Finance and Lending
What is Supply Chain Finance?
August 5, 2020 |
The C2FO Team
Supply chain finance has been around for four decades and continues to grow in popularity. Here’s how this financial model has evolved over the years and what the next generation of SCF looks like.
Paying bills reliably and receiving payments quickly for products and services rendered have always been fundamental to smoothly running any business and keeping it strong.
Supply Chain Finance (SCF) is a 40-year-old method for achieving both. The Global Supply Chain Finance Forum defines SCF as “the use of financing and risk mitigation practices and techniques to (optimize) the management of the working capital and liquidity invested in supply chain processes and transactions.”
Put more simply SCF, which is also known as supplier finance or reverse factoring, enables companies to pay their suppliers faster to improve their liquidity. Many of today’s SCF programs are offered on technology-based systems that automate transactions, and are designed to decrease financing costs and increase efficiency for both buyers and their suppliers.
When a buyer’s credit rating is stronger than a supplier’s, the buyer can less expensively access capital, and this creates the ideal circumstance for SCF. The customer typically creates an SCF program with a bank or other financier. The resulting short-term credit spreads payment risk, and boosts liquidity for both buyers and their suppliers. SCF also often enables suppliers to redirect their increased cash flow to other areas of their businesses.
SCF has evolved over the years to meet changing market needs. A prime example of that evolution is C2FO’s Dynamic Supplier Finance (DSF), a new approach that utilizes what works well with SCF while removing disadvantages for companies and their suppliers. DSF benefits buyers, who can pay from their own balance sheets or from C2FO’s network of funders, and suppliers, which have a say in how much discounting they will accept in exchange for early payment. This increased flexibility creates a more reliable funding stream and encourages more suppliers to participate.
Origins of supply chain finance
SCF started around 1980 as an innovative financing option for corporations and their suppliers. But its roots go back thousands of years to trade finance, which is as old as trade itself, and supply chain management. Mesopotamians used trade finance with invoice discounting from 3,000 B.C. to 1,000 B.C. The Romans also used a form of invoice discounting from 27 B.C. to the mid-15th century by selling promissory notes at discounts in secondary markets.
Starting in the 1920s, supply chain management was used for assembly lines. Electronic data interchange was used as part of supply chain management starting in the 1960s. SCF originally was called “confirming” and was used to finance working capital primarily for domestic trade. It became known as “SCF” in the United States and Europe a few years later.
In the 1990s, the automotive industry became one of the first to use SCF. The retail and manufacturing industries soon followed suit.
When supply chain finance became popular
After the Great Recession of 2008 and 2009 and in more recent years, many companies in various industries in the United States, Europe and the Asia Pacific embraced SCF. Estimates put 80% of global trade as occurring on an open-account basis, led by big corporations but also attracting smaller ones.
A global shift away from traditional financing mechanisms has occurred in the past few years based on importers’ and exporters’ preferences for trade based on open account terms, in which payments become due after suppliers ship and deliver goods.
The change was partially rooted in emerging markets deciding that credit-based trade revealed low confidence in those markets and institutions. A shift from traditional bilateral trade agreements between one buyer and one seller to global supply chains involving thousands of suppliers also prompted the change. This broader approach mitigated exporters’ risks, including the potential for nonpayment.
In the years since the Great Recession, usage of SCF has grown significantly. Anand Pande, global product chair for trade and SCF, and founder of the Growth Paradigm Partnership (GPP), called SCF “a land of unrealized promise” in a 2017 article in The Economist. Pande described reverse factoring as having had $2.8 billion in revenue and the potential for growth to $300 billion, according to GPP. Pande cited this as a possible reason that banks’ revenue from SCF had “underperformed at just 10% to 25% of their total trade revenues, despite 80-90% of global trade flows being dominated by open account supply chains.”
The ICC Academy, an e-learning platform of the International Chamber of Commerce and host of the annual Supply Chain Summit, cited a 2015 McKinsey report that estimated SCF had the potential for global revenue of $20 billion. China’s supply chain finance sector in 2017 was predicted to reach $2.27 trillion by this year. An ICC survey of banks in 98 different countries in 2018 pegged SCF as the upcoming leader for development and strategic focus.
How supply chain finance has changed
SCF solutions for buyers and sellers have evolved to serve various markets and clients, according to the ICC Academy. These solutions have included:
- Receivables discounting
- Forfaiting (buying a future payment obligation with no right of recovery)
- Factoring, in which the “factor” — usually a bank or specialized factoring company — advances 70% to 90% of an invoice up-front and the rest, minus charges, is paid when the debt is collected
- Payables finance
- Loan or advance against receivables
- Distributor finance
- Loan or advance against inventory
GPP’s Pande said “banks were bolder” in the early 1990s by using pre-production supplier financing in trying to solve financing shortcomings. Financing at that time focused on irrevocable purchase orders delivered through enterprise resource planning integrations or host-to-host connections between large global retail companies, mainly in clothing and accessories.
This shift to technology-based delivery systems from global companies providing purchase orders to global banks in growing markets in Asia, Eastern Europe and South America “was a win-win — securing much-needed (small to mid-sized enterprises) financing and the acquisition of new SME clients for banks, while simultaneously bringing sustainability and stability to supply chains,” Pande said.
After the Great Recession, most SCF supported by technology sought to provide safer post-shipment funding supported by invoices accepted by buyers. Technology-based support included proprietary bank platforms or multiple platforms separate from banks and provided by technology companies.
Development of artificial intelligence, natural-language processing and robotic automation is expected to play a big role in bringing about efficiencies to SCF. However, banks must seek to replace conventional models based on risk assessment and compliance with quantitative and qualitative models to increase revenue.
A strain on working capital
The Great Recession left many of the world’s biggest companies unable to confidently project their cash flows, and that certainly applies to many businesses today.
“We are seeing trade put a strain on working capital,” said Sean Harapko, a supply chain transformation leader for EY Americas.
SCF’s ability to support companies that have unpredictable cash flow has strengthened in the past decade, mostly because of the increased use of technology. Though SCF originally was focused more on supply chains, “it has now started to be extended to all supplier types, including long-excluded categories like logistics and media,” Harapko said.
The Supply Chain Management Review identified seven key trends in 2019 as SCF has continued to evolve:
- Companies are using supply chains to better control working capital
- More providers are offering more financing
- “Fundable transaction” definition is expanding
- Supply chain managers are becoming “financial superheroes”
- Blockchain is strengthening in SCF
- SCF is improving from the internet of things, machine learning and artificial intelligence
- Continuing demand for SCF
Dynamic Supplier Finance and supply chain finance
In a further evolution of SCF — and unlike the static discounts offered by traditional SCF programs — C2FO’s unified, cloud-based Dynamic Supplier Finance (DSF) gives both buyers and suppliers more flexibility in addressing their working capital goals. Suppliers have input on how much discounting they will accept to get paid early. Buyers have the option to pay from their own balance sheets or from C2FO’s network of funders. This flexibility better ensures a reliable funding stream, which yields more participation of suppliers when compared to most SCF solutions.
Traditional SCF programs also require extensive paperwork and setups. Top-tier vendors are often the only ones that can access these programs. Conversely, DSF engages small, medium and strategic suppliers, and offers competitive pricing and no spending restrictions, unlike traditional bank financing. This enables DSF to offer companies more control over how and when they fund invoices. Paying suppliers early addresses supply chain sustainability while preserving cash.
DSF’s advantages over traditional SCF include increased control, flexibility and scalability, a reduced cash conversion cycle, and superior supply chain financial health — backed by C2FO’s worldwide network of buyers and suppliers.
These strengths are especially important in the currently turbulent domestic and global economies. To learn more about DSF and other working capital solutions on the C2FO platform, click here.
SCF started 40 years ago as an innovative financing option for corporations and their suppliers. SCF enables buyers to pay their suppliers faster to increase their cash flow and provides customers additional working capital options such as payment terms extension. Its technology-based platforms automate transactions and are designed to lower financing costs, better manage working capital and improve efficiency for both buyers and suppliers.
Companies started embracing SCF soon after the Great Recession. Many more have done so in recent years in various industries in the US, Europe and the Asia Pacific, as importers and exporters have increasingly preferred trade based on open account terms in which payments come due after suppliers ship and deliver goods. A 2018 ICC survey of banks in 98 countries concluded SCF was the coming leader for development and strategic focus.
SCF’s technology-driven evolution continues to strengthen the business models of and relationships between buyers and suppliers. DSF exemplifies that evolution’s forefront.