As far as trade finance techniques go, supply chain finance is a relatively novel concept introduced as recently as 1982.
Since then, both the term and the practice has been growing steadily in popularity and is now offered by several financial institutions to enable seamless global trade.
Like other modes of international trade finance, it is a risk and liquidity management technique that benefits all the parties involved.
The parties involved in a typical supply chain finance arrangement includes a buyer, a seller & a financier.
It operates in stark contrast to the general competitive dynamic between the exporter and the importer and, instead, it boosts collaboration between them and enables quick and smooth processing of business transactions
What is Supply Chain Finance?
Supply Chain Finance (SCF) refers to a set of financial instruments initiated by the buyer that enables suppliers or vendors to receive early payment on their invoices in exchange for goods they provide.
The buyer or the importer makes arrangement for a program where the supplier can exercise early settlement of invoices drawn in the supplier’s favour through the services of a bank or a financial institution.
This is done without affecting the buyer’s own liquidity position so the buyer can unlock working capital that is essential for running the business.
Also known as supplier finance or reverse factoring, SCF is generally used interchangeably with ‘buyer-side finance’ as it is the buyer who intimates the financier of the transaction to make the early payment to the seller.
However, SCF is an umbrella term that includes a whole host of other services in addition to buyer’s finance, and commodity finance, of which commodity trade finance is most popular specially since COVID-19.
In order to safeguard each of their interests, traditional trade finance mechanisms like letters of credit have been in use to ensure security of payment and performance.
However, documentary credit has its own limitations. For one, a trade via a letter of credit is a painfully slow.
It also requires lengthy documentation on a regular basis.
Increasing globalization and the rising complexity of supply chains motivated buyers and sellers to explore better ways of working together.
Commonly, SCF is initiated by a buyer who is a large organization with a better credit rating than the seller and good overall credit worthiness. Due to this fact, the costs of funds for the deal are lower.
This makes SCF an attractive form of financing for both parties.
Parties Involved in a Supply Chain Finance Program
Put simply, there are 3 main parties involved in a supply chain finance program;
- The "Anchor" is the corporation that initiates [the supply chain finance program], the anchor is the buyer or the importer who has a buyer-supplier relationship with several vendors
- The "vendor" is the supplier, this is the party that mainly benefits from the arrangement as they can secure financing at a far lower cost.
- The financial institution, like Drip Capital is the company that makes the early payment to the supplier and charges a fee for this service
How Does Supply Chain Finance Work?
In a successful SCF program, there are three parties - the buyer (importer), the seller (exporter) and a bank, or third-party financier, who undertakes to finance the transaction.
To summarize, here are the steps of a typical supply chain finance solution :-
A buyer and a seller enter into a trading relationship. In most cases, the buyer works with several suppliers.
A payment period of X days is agreed upon this is generally 30,60 or 90 days as per standard industry norms and suppliers almost always need to tap into funds a lot quicker.
The buyer also would like to hold onto their working capital to fund business expansion.
If a supplier were to avail funds based on its own credit rating, the cost of funds would be significantly higher.
In such a case, the buyer initiates the set-up of a supply chain finance program that is extended to multiple suppliers.
The suppliers can choose to discount their invoices and get paid early based solely on the buyer’s credit worthiness.
Since the buyer has strong credit worthiness, the bank or the financial institution can also draw comfort from the program.
In addition, a good credit rating ensures that the buyer can source capital from external sources quickly, and at an attractive rate.
In this manner, the buyer initiates the SCF program while the seller simply makes a sale and receives payment quickly, as per his own flexibility.
In most cases, buyers have SCF programs with hundreds or even thousands of sellers across the supply chain.
There is no official definition of the term supply chain financing that has been issued by the ICC. Due to this, the term is also called by several other names like;
1.Reverse Factoring 2. Buyer’s finance 3. Accounts Payables Finance 4. Suppliers finance
And in other instances, the term is synonymous with other trade finance products that achieve the same objectives but operate quite differently when compared to supply chain finance.
Alternatives to Supply Chain Finance
1. Receivables Purchase:
In this scenario, a bank outright purchases the receivables, in part or whole, from the seller. The receivables are no longer present on the balance sheet of the seller. Once the bank is the official owner of the receivables, responsibility of receiving the payment from the buyer falls upon the bank.
The terms of this payment will be decided between them, and the seller plays no further role. The seller usually pays a small fee to the bank, but it is significantly lower than the cost of getting direct bank financing.
2. Loans or Advances:
In this scenario, the bank provides a loan to the seller against the receivables. The receivables remain on the seller’s balance sheet, and the responsibility of getting payment from the buyer still lies with the seller.
When the seller receives the payment, the loan must be paid to the bank. This is different from a traditional loan because the seller can leverage the buyer’s size, credit rating and on-going business relationship for attractive interest rates for availing the loan.
3. Purchase Order Financing:
In this scenario, the seller must provide the bank with a copy of the purchase order issued by the buyer.
Usually, this form of financing is only used by distributors or resellers, not product manufacturers. The purchase order is the basis of the financing. Read more about distribution financing in our guide.
In principle, this instrument is ideal for procuring funds at a pre-manufacturing or pre-distrubution stage.
In a sense, Drip Capital's SCF solution can be classified as a purchase order financing service as having POs from verified buyers is one of the first steps in our credit appraisal cycle
4. Pre-Shipment Finance:
This form of financing is provided to a seller in order to cover working capital costs and product manufacturing costs.
As the name suggests, pre-shipment finance enables sellers to complete the production and delivery of goods to the buyer.
The financier provides pre-shipment finance on the basis of purchase orders, contracts (between the buyer and the financier) or a Bank Payment Obligation.
5. Inventory Finance:
In this case, the collateral for the finance provided is the inventory itself, which is contracted to be purchased at a later date.
The buyer initiates the process so that the financier provides cash to the supplier, who then keeps the goods in inventory until they are sold in the future.
This is especially useful in the case of products with fluctuating demand; when the demand is high, the goods in inventory can be sold.
An inventory financing service can be of several types, including inventory loans, inventory line of credit.
We've covered the several different types here.
Benefits of Supply Chain Finance
Supply chain finance strengthens collaboration between buyers and sellers.
In the context of international trade finance, SCF boosts the entire ecosystem by building long-term partnerships based on trust.
Another common trade finance solution that helps reduce risk and helps businesses optimise their supply chain finance is buyer's credit.
You can read more on this in our guide on buyer's credit.
In addition, by ensuring that suppliers receive their payment in time, SCF reduces the risk of supply chain disruption and complexity. It is also an effective working capital management technique.
We have a dedicated guide on supply chain risk management here.
Benefits for buyers:
Working capital remains untouched as the bank makes the payment, while the buyer can hold on to liquid cash for extended periods.
SCF strengthens the buyer’s supply chain, thus making it easier to get through disruptions in the face of changing policies and regulations.
By extending immediate payment to sellers, the buyer becomes a preferred customer for suppliers. This enhances the market competitiveness of the buyer.
In the case of dynamic discounting, the buyer receives a discount on his purchase
Benefits of SCF for sellers:
While suppliers receive early payment for their goods that can be used to fund the next business opportunity.
This import funding is received at a much lower cost
Even if the seller has to offer discounts and pay fees to the banks, it still works out to be more cost-effective.
With readily available payment flexibility, sellers can predict future cash flows accurately and improve their standing in the trading ecosystem
Trading relationship with the buyer is maintained
Benefits of SCF for third-party financiers:
Banks can invest in end-to-end redesigning of customer journey as relationships between all three parties gets strengthened.
The banking ecosystem can witness the rise of partnerships with technology vendors to kickstart SCF programs.
Banks in countries with emerging SCF programs can set out on a path of business maturity that can improve banking capacity and reach.
How Supply Chain Finance Helps Small Businesses
Supply chain finance benefits SMEs and business owners across the value chain.
These companies need working capital to remain competitive, and SCF programs ensure they have the liquidity to meet Day Sales Outstanding (DSO) expectations.
They can enhance their credit scores by executing transactions while they don’t have to rely on collateral or ineffective credit products.
Small entrepreneurs rely on the credit worthiness of buyers and can free up working capital to expand their business.
Example of Supply Chain Finance
Supply chain finance can be best illustrated with an example. A buyer - Company X Inc., purchases components to manufacture premium smartphones from company Z & Co., an overseas entity. Z & Co. delivers the parts to Company X Inc. and raises an invoice with credit terms of 30 days which is then approved.
If Company X Inc. and Z & Co. enter a supply chain finance program, Z & Co. can receive payment for its goods as soon as the invoice is approved. Therefore, the company need not wait for the stipulated 30 days. As a result, the program benefits Z & Co. as the company makes a sale, receives quick payment, and improves its credit worthiness. On the other hand, Company X Inc. receives its goods and gets an extended 60 days credit period to pay to the bank.
In some cases, Company X Inc. may receive a discounted price on the invoice upon initiating SCF programs that deliver early payment to Rabbit & Co.
Z & Co. receives quick liquidity and income in such cases, while Company X Inc. gets a discount. This scenario is known as dynamic discounting. SCF programs can involve single banks or financiers, or they can be developed on a multi-funder basis wherein different financial institutions are involved.
Supply Chain Finance Ecosystem
Buyers, sellers, and banks conduct the transactions that comprise supply chain finance programs. Behind the scenes, a much larger ecosystem exists with diverse players.
The parties in this ecosystem determine the success of SCF programs and how smoothly goods and finances exchange hands. These are the key players in a supply chain finance ecosystem:
• Advisors
• Banks
• Buyers
• Credit insurers
• Distributors
• Funders
• Industry associations
• Platform providers
• Regulators (central banks and ministries)
• Suppliers
Trade Finance Vs. Supply Chain Finance
Trade finance is a broader umbrella term that includes measures that protect parties against the risks of international trade, supply chain finance is a sub-set of trade finance.
Supply chain finance can also be classified as a trade finance solution that fills working capital gaps in domestic and international trade, but they differ in the degree of importance banks and financial institutions have placed upon them.
The Rising Impact of Blockchain on Supply Chain Finance
When it comes to invoicing, blockchain has many benefits. It creates a single source of truth and an audit trail built on transparency. Buyers and sellers can easily see transaction history, while intelligent contracts automate specific transactions once milestones are reached.
For small businesses, in particular, the benefits of blockchain can be a game-changer. It can deliver supply chain finance to more vendors in the supply chain, while middle-market buyers can begin exploring SCF programs.
However, blockchain is still in the nascent stage regarding supply chain finance across borders. Its full impact is yet to be realized as its unique long-term benefits become more evident.
Instead, technologies like Artificial Intelligence (AI) and Robotic Process Automation (RPA) drive more remarkable change across supply chains. These technologies can enhance and automate manual tasks, thus making SCF programs broader and more effective. They can also help predict supplier behaviour which can improve the effectiveness of supply chain finance programs.