are specified by their larger
trading partners.

When dealing with suppliers, for example, they cannot usually demand extended payment
terms in the way that a global corporate would. Given their relative balance sheet
weakness, they may well be required to pay deposits when placing an order. The SME’s
inability to raise working capital finance easily is, therefore, exacerbated by the
unfavourable terms of trade they are obliged to agree with suppliers.

Similarly, when dealing with buyers, an SME cannot easily demand payment upon delivery
and, particularly in respect of export markets, will have to accept longer payment terms if
they are to be competitive. The longer transit times and higher consignment values
associated with international trade have the effect of increasing the financial burden still
further.

7.2.3 Propensity to trade internationally

The propensity of SMEs to trade internationally varies from country to country. In

developed economies, they are likely to import more than they export as their main sales
focus is often domestic. In emerging economies, however, there is likely to be a greater
focus on exporting.

In both developed and emerging markets, the SME segment is invariably regarded as a key
driver of economic growth. SMEs often make up a large percentage of both GDP and
employment, and successful growth of the SME segment is seen as a barometer of the
health of the overall economy.

Global credit gap

The World Bank estimates that up to 50% of SMEs have limited or no access to formal credit
channels, leading to a global credit gap as large as $2.7tr (Global Partnership for Financial
Inclusion, 2017) and according to the World Economic Forum (2017), the SME market
represents 50% of global GDP and two-thirds of global employment.

Since the reports of 2017, this situation has not improved and the inaccessibility of finance
to support SME growth remains, therefore, as one of the major challenges facing the supply
chain finance industry.

© The London Institute of Banking & Finance 4

Activity 7.1 Benefits of trade to SMEs
Part 1 – Explore

Read these sections of the ICC Banking Commission’s 2017 report.

• SME competitiveness: thinking strategically about regional integration and regional

value chains (p198–203); and
• Access to trade finance for SMEs and first-time clients of banks in Africa – from the
perspective of financial institutions (p204–207).

ICC Banking Commission: Rethinking trade finance.

Part 2 – Reflect

Now consider the following questions:

• Why do SMEs often start by trading with neighbouring countries?

• How do regional value chains relate to global value chains?
• How do trade agreements enable SMEs to participate in global value chains?
• To what extent are SMEs in Africa able to access finance to support their
international trade activities?

7.2.4 Liquidity

Maintaining liquidity is a continual challenge, exacerbated by changes in physical supply

chain patterns, led by companies holding more stock in their inventories to protect against
delays (especially as SMEs seek to grow their international business). History is littered with
profitable SMEs that failed because they ran out of cash.

Availability of tangible security

In many markets, credit appetite for SMEs is determined by the availability of tangible
security, such as property or other fixed assets, or collateralised personal guarantees. The
fixed assets are often not available or are already fully encumbered and are, in any event,
not linked to the underlying commercial transactions that need to be financed. Owners may
not be willing or able to put their personal assets (eg their house) on the line as security for
increased working capital facilities for their business.

Problems with tangible security

A reliance on tangible security is not sustainable and certainly not sufficiently scalable to
support an SME’s growth. Furthermore, the false confidence created by reliance on such
security can lead to lenders agreeing to provide finance for business growth that is simply
not viable. When the increased trade facilitated by this ‘secured’ finance then goes wrong,

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the finance provider has no option but to liquidate the security. This often means putting
the SME into insolvency and putting the SME’s owners out of their homes.

7.2.5 Education gaps

SME owners

SME owners are often ill-equipped to request additional working capital facilities to support
growth in trade.

They lack the knowledge and skills to analyse the financial impact of the increased business
in terms of risk, finance and payments. As a result, they may well ask for the wrong solution
and the wrong level of credit facilities. They may even find themselves agreeing to a new
line of business that cannot possibly be financed effectively.

They do not understand what products are available from their own bank, from competitor
banks and from non-bank finance providers.

Finance providers

In many markets, the education gap applies equally to the finance providers servicing the
SME segment. Many still insist on fixed asset security, notwithstanding the fact that it is
often not available and, where it is available, may mean that they support a deal which is
not commercially viable.

7.2.6 Key drivers

SMEs are primarily driven by the need to maintain and manage liquidity. This is a matter of
survival, as running out of cash is usually a terminal event for an SME. Suitable working
capital solutions do exist for SMEs but they are less readily available and more expensive
than is the case for larger corporates. The relative lack of availability is exacerbated by a lack
of awareness of the solutions that do exist on the part of the SME owners. In essence, they
‘don’t know what they don’t know’ so education is as big an obstacle as availability.

FACTFIND

Causes of failure

Review the following to discover the most common causes of failure in the SME segment:

OnStrategy: Ten common causes of business failure

Bplans: What is the biggest cause of business failure?

© The London Institute of Banking & Finance 6

Xenia: Seven warning signs your business may be at risk

Access to trade finance

• The global trade finance gap is estimated at US$1.5 trillion.

• 40% of the gap originates in Asia and the Pacific.
• 74% of rejected trade finance transactions come from SMEs and midcap firms.
• At least 36% of rejected trade finance may be fundable by other financial institutions.

(Di Caprio et al., 2017)

7.3 Mid-market companies

Mid-market companies (MMCs) are larger than SMEs and are less likely to be owner-
managed. Most will be run by a professional management team with a high degree of
competence in most of the key disciplines. They will have a qualified, full-time finance
director and probably a treasurer as well. They are likely to have some expertise in
international trade and be familiar with many of the supply chain solutions available from
their bank and from competitor banks.

7.3.1 Financial strength

Mid-market companies have greater financial strength with better capitalisation and
stronger balance sheets. Many mid-market companies will be supported by some form of
private equity and have more resources available to weather a financial storm. They tend,
however, to be sub-investment grade and may well still be privately owned, though larger
mid-market companies may be publicly listed on a stock exchange.

Companies in this segment have a higher propensity to trade internationally and many will
have set up branch offices, subsidiaries or joint ventures in their key overseas markets.

Access to working capital is generally easier for mid-market companies than for SMEs.
Pricing will generally be lower, reflecting the better credit quality relative to SMEs. Mid-
market companies tend to be multibanked and their banking arrangements will typically
include lending covenants that aim to protect each bank in the panel.

When it comes to raising finance, mid-market companies have more options and greater
choice. Their longer-term funding requirements may be covered by a combination of
revolving credit facilities, probably syndicated across their banking panel, and equity. A
dedicated solution for financing their supply chain is, nevertheless, often appropriate.

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7.3.2 Bargaining power

Mid-market companies have more bargaining power than SMEs, often allowing them to
negotiate more favourable terms of trade with their suppliers and buyers. Being a relatively
strong party in their supply chain, they may well use their greater debt capacity and more
favourable pricing to improve their competitiveness by providing financial support to their
trading partners. Such support would be reflected in the commercial terms (payment terms
and pricing).

Reasons why MMCs may need supply chain finance include:

• liquidity;
• competitive positioning; and
• balance sheet efficiency.

7.3.3 Liquidity

As with the SMEs, mid-market companies also need to manage their liquidity effectively. In
their case, however, access to finance is not such a challenge and neither is pricing. It is,
nevertheless, essential that mid-market companies arrange the optimum financing solution
to facilitate their trading activities.

Complex financing needs

Their financing needs may be more complex due to the higher transaction volumes and
values, and the more diverse range of trading partners. They are more likely to be trading
through their own branch offices, subsidiaries and joint ventures in overseas markets,
necessitating more sophisticated financing solutions.

Treasury management challenges

Due to their size, complexity and geographic spread, it is highly likely that mid-market
companies will have surplus liquidity in certain markets at the same time as having a funding
requirement in others. To add further complexity to their treasury management challenge,
the surpluses and shortfalls are likely to be in different currencies as well as different
jurisdictions. An effective international cash and liquidity management solution is,
therefore, as important as an effective finance solution.

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7.3.4 Competitive positioning

Though not as powerful as global multinational corporates, mid-market companies will

often be stronger than many of their trading partners. To a certain extent, they could use
their influence to dictate terms of trade that are hugely in their favour, but this is typically
seen as ineffective in the longer term.

Ease finance burden of trading partners

Mid-market companies will certainly try to obtain the best pricing, but most also recognise
that the stability of their supply chain is critical to their long-term success. Mid-market
companies can use their easier access to finance and their ability to raise finance at lower
pricing to ease the financing burden faced by their smaller trading partners. Granting
extended credit to buyers, for example, can reduce the buyer’s need for post-import
(inventory and debtor) financing. Mid-market companies will, of course, reflect the cost of
the credit extension in their pricing but, as their cost of debt is lower than that of their
smaller buyers, both parties can benefit.

Win-win situation for all

The cost of the financing, plus a small margin from their buyers, can be recovered whilst the
buyers get access to finance that they would struggle to source themselves, at a price which
is lower than they would have to pay if they borrowed the funds themselves to finance their
post-import period. So it is a win–win situation for all. Financing solutions such as this which
offer extended credit to buyers, result in the product offering becoming more attractive
relative to their competitors. In essence, the financial support becomes one of the features
and benefits of the product that the mid-market company is seeking to sell, allowing them
to increase sales and generate profits.

Supporting smaller suppliers

On the sourcing side, mid-market companies could support their smaller suppliers by
shortening their credit terms, though this rarely happens in practice. Most mid-market
companies will resist offering to ‘pay early’ as this will impact their own liquidity and will
also reduce their ‘days payable outstanding’ (DPO). Though mid-market companies are not
investment grade and may not even be publicly quoted, DPO remains an important measure
against which the corporate treasurer may well be measured. Instead of offering to shorten
the credit terms on payables, mid-market companies may be able to put in place a financing
programme that enables their suppliers to access payment early at lower pricing than would
otherwise be the case. Financing programmes such as this are more difficult for an MMC to
arrange than would be the case for an investment grade corporate, but more finance
providers are now entering the market and are prepared to offer finance to this segment.

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7.3.5 Balance sheet efficiency

There are actually two aspects to ‘efficiency’ in the context of supply chain finance –
operational efficiency and balance sheet efficiency. We will consider operational efficiency
in section 3.3. At this stage, we will focus on balance sheet efficiency.

Balance sheet efficiency is concerned with four key metrics:

• days sales outstanding (DSO);

• days payables outstanding (DPO);
• days inventory outstanding (DIO); and
• debt-to-equity ratio.

These measures are not as critically important for mid-market companies as they are for
investment grade corporates, but they are generally accepted measures of the effectiveness
of working capital management. We have, therefore, included them in this section.

If a mid-market company has ratios which are materially inferior to the levels expected in
their industry, they may find that access to debt becomes more difficult and more
expensive. They may also have lending covenants with their panel of banks which refer
specifically to their debt-to-equity ratio.

7.3.6 Key drivers

A key driver for mid-market companies may, therefore, be to select a financing solution that
does not negatively impact these ratios. For example:

• Offering extended credit terms to buyers will cause DSO to increase. This is
something the treasurer may try to avoid. A financing solution that allows extended
credit terms without increasing DSO will, therefore, be more attractive.
• Paying suppliers early will cause DPO to decrease. As noted, treasurers may resist
this so a financing solution that enables a supplier to get paid more quickly without
impacting DPO will be more attractive.
• Managing DIO is primarily a function of the efficiency of the sourcing, manufacturing
and stockholding processes. The way in which inventory is financed can, however,
have a material impact on DIO. For example, a financing solution that involves the
inventory being sold to the finance provider rather than pledged as security for a
loan will cause DIO to reduce. This may be attractive to the treasurer.
• Finance that appears on the balance sheet as ‘bank debt’ will cause the debt/equity
ratio to deteriorate. This is not always avoidable but certain supply chain finance
solutions are structured so that they do not create debt or result in trade creditors
being reclassified as debt. Auditors are ultimately the arbiters of the classification of
this type finance.

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7.4 Investment grade/major corporates
Major corporates are larger again than mid-market companies, but share some of the same
drivers. They will have a complex organisational structure with dedicated functions to
manage each discipline. They will have multiple subsidiaries located around the world and
some of their trading activity may well be intragroup.

Specialist functions

They will have a highly professional finance function incorporating treasury management
and day-to-day management of payables and receivables. They will also have a separate
procurement function that manages supplier relationships and a sales function that
manages customer relationships. In addition, they will have a production function that
manages the manufacturing processes, an inventory management function that manages
stock, and a logistics management function that manages the movement of all goods.

Collaboration is key to success

Such a high degree of specialisation bodes well for the standard of professionalism of each
function, but there are also challenges to such a complex structure. All functions have to
collaborate in order for the business to be successful, but their skill sets and performance
measures are different. This can lead to a fragmented approach to decision-making with
regard to supply chain finance.

Conflicting performance measures

The performance measures in respect of each function may appear to be in conflict. For
example, the treasurer will want to pay suppliers as late as possible, whereas the
procurement function will be concerned with maintaining a good relationship with suppliers
and negotiating the best price. Similarly, the treasurer will want buyers to pay as quickly as
possible, but the sales function will be more focused on getting the best price and
generating repeat business, and will see offering deferred credit terms as supportive of
these goals.

Supply chain finance champions

In order to promote a more holistic approach to supply chain finance, many major
corporates now form virtual teams of ‘supply chain finance champions’ comprising a mix of
treasury and procurement functions that collaborate to protect their supply chains and
optimise their supply chain effectiveness, from a financing as well as an operational
perspective.

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7.4.1 Bargaining power

Major corporates are, for example, even more powerful than mid-market companies and
can, therefore, exercise much greater influence over the terms of trade agreed with their
trading partners. Due to their investment grade status, they have more options with regard
to raising finance, including through the capital markets. Their ability to borrow is often
limited by single name concentration limits with individual banks, rather than by their
absolute debt capacity. This can lead to very large, geographically distributed banking
panels.

Market sentiment

Their investment grade status has a potential downside: investors are fickle and can react
dramatically to changes in key performance indicators. For example, a profits warning or an
announcement to the effect that turnover may be below earlier forecasts will often cause
the share price to decline. In extreme cases, this may result in a company becoming more
vulnerable to being taken over. Market sentiment is heavily influenced by annual accounts
and interim announcements. The balance-sheet ratios identified as important for mid-
market companies are often just as critically important to a major corporate.

Anchor party

Major corporates are very likely to be the strongest player in each supply chain in which
they participate and are often referred to as the ‘anchor’ party, a role which reflects that
they have the strongest credit rating in the supply chain. This in turn would lead finance
providers to develop solutions and structures through which they can gain comfort from the
MC’s credit standing to support the provision of finance to the MC’s upstream trading
partners (ie their suppliers and their suppliers’ suppliers).

Potential stabilising force

Major corporates can wield their bargaining power to force trading partners to accept
onerous payment terms and pricing but, in practice, most major corporates recognise that
this would generate short-term benefits at best, to the detriment of longer-term
relationships and supply chain stability. Major corporates now tend to adopt practices that
support their trading partners and stabilise their supply chains. Major corporates are very
visible and their behaviour is subject to global scrutiny. They are very sensitive to market
sentiment and are generally keen to ensure that they are seen to treat both suppliers and
customers fairly.

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7.4.2 Key drivers

In many ways the core drivers of major corporates are similar to those of mid-market
companies, albeit the drivers may appear somewhat more extreme.

Their drivers may be summarised as follows:

• competitive positioning;
• optimum use of debt capacity;
• balance sheet efficiency; and
• corporate social responsibility.

7.4.3 Competitive positioning

Similar to mid-market companies, major corporates will also certainly try to obtain the best
pricing, while also recognising that the stability of their supply chain is critical to their long-
term success. Major corporates can use their easier access to finance and their ability to
raise finance at lower pricing to ease the financing burden faced by their smaller trading
partners. A major corporate may support their buyers by allowing deferred payment terms
or by encouraging them to join a distributer finance programme. As the corporate’s cost of
debt is even lower than that of most mid-market companies, the potential benefit is
generally greater.

On the sourcing side, major corporates are increasingly likely to run payables finance
programmes which their larger, more strategic suppliers are invited to join. This has the
effect of providing early payment to suppliers without reducing the major corporate’s DPO.
Given their investment grade status, ratios such as DPO, DSO and DIO are closely monitored
by analysts, resulting in efforts to keep these ratios within industry norms.

Major corporates can also derive competitive advantage by supporting their supply chains
through the appropriate use of supply chain finance. This arises because:

• the access to finance enables the suppliers to increase their sales, secure in the
knowledge that they have a reliable source of finance at acceptable pricing;
• being financially more secure, the suppliers are less likely to get into financial
difficulties, thereby avoiding the risk of supplies being disrupted; and
• by providing financial support through the supply chain finance solutions, better
pricing can be obtained.

Image is also very important to major corporates. An increased focus and global acceptance
of climate change has led to an increased focus on environmental, social and governance

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(ESG) strategies, which have become a primary focus for both corporates and their banks.
ESG strategies are now at the heart of the organisation and financing of supply chains. By
treating suppliers and buyers fairly, encouraging practices that support ESG principles, and
by providing financial support, positive publicity is generated, which consequently enhances
the brand.

7.4.4 Optimum use of debt capacity

As noted, major corporates tend to have very a large panel of banks, each of which will be
keen to obtain their share of the available ‘wallet’. In this context, ‘wallet’ refers to the
value of banking fees and interest income generated from the relationship. Banks will want
to ensure that their share of income is consistent with their share of credit exposure. Once a
bank reaches their single name concentration limit for a major corporate, they cannot write
any new credit-based business without selling down existing assets.

Supply chain finance programmes use debt capacity, so major corporates are keen to ensure
that they avoid having an overconcentration of limits with individual panel banks, as this
might result in the banks’ inability to provide other deals.

7.4.5 Balance sheet efficiency

As noted earlier, balance sheet efficiency is a critically important driver for major
corporates. Analysts will scrutinise a major corporate’s DSO and DPO and make comparisons
with other similarly sized companies in broadly the same industry segment. If a major
corporate’s DSO appears greater, or their DPO appears shorter than those of their peer
group, an analyst is likely to adopt a more negative view of the company’s management
effectiveness and this may well be reflected in their buy/sell/hold recommendations. This in
turn impacts the share price.

Receivables finance solutions: non-recourse basis

It is, therefore, even more important for a major corporate than for a mid-market company
to adopt supply chain finance solutions that are not detrimental to these balance sheet
ratios. For example, receivables finance solutions will typically be structured on a non-
recourse basis such that their auditors agree that the finance may be regarded as ‘off-
balance-sheet’. This has the effect of reducing DSO without the appearance of debt on the
balance sheet. In effect, the debtor position is converted into a cash position on the balance
sheet.

Balance-sheet-neutral treatment

The same principle applies to the financing of payables. The supply chain finance solution in
this case would invariably be structured such that DPO is not reduced and may even be

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extended with the resulting trade creditors’ position in the balance sheet being retained. A
key requirement is often to avoid trade creditors being reclassified as bank debt. In order to
achieve this ‘balance-sheet-neutral’ treatment, payables finance programmes are usually
structured such that the finance is provided at the request of the supplier, making them the
‘instructing party’ and placing the major corporate at ‘arm’s length’ from the financing
transaction.

Calling off stock ‘just in time’

Major corporates will also try to optimise their inventory position such that the DIO is not
out of line with their peer group. This might result in demands on suppliers to maintain
higher levels of stock in order to ‘call off’ the stock that they require at short notice (ie ‘just
in time’) without having to hold excessive levels of stock themselves. Of course, this simply
passes the stockholding problem, along with its attendant financial implications, to their
suppliers, who will usually be somewhat smaller and less able to carry the financial burden.

Distributor stockholding

Similarly, when dealing with distributors of their products, a major corporate will often insist
that the distributor holds the stock. The major corporate may support the distributor by
sponsoring a finance programme that their distributors can join, enabling them to finance
the higher levels of stock required.

7.4.6 Environmental, social and governance standards

As mentioned, there is a growing focus on ESG affecting corporates and their supply chains.
In addition to brand image and consumer perception, governments are also putting
pressure on corporates to become more environmentally friendly. In some jurisdictions,
corporates are being required to provide more reporting on their energy-use, carbon
footprint and, in the auto sector, emissions from different types of vehicles. Governments
are now setting ‘Net zero’ targets relating to carbon emissions, which will affect the way in
which the corporates plan and manage their product development and supply chains, and
this has all added to the focus on improving their ‘Green’ score.

Many major corporates have also been criticised in the past for their treatment of suppliers
or for dealing with suppliers that treat their employees badly. In recent years, most major
corporates have recognised the need to vet their suppliers carefully to ensure that they are
not deemed ‘guilty by association’ of the misdeeds of their suppliers. As a result, they are
now likely to visit their suppliers to assess their operating practices, particularly with regard
to working conditions, employee treatment and child labour. The major corporates, having
been stung by previous criticisms, now proudly announce the steps they take to ensure that
they deal with ethical suppliers. In many ways, their motivation is entirely honourable, but
there are potential financial consequences. By working only with ethical suppliers, it is
possible that the cost of sourcing will increase since their suppliers carry higher overheads

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as a result of their maintaining appropriate standards. Their choice of suppliers may also be
restricted if certain suppliers are disqualified due to their unacceptable practices.

On the other hand, the major corporates will often reference their supplier selection
standards in order to verify their own ESG and ethical approach. The resulting positive
publicity enhances the major corporate’s brand and helps to support higher pricing.

Most major corporates are also keen to demonstrate their own high standards of corporate
behaviour with regard to their treatment of suppliers. Though it is not unheard of for a
major corporate to force a supplier to accept onerous terms (eg extended call-off periods,
extended credit periods, enforced discounts, no commitment to take up stock held by the
supplier etc), most major corporates like to be seen to be treating suppliers fairly. In the
context of supply chain finance, this typically means inviting suppliers to join a payables
finance programme so that they are paid early without having to use their own banking
facilities.

7.5 Addressing financial consequences

Supply chain finance, in its broadest definition as discussed in Topic 1, aims to deliver:

• risk mitigation;
• finance; and
• settlement.

Transactional solutions and flow-based solutions

The transactional solutions exemplified by the traditional trade finance products typically
address all three issues. Flow-based solutions, with which supply chain finance is more
generally associated, tend to revolve around the provision of finance with relatively low
levels of risk mitigation. Settlement may be an intrinsic part of a supply chain solution (eg
payables finance) but settlement of a receivables finance deal may, in certain
circumstances, take place directly between buyer and seller.

Settlement options

In the comments that follow regarding settlement either being separate from the supply
chain finance solution or integrated into it, we will make passing reference to one or two
products, recognising that we have not defined any products or techniques as such at this
stage.

In practice, with a factoring or invoice discounting solution, the buyer will typically be
instructed to pay proceeds into a dedicated collection account controlled by the bank. This
provides a measure of control over the source of repayment. With a receivables finance
programme for a major corporate, however, the financing bank may be happy to appoint

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the client as their collection agent, in which case the buyer will pay the seller directly and
the latter will provide the financing bank with an updated schedule of outstanding invoices.

The payment process can be integrated with the financing solution as in the case where a
buyer is taking credit from suppliers but using, a payables finance solution to allow early
payment of invoices approved by the buyer and financed by the financing bank.

7.6 Financing requirements

Most flow-based supply chain finance solutions today are driven by invoices and deliver, as
a consequence, post-shipment finance. As discussed in Topic 3, a company’s financing
requirements start before they ship the goods and raise the invoice. They have to source
raw materials/components/finished goods, undertake the production process and then
finance the inventory prior to shipment. This does not mean, however, that supply chain
finance cannot fund the pre-shipment period. In practice, as a trading company is both a
buyer and a seller, it is often possible to use supply chain finance to fund both pre-shipment
and post-shipment phases.

A trading company might finance the pre-shipment period by taking credit from their
suppliers and then financing them with a payables finance solution. Once they are ready to
ship and raise an invoice, they can then use a receivables finance solution.

Flow-based financing solutions have many advantages over traditional transactional

instruments, such as Letters of Credit, in terms of efficiency and cost, but the relative scope
of supply chain finance should be noted. Supply chain finance does not replicate all of the
features and benefits of a letter of credit, nor is this its purpose. The major difference
relates to the level of risk mitigation offered to the client. Where risk mitigation is a key
driver (eg with shipments of high value, with higher risk or high complexity) a traditional
transactional solution, such as a letter of credit, is likely to be appropriate. With higher
volume/lower volume regular business with established counterparties, the benefits of the
letter of credit are outweighed by the cost and efficiency gains associated with supply chain
finance.

7.7 Payables finance solution compared with a letter of credit

To illustrate further, the following points should be noted:

No risk mitigation benefits

Unlike with a traditional letter of credit, the trading company’s suppliers do not benefit from
any risk mitigation prior to shipment and acceptance of the goods. With a payables finance
solution, the finance is only available to the supplier once the trading company has
approved the invoice. By contrast, had the trading company opened a letter of credit in

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favour of their supplier, this would have happened shortly after the confirmation of the
purchase order and well in advance of shipment. The supplier would have benefited from a
conditional undertaking from a bank that payment would be made against conforming
documents, providing a strong element of risk mitigation. In addition, the supplier would
have been able to use the letter of credit to support the provision of finance prior to
shipment.

Good credit quality

The trading company has to be of sufficiently good credit quality to support a payables
finance solution. Investment grade companies would generally have no problem with this,
but an SME would not have the debt capacity to anchor a programme without additional
risk mitigation, such as credit insurance. A payables finance programme relies on the
company’s ability to pay for the goods they have sourced. Unlike a receivables finance
solution, it is not ‘self-liquidating’ as there is no primary source of repayment other than the
trading company itself.

Once the company has raised an invoice, it can be financed. However, there remains a
degree of performance risk until such time as the buyer approves the invoice. Should the
invoice not be approved, the finance provider will demand repayment. As such, receivables
finance, prior to invoice approval, does not mitigate performance risk. Once the invoice has
been approved, the finance will often be ‘without recourse’, which means that the risk of
non-payment by the buyer has been eliminated. Of course, while this is true from the
company’s perspective, it is not true from the finance provider’s perspective. The latter now
carries the risk of non-payment by the buyer and may well mitigate this through credit
insurance.

Supply chain finance meets different needs than does traditional trade finance

The purpose of the above-mentioned comparison was not to disparage supply chain finance
relative to traditional trade finance, but it is important to understand the parameters within
which supply chain finance operates. If risk mitigation were to be of paramount importance,
then a trade finance solution would almost certainly be more appropriate. Given that 90%
of global trade is not settled by trade finance, it is reasonable to assume that risk mitigation
is not such a high priority relative to the provision of finance. That said, the development of
digital supply chain solutions is likely to facilitate enhanced risk mitigation, which should
result in greater appetite to finance global trade. This is particularly the case in the SME
segment where access to finance can be a major growth constraint.

Conclusion
Supply chain finance is relevant for all segments (major corporates, mid-market companies
and SMEs). Though supply chain finance is primarily a financing solution, in some cases it
can also provide a degree of risk mitigation and may incorporate the settlement process.

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The benefits that companies are looking for when they adopt a supply chain finance solution
are somewhat dependent on the segment that they occupy. Whilst SMEs are primarily
driven by the need to access finance, larger corporates tend to have a more varied set of
drivers. In the mid-market segment, balance sheet efficiency is often the primary driver.

Supply chain finance is potentially a great enabler for increased global trade. As traditional
trade finance supports a small and declining proportion of global trade, more transactions
are being settled on open account terms. The gap in availability of finance to support trade
is particularly acute in the SME segment in emerging markets. Supply chain finance has the
potential to address this finance gap.

Think again...

Now that you have completed this topic, how has your knowledge and understanding
improved?

For instance, can you:

• explain how client needs differ between segments (SME, mid-market companies and
major corporates);
• understand the significance of relative bargaining power; and
• explain why balance sheet treatment, supply chain stability and corporate social
responsibility might influence the selection of a supply chain finance solution?

Test your knowledge

1. Which of the following statements is/are correct?

Select one:

A. SMEs typically have strong balance sheets and have easy access to alternative
sources of finance.

B. SMEs are often family-owned businesses with limited access to the finance
required to grow their business.

C. SMEs generally have a strong bargaining position relative to their suppliers and
buyers.

Feedback

SMEs typically have relatively weak balance sheets and, as a result, their access to finance
can be relatively constrained. Given their size relative to many of the suppliers and buyers,

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SMEs typically have a relatively weak bargaining position and often have to accept the
payment terms and pricing demanded by the counterparties. (See section 7.2.)

The correct answer is: SMEs are often family-owned businesses with limited access to the
finance required to grow their business.

2. Which of the following statements is/are correct? Select all that apply.

Select from:

A. SMEs are not typically knowledgeable regarding the availability of supply chain
finance.

B. SMEs are often ill-equipped to understand the working capital impact of a large
export contract which, on the face of it, appears highly attractive from a profitability
perspective.

C. Finance providers often insist on fixed asset security to support the working
capital finance required to support growth in trade.

Feedback

SMEs are not usually aware of the availability of supply chain finance and on many occasions
do not understand the impact of large export contracts on working capital. Finance
providers often insist on fixed asset security to support the working capital finance required
to support growth in trade. (See section 7.2.)

The correct answers are: SMEs are not typically knowledgeable regarding the availability of
supply chain finance, SMEs are often ill-equipped to understand the working capital impact
of a large export contract which, on the face of it, appears highly attractive from a
profitability perspective, and finance providers often insist on fixed asset security to support
the working capital finance required to support growth in trade.

3. Which of the following statements is/are correct? Select all that apply.

Select from:

A. Mid-market companies have greater financial strength and easier access to

finance than SMEs.

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 B. Mid-market companies’ sole objective when considering how to finance their
supply chain is to negotiate payment terms with suppliers and buyers that reduce
the need for working capital finance to a minimum.

C. Mid-market companies are often able to negotiate better pricing or make their
product more attractive to customers by granting deferred payment terms.

Feedback

Reducing the need for working capital finance is often one of a company’s objectives, but it
is unlikely to be the only objective. In practice, mid-market companies will also consider
how they can use their access to cheaper funding, relative to their SME suppliers, to secure
their supply chain and negotiate finer pricing and/or deferred payment terms. (See section
7.3.)

The correct answers are: Mid-market companies have greater financial strength and easier
access to finance than SMEs, and a mid-market companies are often able to negotiate
better pricing or make their product more attractive to customers by granting deferred
payment terms.

4. Which of the following statements is/are correct?

Select from:

A. Major corporates have highly professional finance functions that are well-
equipped to manage working capital and the day-to-day management of payables
and receivables.

B. Accounting treatment is often a major consideration for major corporates when

negotiating payment terms with suppliers and buyers, and in determining a supply
chain finance solution.

C. Supply chain finance is always the best way to finance a major corporate’s supply
chain.

Feedback

Major corporates have multiple sources of finance, of which supply chain finance is just one.
That said, supply chain finance is often selected because of the accounting treatment
benefits that can be achieved with other solutions. In addition, supply chain finance often
enables a major corporate to leverage their position as ‘anchor party’ to the benefit of their
suppliers and buyers. (See section 7.4.)

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The correct answers are: Major corporates have highly professional finance functions that
are well-equipped to manage working capital and the day-to-day management of payables
and receivables, and accounting treatment is often a major consideration for major
corporates when negotiating payment terms with suppliers and buyers, and in determining
a supply chain finance solution.

5. Which of the following statements is/are correct in respect of major corporates? Select all
that apply.

Select from:

A. Optimum accounting treatment in respect of a payables finance structure can be

assured if the supplier signs a receivables purchase agreement with the finance
provider.

B. Negotiating terms with suppliers whereby the latter has to hold stock pending
call-off (ie a ‘just-in-time’ strategy) places the working capital finance burden on the
suppliers.

C. A payables finance solution can support a strategy to extend DPO.

Feedback

Accounting treatment cannot be assured as other factors will be taken into account by the
major corporate’s auditors. That said, having their suppliers sell their receivables to the
finance provider will usually be a requirement for favourable accounting treatment. Upon
approval of the invoice, the buyer incurs a payment obligation, but this might not mean they
have to pay immediately. If the payment terms allow deferred payment, the buyer does not
have to pay until the due date. (See section 7.4.5.)

The correct answers are: Negotiating terms with suppliers whereby the latter has to hold
stock pending call-off (ie a ‘just-in-time’ strategy) places the working capital finance burden
on the suppliers, and a payables finance solution can support a strategy to extend DPO.

References
Di Caprio, A., Kim, K. and Beck, S. (2017) 2017 trade finance gaps, growth, and jobs survey
[pdf]. Available at: www.adb.org/sites/default/files/publication/359631/adb-briefs-83.pdf

Global Partnership for Financial Inclusion (2017) Alternative data transforming SME finance
[pdf]. Available at:

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www.gpfi.org/sites/default/files/documents/GPFI%20Report%20Alternative%20Data%20Tr
ansforming%20SME%20Finance.pdf

World Economic Forum (2017) How small business can play a big role in humanitarian crises
[online]. Available at: www.weforum.org/agenda/2017/01/how-small-business-can-play-a-
big-role-in-humanitarian-crises/

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