A Financial Crisis Is Looming for Smaller Suppliers 04/07/2021 15:29

Crisis Management

A Financial Crisis Is Looming

for Smaller Suppliers
by Federico Caniato, Antonella Moretto, and James B. Rice, Jr.

August 06, 2020

Kmatta/Getty Images

Summary. Government and large-company efforts to assist small and medium-

size suppliers (SMEs) have not been enough to prevent their collapse, which could
further compromise a global financial system already stressed by the pandemic.
This article, which is based... more

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High-profile bankruptcies, refinancing deals, and drastic cost-cutting

involving the likes of Brooks Brothers, JCPenney, Hertz, Neiman
Marcus, Ford, and GM are testament to the financial distress wrought
by the Covid-19 pandemic. But a less visible crisis deep within supply
chains is destabilizing small and medium-sized enterprises (SMEs)
and could add to the woes of the global economy.

SMEs tend to be the first to feel the effects of financial crises. But
their current plight is exacerbated by punitive payment terms that
large companies began introducing in the aftermath of the 2008
financial meltdown. These practices, in combination with the
pandemic crisis, have starved countless SME suppliers of working
capital and threaten to trigger a tidal wave of failures.

There are ways to avoid this outcome. Governments should provide

financial support geared to the needs of SMEs, and large companies
can assist by identifying and supporting suppliers at risk. SMEs can
help themselves through a more rigorous approach to managing their
working capital. And innovative supply-chain-finance solutions,
including a new generation of digital solutions, can play a key role in
providing sources of credit for SMEs. These solutions must be applied
as soon as possible. If SMEs fail en masse, the ripple effects will hit
larger companies and could further compromise a global financial
system already stressed by the pandemic.

Why SMEs Are More Vulnerable

Over recent decades, companies have striven to become lean

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organizations by reducing inventory and optimizing operations to

increase efficiency. However, these measures have also made their
operations more fragile by, for example, increasing their dependence
on a finely tuned supply base that is vulnerable to disruptions.

The 2007-2008 global financial crisis deepened these fragilities. For

example, during that crisis, banks attempting to reduce their
exposure to credit risk either wouldn’t lend to SMEs or did so at
usurious rates, further undermining the financial viability of SMEs.

The extraordinary measures taken

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example, in Europe liquidity was
available at low cost to large firms
but not SMEs, largely because the
introduction of stricter financial criteria, such as the Basel Rules, led
banks to reduce lending to SMEs — now considered more risky —
and to increase interest rates on loans to small businesses.

SMEs found themselves pressured from two sides: a banking system

less willing to offer them loans and customers’ extended payments
terms. Companies in need of cash — especially large firms — have
increasingly turned to the only source of cash available: their
payables. An as-yet unpublished study that we conducted of the top
800 producing firms in the European Union and the United States
over a 13-year period through 2017 found that large firms
systematically extended their payment terms to suppliers (i.e., how
long they take to pay them), and these supplier firms did the same to
their suppliers.

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Unfortunately, the buck stops at SMEs, which do not have the power
to force payment extensions on their suppliers. Consequently, for a
number of years, SMEs have had to absorb the cost of punitive
payments practices to finance their receivables just to stay in
business. During the 2004-2017 period, firms extended their days of
payables outstanding (DPOs) from 76 in Europe and 59 days in the
United States to 83 and 69, respectively.

SMEs that have been weakened by years of extended payment terms

now have to deal with the challenges of the coronavirus pandemic. In
addition to the precipitous falloff in demand and mandated
shutdowns caused by the pandemic, outstanding invoices are not
being paid. Their situation is precarious.

Ways to Avoid a Global Crisis

Can such outcomes be averted? Can governments and larger

companies help SMEs weather the current storm, put them on a
stronger financial footing, and lower the risk of systematic failures?
We believe the answer to these questions is yes — provided that
governments and companies take action now. There are a number of
remedies they can employ.

Provide SMEs with much-needed cash. Governments need to do

more to inject cash into the financial system with safeguards to
ensure that the liquidity goes beyond large firms and reaches SMEs.

In the United States, the Paycheck Protection Program (PPP) has

been effective in providing some financial support to SMEs. There
have also been government programs to increase liquidity. In Europe,
both national governments and the EU are offering financial support
to business, with a special focus on SMEs. Most of this support is in
the form of loans backed by a national or European guarantee, to
lower the cost for the borrower. Some countries, such as the UK and

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Italy, are trying to support supply chain transactions by providing

governmental guarantees in place of trade credit insurance that is
becoming too expensive. In the United States, the Small Business
Administration offers several programs, including some that provide
express loans and debt relief.

However, the effectiveness of such measures depends on how quickly

and efficiently bureaucratic banking systems can deliver these funds.
The U.S. government relief programs described above have
distributed funds quickly, but the extent to which they have helped
SMEs beyond payroll relief is unclear.

Nurture suppliers. The government relief programs alone will not

suffice. Larger firms need to assist their smaller cash-starved
suppliers. This strategy calls for identifying critical suppliers and
protecting them through the current crisis and the restart of their
operations. This can be done by paying them earlier than usual,
paying for future orders, or using supply-chain-finance programs to
ease credit restrictions on suppliers. (See this HBR article for more
ways firms can assist suppliers.)

For example, Gucci (owned by the Kering group), which kept its large
network of small Italian craft suppliers alive in the aftermath of the
2008 financial crisis, announced a renewal of this support for
suppliers in late May 2020. French mobile telecom operator Iliad
chose to pay its SME suppliers cash instead of waiting the normal 60
days in order to give them immediate liquidity. Beer maker Birra
Peroni has offered 60 days of extra payment terms to help its
distributors while bars and restaurants conduct limited business or
remain closed.

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Proactive working-capital management. Large firms should

orchestrate efforts to improve financial performance by focusing on
aggressively reducing all three components of working capital:
inventory, payables, and receivables. To reduce inventory, firms
should revisit their supply chains and reduce inventory requirements
and their cycle time — the time the firm must fund production and
distribution operations to the point of sale. This requires them to
redesign their supply chains (including the supply chain flows),
optimize inventory levels, streamline operations, and rationalize
service and product offerings.

Doing all this will take time, but it is a potentially more rewarding
one because optimizing inventory is a highly effective way to improve
a company’s working capital position without adversely effecting
other members of the supply chain. Most firms already aggressively
work to reduce their receivables through incentives to their
customers and stretch payables, but a more thoughtful approach is
required in order to nurture suppliers.

Interestingly, our research found that there was no meaningful

change in inventory after the global financial crisis, which suggests
that the large firms depended mainly on extending payables and
speeding collections to reduce working capital — not on improving
operations. This finding indicates that companies are missing an
opportunity to free up working capital through inventory
optimization or supply chain redesigns.

Supply-chain-finance solutions. There are a number of ways to

leverage the relationships among companies in a supply chain to
improve the access to credit by its weaker players, especially SMEs.
The most common one, reverse factoring, entails a large,
creditworthy buyer arranging for its financial institution to buy the
receivables of its suppliers. The financial institution can pay the

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supplier immediately (less a discount based on the buyer’s credit

rating) while the buyer pays the bank with the usual payment terms.
This solution has many variations, but the core benefit is leveraging
the creditworthiness of the party with the better rating, providing
credit at more attractive rates for the SMEs. Many large firms —
including Siemens North America and P&G — have adopted these
methods since the Great Recession and have expanded them in
response to the current pandemic.

Here are some other financing strategies that large companies can
employ to help their struggling smaller suppliers or smaller suppliers
can use on their own.

Exploit better data. With massive amounts and new sources of data
now available, large firms should be using this resource to better
assess suppliers’ health and viability and then help them. Gucci, for
example, provided detailed operational data from suppliers to the
banks, which enabled the banks to more accurately assess suppliers’
creditworthiness. Luxury group OTB (owner of the Diesel brand,
among others) offers reverse factoring to suppliers who meet quality
and reliability requirements. Puma (footwear, apparel) and Pimkie
(women’s fashion) include sustainability and CSR assessments in its
evaluations of suppliers when selecting them for inclusion in its
financing programs.

Leverage digital solutions. SMEs can take advantage of digital supply

chain solutions themselves or in collaboration with larger firms.
FinTech startups and other parties are using AI and advanced credit
scoring algorithms to assess the creditworthiness of receivables to
offer immediate payment to suppliers.

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Apply novel solutions. Aside from traditional financing options, such

as reverse factoring, there are many alternative solutions that achieve
similar benefits: ready access to liquidity, spreading risk among
supply chain partners, and optimizing working capital usage. They
include dynamic discounting (buyers offering early payment in
exchange for discounts), inventory finance (loans with inventory as a
collateral), purchase order finance (loans backed by purchase orders),
and invoice trading (platforms for selling receivables). Ford,
steelmaker Feralpi, and cruise ship builder Fincantieri are some of the
companies that are using these approaches.

Time to Act

Today, companies are struggling to stay alive until orders rebound or

ramp up or expand operations. These challenges require liquidity
throughout the supply chain. The approaches we’ve described will
make large firms and their supply chains more resilient.

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the creation of these resources.

Federico Caniato is a full professor at the School

of Management of Politecnico di Milano, where he
directs the Supply Chain Finance Observatory.

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Antonella Moretto is an assistant professor at the

School of Management of Politecnico di Milano,
where she co-directs the Supply Chain Finance
Observatory.

James B. Rice, Jr. is deputy director of the MIT

Center for Transportation & Logistics.

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