Topic 6 Financial consequences of

physical and financial supply chain events

Introduction

In this topic, we consider the financial consequences of the events identified in Topics 3 and
4 (physical and financial supply chains, respectively) using the data described in Topic 5
(information supply chain). The financial implications arise whenever an event causes a
company’s financial position to change. These changes do not just relate to immediate cash
movements, but also relate to commitments or obligations which might result in a cash
movement in the future. We can categorise the financial implications in three ways: events
that create or mitigate risk; events that change the working capital position; and events that
cause cash to flow to or from the company.

Learning objectives

By the end of this topic, you will understand:

• the risk, funding and working capital implications of each of the key supply chain
events; and
• how physical and financial supply chain events combine to result in financial
consequences.

Think...

How do you think a company’s working capital position might be impacted by the events in
the physical supply chain?

What about the financial supply chain? How do you think the events in the physical supply
chain impact the financial supply chain?

How can finance providers benefit from having visibility of these physical and financial
supply chain events?

6.1 Financial consequences of supply chain events

In this section, you will learn about the risk, funding and liquidity aspects that will apply to
the following key physical and financial supply chain events:

• purchase order (financial);

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 • pre-shipment inspection (physical);
• despatch/shipment (physical);
• sales invoice raised (financial);
• goods approved (physical);
• sales invoice approved (financial); and
• invoice payment (financial).

Factfind

Read the following article about the evolution of financial supply chain management (FSCM)
to learn how financial and physical supply chains have converged in recent years. This will
also introduce you to some of the key concepts covered in this topic, such as working capital
management.

Del Vecchio: What is financial supply chain management?

6.1.1 Purchase order

The sales contract or purchase order represents the formal agreement between the buyer
and seller. While there was probably much discussion and negotiation before this was
issued, the purchase order represents the completion of negotiations, with the buyer being
satisfied that the goods description, shipping terms, payment terms and other conditions
are understood and agreed; and the seller being happy that they can fulfil the order as per
the terms agreed and at an acceptable profit margin.

Risk implications

At this juncture both the seller and buyer are taking risk. From the buyer’s perspective,
although their obligation to accept and pay for the goods is conditional upon the contractual
performance by the seller, they still carry a risk that the seller’s failure to perform could
damage their own ability to run a production line or satisfy their own customer
commitments.

The seller is carrying a risk that they may be committing to their own manufacturing and
sourcing without any surety that the buyer will accept the resultant goods and/or pay for
them as per the agreed terms. The reliability of the purchase order may also be undermined
by conditions that are outside of the seller’s control (eg sale or return clause, price variation
clause, extended/infinite ‘call-off’ schedule at buyer’s discretion, unilateral
cancellation/variation clause).

Working capital implications

The working capital implications at purchase order stage will be determined by the terms
agreed between the seller and the buyer.

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If, for example, the seller is supplying from stock or if it has been agreed that the buyer will
pay a percentage of the purchase order value in advance, then the working capital impact
on the seller will be minimised. However, if the seller does not receive any deposit or cash
with order and has to source raw materials, components and sub-assemblies and then
incurs additional manufacturing costs, then the working capital impact of receiving the
purchase order will be greater.

From the buyer’s perspective, if they have to pay all or part cash with the order then this
will have an impact on their working capital position.

Cash flow implications

These are also determined by the terms of the contract agreed between seller and buyer.

A seller may have to pay for goods sourced from suppliers and may incur manufacturing
costs following receipt of a purchase order. On the other hand, they may receive cash from
the buyer if the terms specify payment in full or in part in advance of shipment.

If part or full payment in advance is agreed, the buyer will have to make the payment
following issuance of the purchase order.

Check your understanding

With which party does risk reside when a purchase order has been agreed?

a) Both parties.
b) The seller.
c) The buyer.

Answer

Both parties experience risk. The buyer has no guarantee that the seller will fulfil the terms
of the purchase order and the seller has no guarantee that the buyer will accept or pay for
the goods.

6.1.2 Pre-shipment inspection

This may be carried out by an independent inspection agency such as Société Générale de
Surveillance (SGS), by an agent acting on behalf of the buyer or by the buyer directly. For
certain types of goods, the inspection may be a requirement of the importing country.

Risk implications

From the buyer’s perspective, a ‘clean’ inspection report (ie a report that confirms that the
goods conform with the purchase order and are in good condition) provides a degree of risk

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mitigation in that the report provides assurance that the goods exist and are fit for purpose.
Depending on the terms agreed, it is possible that the buyer’s obligation to accept the goods
might be triggered by the inspection report.

From the seller’s perspective, a ‘clean’ inspection report provides assurance that the buyer
will have an obligation to accept the goods.

Working capital implications

The issuance of an inspection report does not usually have a direct impact on working
capital. It is possible, however, that the terms require the buyer to make an advance
payment upon issuance of a ‘clean’ inspection report, in which case this will impact their
working capital position (ie surplus liquidity will reduce or a finance requirement will
increase). Conversely, this will have a positive impact on the seller’s working capital
position.

Cash flow implications

As noted above, there would not normally be a requirement for the buyer to make a
payment to the seller at this point, unless this had been agreed in the contract

6.1.3 Despatch/shipment

When goods are despatched, a transport document of some sort will be issued. The nature
of the document will depend on the mode of transport. Where goods are despatched by
sea, the document may also have the properties of a document of title, which may be
transferable.

Incoterms® rules

Responsibilities for the cost of freight, transit insurance and the point at which responsibility
for the goods themselves is transferred from the seller to the buyer are specified in the
purchase order using standard shipping terms. These are defined in Incoterms® rules
published by the International Chamber of Commerce (ICC). These rules are subject to
periodic revisions to reflect changes in the international trade system. The 2020 edition
launched in September 2019 includes a few modifications as well as “more detailed
explanatory notes with enhanced graphics to illustrate the responsibilities of importers and
exporters for each Incoterms® rule” (ICC, 2019).

Risk implications

This event is a significant step in the process of performance risk reduction as it provides
prima facie evidence of contractual fulfilment by the seller. As such, both the seller and
buyer have more certainty that the goods exist and will be delivered in accordance with the
agreed terms.

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From the seller’s perspective, greater certainty is provided that the buyer will accept the
goods. On the other hand, the seller no longer has possession of the goods and has
essentially lost control of them, creating a risk of loss should the buyer subsequently decline
or be unable to pay for them. The extent to which this represents an increase in risk will
depend on the shipping terms and the mode of transport used. Where a document of title is
used, and this is handled by the seller’s bank, the risk can be mitigated based on the
conditions against which the document will be released to the buyer. Until it is released, the
goods remain under the control of the seller.

From the buyer’s perspective, evidence of shipment reduces the risk that the goods do not
exist or will not arrive. Depending on the mode of transport and type of shipping document,
the buyer may also take comfort from the fact that they will be able to take possession of
the goods before making payment.

Both parties will be exposed to the risk that the goods are damaged in transit. The risk
switches from seller to buyer at a specific point in time depending on the shipping terms
agreed. This risk is usually mitigated using carriage insurance.

Working capital implications

The issuance of a shipping document does not usually have a direct impact on working
capital. It is possible, however, that the terms require the buyer to make payment
immediately upon shipping, in which case this will impact their working capital position (ie
surplus liquidity will reduce or a finance requirement will increase). Conversely, this will
have a positive impact on the seller’s working capital position.

Cash flow implications

As noted above, there may be a requirement for the buyer to make a payment to the seller
at this point.

Check your understanding

Please visit the course site to complete this activity.

6.1.4 Sales invoice

The sales invoice from the seller to the buyer is normally raised on the shipment of the
goods. This reflects the seller’s view that they have performed in accordance with the
agreed terms and conditions of the purchase order.

Risk implications

From the seller’s perspective, the risk has shifted to one of credit risk on the buyer and their
ability to pay. There is still an element of performance risk present until the invoice is
actually approved by the buyer.

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Working capital implications

From the seller’s perspective, a receivable (ie a debtor) is created in their balance sheet and
the stock value reduces at the same time. Whether this impacts their overall working
position will depend on the terms of payment agreed with the buyer.

From the buyer’s perspective, there will not normally be any working capital impact even if
the terms specify that payment is due ‘at sight’ as they would not pay until they have
accepted the goods and approved the invoice.

Cash flow implications

Once again, it is unlikely that a payment would be made or received upon issuance, as
opposed to approval, of an invoice.

6.1.5 Sales invoice approval (and goods acceptance)

The buyer will usually want to check the goods themselves to ensure that they are
compliant with their purchase order before approving the invoice, so we have combined
these two events for the purpose of this explanation. As noted previously, a buyer may be
prepared to approve the invoice before actually receiving the goods on the basis of a ‘clean’
inspection report.

Most buyers will, however, only approve the seller’s invoice for payment after the
despatched goods have arrived and been checked for compliance with the purchase order.
It is not uncommon for the invoice to sit with the accounts/payables department until such
time as procurement confirms its approval for payment.

Risk implications

From the seller’s perspective, the performance risk has been eliminated and the seller is
now exposed solely to credit risk, ie the inability of the buyer to pay.

From the buyer’s perspective, having accepted the goods, they are no longer exposed to the
risk that the goods do not meet their requirements. They do, however, now have a future
obligation to pay, which could be regarded as a risk should they lack the resources to do so
on the due date.

Working capital implications

The approval of an invoice creates an obligation to pay on the due date. A creditor will be
created on the liability side of their balance sheet and stock will be created on the asset
side. At this point their working capital position will be impacted (reducing surplus liquidity
or increasing finance requirements) but, as both liability and asset are ‘current’, the net
effect is neutral.

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Similarly, there will be no impact on the seller’s working capital until payment is due.

Cash flow implications

When the invoice is due, the buyer will pay the seller.

Factfind

Depending on the nature of the goods being delivered, the approval proccess can be quite
complex. Read the following article, which outlines the invoice approval process.

Inpute: Invoice approval: A 7 step guide to compare your process to best practice

6.1.6 Invoice payment

Risk implications

Assuming the invoice is indeed paid, at this point risk is extinguished.

Working capital implications

When the buyer makes the payment this will reduce their surplus liquidity or increase
finance requirement.

From the seller’s perspective, the opposite occurs, ie receipt of payment either increases
surplus liquidity or reduces borrowing.

Cash flow implications

The buyer makes, and the seller receives, payment.

Check your understanding

Considering the full supply chain process, which of the following statements is an accurate
reflection of how risk is shared between buyer and seller?

a) The seller experiences lower levels of risk at the start of the process.
b) The buyer experiences lower levels of risk at the start of the process.
c) Risk is shared between participants throughout the process.

Answer

The buyer and seller will be exposed to different types of risk throughout the process, but
both will experience risk. This remains the case until the buyer pays the invoice and all risk is
eliminated.

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6.1.7 Further risk considerations

Given the cross-border nature of international trade, country risk should also be considered.
The buyer may have the ability to pay in local currency but, due foreign exchange or other
restrictions impacting the convertibility of their currency, it is possible that the funds cannot
be transferred to the seller. This risk is not linked to a specific event but is a consequence of
where the parties are domiciled.

6.2 Relationship between the physical and financial supply chain

As highlighted in Topic 3, the physical supply chain reflects the physical production,
movement and storage of raw materials, components and finished goods, while the
financial supply chain reflects the financial events that support it. The events in both the
physical and the financial supply chain have financial implications and consequences in
terms of risk, working capital and cash flows.

The main elements that dictate the relationship between the physical and financial supply
chain are derived from the purchase order terms agreed by the primary parties in the supply
chain, namely the buyers and sellers. As noted previously, the timing as well as the nature of
each event can have a material influence on the financial impact of the event.

6.2.1 Closed-loop supply chain

Figure 6.1 below plots the physical and financial events on a single timeline. In this example,
the client receives a purchase order from their buyer before placing an order for the
required goods with their supplier. The selling and buying events are shown in parallel, with
the physical events in blue and the financial events in red. This is a typical closed loop
(sometimes referred to as self-liquidating) scenario where goods are sourced to meet
specific purchase orders.

Figure 6.1 Typical timeline

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As previously highlighted, performance is key to the success of the physical supply chain.
This is the responsibility of the seller, who must carefully manage their activities to ensure
that a failure on their (or their suppliers’ part) does not result in the purchase order not
being fulfilled as per the required specifications and time frames.

Failure to perform in one part of the supply chain can have a knock-on effect in other parts.
For example, a car manufacturer that finds a specific part is not available to support its
assembly line may have to halt production until such time as that part is delivered.

However, they also must use the same efforts and planning to manage the financial
implications of the financial supply chain events. In particular, they need to manage the risk,
working capital and cash flow implications so as not to disrupt the flow in the physical
supply.

6.2.2 Combining the physical and financial supply chain

Figure 6.2 uses the same scenario as Figure 6.1. In this case, however, we are highlighting
the risk and working capital implications.

Figure 6.2 Physical and financial supply chain combined

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Performance risk reduces for the buyer as the different supply chain events progress, a
reflection of the seller completing more of the steps necessary to deliver the goods to them.

Once performance risk reduces with the delivery of the goods, credit risk becomes the
primary risk, when the seller has to await payment from the buyer after they’ve shipped the
goods.

However, credit risk will always have been present for the seller, from the time they receive
the purchase order and start to incur costs in relation to fulfilling that order.

Conclusion
It is important to understand the concept of supply chain events as supply chain finance is
predominantly ‘event-driven’. This is what makes supply chain finance more attractive than
many other forms of finance. These ‘events’ arise in both the physical and financial supply
chain and are evidenced by data from the information supply chain. Together, these events
have consequences that the client needs to account for and manage.

Finance providers also need to be able to identify and evaluate the consequences,
otherwise the source of repayment of their advances may be undermined. The financial
consequences relate to more than just working capital; they also relate to risk and cash flow
(ie payments). The risk dimension is easy to underestimate, but failure to manage this
effectively can have dire consequences for the client and the finance provider. We can see
that risk comes in many forms; the key ones being performance risk and credit risk, plus, in
the case of cross-border trade, country risk.

Think again...

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

For instance, can you:

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• identify the key physical supply chain events and understand their financial
consequences;
• identify the key financial supply chain events and understand their financial
consequences; and
• distinguish between performance risk and credit risk, and identify how they are
impacted by the key events?

Test your knowledge

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

Select one:

A. Financial consequences arise only in respect of events in the financial supply

chain.

B. The only financial consequences that the finance provider need focus on relate to
working capital.

C. Financial consequences may be risk related as well as working capital related.

Feedback

Events in the physical supply chain (eg entering into a contract) can also have financial
consequences. Financial consequences can be risk related as well as working capital related.
(See section 6.1.)

The correct answer is: Financial consequences may be risk related as well as working capital
related.

2. What financial consequences arise when a purchase order is issued? Select all that apply.

Select from:

A. The buyer incurs a future payment obligation.

B. The buyer is exposed to the risk of non-performance by their supplier, which could
impact their ability to run their production line or satisfy their own customer
commitments.

C. The buyer has to raise finance in order to settle with their suppliers.

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Feedback

The buyer will have to hold the funds to pay their supplier, assuming the latter has fulfilled
their contractual obligations, but this might not result in a financing need. This will depend
on the terms of trade agreed with their supplier, their production/stockholding operating
model and the terms agreed with their own customers. It is quite possible that a buyer will
have the funds available to pay the supplier without having to raise finance. (See section
6.1.1.)

The correct answer is: The buyer incurs a future payment obligation and the buyer is
exposed to the risk of non-performance by their supplier, which could impact their ability to
run their production line or satisfy their own customer commitments.

3. How might pre-shipment inspection impact a buyer’s financial position and the seller’s
financial position? Select all that apply.

Select from:

A. As soon as goods are inspected and found to conform to their purchase order, the
buyer has to pay for them, creating a cash-flow implication and possibly a finance
requirement.

B. A ‘clean’ inspection report reduces the buyer’s exposure to the risk of non-
performance by the supplier.

C. A ‘clean’ inspection report reduces the supplier’s exposure to the risk that the
buyer will not take up the goods when they arrive.

Feedback

Option 1 is incorrect – the buyer will not be required to pay for the goods unless the terms
of payment specify ‘payment in advance’. Their ability to decline to take up the goods upon
arrival will, however, be reduced if, as stated in the inspection certificate, the goods
conform to their purchase order, so a future payment obligation may be created. (See
section 6.1.2.)

The correct answer is: A ‘clean’ inspection report reduces the buyer’s exposure to the risk of
non-performance by the supplier and a ‘clean’ inspection report reduces the supplier’s
exposure to the risk that the buyer will not take up the goods when they arrive.

4. How does shipment impact the financial position of the buyer and seller?

Select one:

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 A. Risk of contractual default by the seller is reduced.

B. The seller is exposed to increased risk as, once they release the goods to the
carrier, they have lost control of the goods and may incur a loss if the buyer does not
pay.

C. The cost of freight has to be financed by the seller.

Feedback

Although the seller is exposed to increased risk with many forms of transport, if the goods
are shipped by sea, the seller retains control of the goods until they release the bills of
lading. The shipping terms determine who is liable to pay the freight costs (eg with FOB
terms, freight is payable at the destination by the buyer). Even if freight is paid by the seller
(eg with CIF terms) it does not necessarily mean that the seller has to raise the finance to
fund this. The freight costs could be funded out of the seller’s own resources. (See section
6.1.3.)

The correct answer is: Risk of contractual default by the seller is reduced.

5. How does an invoice impact the financial position of a seller and a buyer?

Select one:

A. Once the seller raises an invoice, the buyer incurs a future payment obligation.

B. As soon as the buyer accepts the goods and approves the invoice, they have to
pay the supplier, and may need to raise finance in order to fund this payment.

C. Once the seller raises an invoice and this is approved by the buyer, the seller is
exposed to credit risk on the buyer.

Feedback

The buyer only incurs a future payment obligation once an invoice has been approved. If the
seller has failed to fulfil all contractual obligations, the buyer is not obliged to approve the
invoice.

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 6.1.4.)

The correct answer is: Once the seller raises an invoice and this is approved by the buyer,
the seller is exposed to credit risk on the buyer.

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References

ICC (2019) ICC releases Incoterms® 2020 [online]. Available at: iccwbo.org/media-wall/news-
speeches/icc-releases-incoterms-2020/

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