Payables Finance or Accounts Payable Financing

Modern supply chains have grown longer and more complicated as trade becomes increasingly global in nature. To cope with this expansion in trade, manufacturing and distribution companies have begun engaging in working relationships with several companies worldwide to procure raw materials/semi-finished goods or the final product.

This is economically feasible as the procuring company can source better quality raw materials or finished products from specialists at lower costs. However, this also creates working capital problems, especially for cash-starved suppliers.

Popular financing solutions like bank loans or working capital loans are expensive for suppliers in developing countries where credit is costly. On the other hand, buyers/importers, although highly creditworthy, may have vast proportions of their capital stuck in inventory or in between the sales process, finding it challenging to meet finances.

This has given rise to payables finance or accounts payable financing as a financial product. However, analyzing the cash conversion cycle (CCC) is critical to understanding how the solution works.

Cash Conversion Cycle

The cash Conversion Cycle or CCC is the number of days a manufacturing company takes to realize its money invested in inventory into cash flows from sales proceeds. Simply put, CCC measures how long input investments are locked up in the production and sales processes.

Infographic on Cash Conversion Cycle (CCC)

CCC is calculated using three metrics– how long the company takes to sell its inventory, how long it takes to collect receivables from sales, and how long it takes to pay its suppliers.

To calculate CCC, add Days of Inventory Outstanding (DIO), or the number of days it takes for the inventory to be sold, and Days of Sales Outstanding (DSO), which is the number of days it takes for sales proceeds to be credited into the company's books. From this figure, deduct Days of Payables Outstanding (DPO), or how long a company has to pay its suppliers.

So, CCC= DIO+DSO-DPO

Why CCC Matters

A low or decreasing CCC is a positive sign of a company's financial well-being. So, cutting down on each component of the CCC is what the importer or the buying company should focus. While inventory and sales management measures are essential, getting better supplier payment terms is also desirable.

However, pressurizing suppliers for longer payment terms isn’t equitable or sustainable, affecting vendor relations in the long run. This is essential to consider as many smaller suppliers find it difficult to get bank finance independently and work on tight working capital margins.

Moreover, given that supply chains are intricate and require strict adherence to timelines, even a single supplier facing financial difficulties can disrupt the entire supply chain. Which can prove detrimental to a buyer or importer’s operational capabilities.

What is Payables Finance?

Payables finance or accounts payable financing is a working capital solution typically initiated by the buyer/importer to benefit its supplier or network of suppliers. Unlike accounts receivable financing solutions, a payables financing solution generally leverages the credit profile of the buyer/importer.

Also known as reverse factoring, these solutions are generally far more cost-effective as they are initiated by medium-large-sized manufacturing or distribution firms having a healthy credit profile for the supplier’s benefit.

Payables financing takes two forms:-

1) Dynamic Discounting: Although relatively unknown, dynamic discounting is also a payable finance solution where a buyer gives the supplier the option of earlier payment terms in return for a discounted price on the goods/services purchased. It is known as 'dynamic' as discounts vary depending on the payment dates chosen by the supplier. So, the earlier a payment is made, the greater the discount. Also, the seller has the flexibility to either hold the invoice or demand payment depending on prevailing business conditions. Infographic on Dynamic Discounting

2) Buyer-led Payables Finance: Unlike dynamic discounting, which is solely between buyers and suppliers, buyer’s finance is a supply chain finance (SCF) technique with a financial institution as an intermediary.

The buyer contracts with the financial institution to allow its suppliers to discount their invoices with the financial institution in return for early payment. The buyer, in turn, agrees to pay the financial institution the total invoice value on the agreed due date. This engagement is done under an Open Account (OA) basis, meaning the supplier and buyer need not enter into separate contracts for each shipment.

A typical SCF model

Infographic on Buyer led Payables Finance

Note: This article will be referring to ‘Payables Finance’ as the ‘Buyer-led Payables Finance’ product, as ‘Dynamic Discounting’ is often used in an independent context solely as an agreement between buyer and seller.

Payment terms under Payables Finance

Payables finance under SCF agreements typically begins with the financial institution's creditworthiness study of the buyer. Once done, a solution is agreed upon, with the buyer specifying a set of suppliers it does business with and the financial institution providing a mutually agreed upon discounting schedule.

The financial institution then onboards these suppliers with the provision of their Know Your Client (KYC) documents.

Every transaction is triggered by the buyer unconditionally approving an invoice or account payable. This is usually done electronically, making the approval process instantaneous and constitutes an obligation by the buyer to pay the invoice amount on the due date.

The seller now has the option to hold on to the invoice for full payment at maturity or discount it with the financial institution at the agreed-upon rate.

Although the buyer initiates the financing request, the payments are made directly to the supplier’s account.

Benefits of Payables Financing

Regardless of which payables financing option a company chooses, both parties can mutually benefit.

Benefits for buyers:-

  • Stability in supply chains, ensuring operational continuity for buyers.
  • Working capital concerns being addressed ensure better relations with suppliers.
  • Shorter CCC with improved payment terms and thus better liquidity position.
  • The automated payment process leads to streamlined operations.

Benefits for sellers:-

  • Securing funding at lower costs compared to traditional banking sources by leveraging the buyer's credit rating.
  • Greater visibility of working capital and cash flows leads to better forecasting and flexibility to finance or hold the invoice till maturity.
  • Reducing the impact of longer payment terms demanded by financially-powerful buyers.

Is payables financing the right option?

Payables finance is a tremendous competitive advantage for businesses and their suppliers. This is especially so for companies with extensive supply chains spanning various geographies. Manufacturing companies are an obvious beneficiary as they typically carry a lot of inventory and deal with many suppliers.

Also, distribution companies that typically hold a lot of inventory can benefit from a payables finance solution.

In the past, one of the main criticisms regarding payables financing was that it was reserved only for more extensive, well-reputed companies that work with suppliers worldwide to cater to its domestic operations.

However, even mid-size and relatively smaller-sized firms in developed countries are increasingly opting for payables finance solutions to seize opportunities and work with their preferred list of suppliers.

Overall, this financing solution is ideal if the company:-

  • Has a high transaction turnover
  • Has a large proportion of working capital to revenues
  • Has a relatively large cash conversion cycle
  • Operates on medium-thin margins
  • Works with a variety of suppliers with different financial requirements
  • Regularly faces fluctuating demand and supply curves
  • Has a moderate to healthy credit rating

Why Choose Drip Capital?

As a technology-enabled trade finance company that provides effective working capital solutions for importers/buyers in the US, Drip Capital offers payables finance solutions for importers looking to secure strong working relationships with suppliers worldwide while leveraging its own creditworthiness.

To date, Drip Capital has facilitated 50,000 cross-border trade transactions across 100+ countries and assisted SMBs in growing their business by ensuring liquidity constraints are addressed for all the parties in a given trade transaction.

The Drip Capital Advantage

  • Collateral-free financing Fund sales growth with outstanding trade receivables without the need for any collateral.

  • Completely digitized onboarding and disbursing process An automated process ensures minimal manual intervention and quick disbursements to address business exigencies.

  • A personalized service A dedicated account manager to handle all interactions and promptly resolve any issues.