Supply Chain Financing- A story beyond Liquidity Management

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What is supply chain finance?

Solutions that work towards optimizing the cash flow by allowing businesses to extend their payments to their suppliers while providing the option for the large and SME suppliers to get paid early is supply chain financing. It offers financing
facilities to suppliers based on the acceptance of Invoice/Bill by the Buyer against an underlying Trade transaction.

In simple terms, Supply Chain Finance is a partnership of the banks with selected corporate clients also referred to as 'Anchors' who act as guarantees, to support with the working capital needs of their chosen suppliers and buyers. The strength of the client’s commercial arrangements and relationships between buyer and seller is a very important factor that is considered while evaluating credit quality of suppliers/buyers.

This is very different from the traditional practice of standalone risk evaluation which was focused only on suppliers/buyers financial strength and historic financial performance.

Supply chain financing can be in the form of Vendor Financing, Dealer Financing, Factoring, Reverse Factoring, Sales Invoice/Bill discounting, Purchase Invoice/Bill Discounting, LC Bill discounting etc.

These financing facilities provide suppliers with liquidity and thereby strengthen their balance sheet. From Suppliers perspective, early realization of receivables inherently provides an opportunity to enhance his capabilities to produce more and therefore order more from his suppliers and so on.

Whereas, for a Buyer against whom the bank usually predicates its risk is presumably better rated and hence the cost of financing is usually lower than the supplier’s standalone ability to finance similar risk. This allows the buyer to exploit the supply chain benefits that are extended to its suppliers by extended payment terms thereby easing his working capital as well.

All this together results in a win-win situation for both the parties, and also minimizes the risk across the supply chain. And therefore a bank financing a supply chain practically acts as a catalyst for companies to grow further in terms of higher sales orders, better profitability in the form of cost of debt and liquidity management or both.

What you should know about supply chain finance?

Supplier Chain Finance is an extension of the amount that the buyer owes to the supplier and is not considered financial debt. For the suppler, it is the receivable of the payment towards its product.
It is not a single-bank facility and can be extended to more than 50 financial institutions worldwide.
It is not factoring and one hundred percent of the invoice is paid to the supplier after deducting a small transaction fee. Additionally, there is no alternative burden on the supplier once the invoice is paid.
Supply chain finance is a facility that is offers value to firms of all sizes and credit ratings, and SME suppliers.
It can also be a composed of a mixed program where financing is shared by the buyer, capital markets, and financial institutions as well.

Evolution of Supply Chain Finance

Supply chain financing has been based on Hub and Spoke model. The Hub and Spoke model is a system of connections arranged like a wire wheel. A Bank establishes comfort based upon the credit worthiness of the Hub or the Anchor supported by Trade controls in order to limit the supplies/ payments in case of any signs of stress in the supply chain. Unlike traditional financing wherein banks provide working capital finance, supply chain financing enables the bank to closely monitor the transaction based payment cycles and puts corrective measures in place in case of any red flags. These are a conscious balance between risk reducing and operationally intensive trade flows to single payout financing with naturally higher risks.

Figure : Evolution of supply chain finance from security perspective

Taking a look at the evolution of supply chain finance from security perspective, you can conclude that, while credit worthiness of the anchor has remained constant, the level of security to bank has diminished with years.

Initially banks had started supply chain relationship with Obligors (debtors) as suppliers or dealers based on security. These securities were in the form of corporate guarantees from the anchor companies, or acceptance of bill of exchange drawn on the anchor (Drawee) under Negotiable Instrument act. Furthermore, banks also had additional risk mitigants in place. These were over and above the trade controls committed under the program.

However, with the standardization in product, multiple banking relationships and good track records, the security has slowly transited from 25-50% First Loss Default Guarantee (FLDG), to close to zero FLDG from the anchor companies.

There is a basic expectation from corporates to develop supply chain efficiencies and derive comfort from it. And banks are now deriving its comfort purely from the supply chain efficiencies, a new paradigm which has become in evitable.

Technology – The Backbone for all future Supply Chain Financing:

Since purchase order financing often requires a confirmation through letters of credit or other instruments, it often seen to be underutilized. This is one of the biggest challenges that banks face, as they are able to go one step in the supply chain based on the comfort derived from the anchor, but do not wish to go further down.

This is mainly due to bank’s inability to monitor the flow of goods/money, risk of diversion of funds by the players in the supply chain, etc. That’s aside, understanding the difficulty in enabling controls, predicating risk of payments other than an anchor or the non-obligation of the anchor to honor transactions which are not bought by him directly.

Technology is the answer to these challenges!

Blockchain technology can ease this requirement and enable purchase order financing for wider use by SMEs. It can greatly help in boosting the purchase order financing by ensuring better efficiency, greater security, and higher confidence in the data used for making financial decisions.

This, by definition can be as simple as integrating the ERP system of an anchor to that of a bank wherein the accepted invoices can result in immediate financing or could be as advanced as linking all the players in the supply chain to a blockchain architecture right up to the last level. To know more about blockchain, read the article, "Blockchain - Racing to the future"

Figure : A typical supply chain. Banks are present at Tier I level and with technology like Block chain can go down further levels

If banks are able to inbuilt checks on the flow of money from the Anchor right upto the last supplier and correspondingly monitor the flow of goods, a large part of the Banks risk gets addressed. This may not look plausible currently but it may happen soon with new technologies. This may be one of the opportunities. There can be many more which could be explored.

It’s important that we are one step ahead of others, leverage on anything novel which makes sense and get as much business as possible, before the others wake up to the realities. TReDS (Trade Receivables Discounting System) could not have been imagined few years back but now we have a Trade Digital platform supported by RBI and which allows auctioning and financing of Trade Receivables.

Way Forward:

Supply chain financing may not be just a liquidity management tool. In future companies will decide on banks based upon their ability to finance the complete supply chain, ease of monitoring trade & cash flows, cost savings on integrating their systems with banks and the overall growth in business that they can envisage. Banks on the other hand will leverage their technological strength to finance trade flows, build confidence to finance a relatively riskier counterparty. This will be on the back of inbuilt red flags which will automatically correct the course of financing.

For all your financial needs, get in touch with a relationship manager at Kotak Mahindra Bank. The contact details are given below.

Supply Chain Financing- A story beyond Liquidity Management

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