What next for supply chain finance?

Banking & Finance
| The European | 19 July 2021

Director at Kroll James Gillibrand unpacks the world of supply chain finance, and highlights why the solution is only as strong as its weakest link 

Supply chain finance (SCF), also known as reverse factoring or supplier finance, is a working capital financing solution designed to create a symbiotic commercial relationship by optimising cash flow for a supplier whilst facilitating profitability and supply-chain stability advantages for the customer (“the buyer”). 

When compared to alternative working capital financing, such as invoice finance, SCF looks in the opposite direction down the supply chain and provides a financing option to the buyer to accelerate the payment of supplier invoices. In contrast to invoice finance, where a lender usually spreads the credit risk over several debtors, the SCF provider is concentrating its finance on one entity with the strength of its balance sheet alone supporting the debt. As a consequence, SCF facilities remain an exclusive tool of large corporates and multinationals.

Typical stages of how SCF works  

  •  The buyer enters a financing arrangement with a lender to operate an SCF facility which provides for the buyer (borrower) to pay its suppliers.
  • The buyer offers the suppliers the opportunity to receive early payment of invoices by agreeing to the SCF terms which is funded through the buyer’s SCF facility with the lender.
  • Under the SCF facility, after delivery of goods and once invoices are approved for payment, the lender pays the supplier via the SCF facility, meaning the supplier receives early settlement of its invoice.
  • The buyer then repays the lender on the original payment terms of the invoice (e.g. 60 days after receipt of the invoice. The lender either takes a fee by discounting the payment to the supplier or by charging a fee to the buyer when the invoice is paid).On first impressions, SCF brings significant benefits to all parties. However, as with many types of finance products, these benefits have equivalent quid pro quos, especially for the supplier. 

Practical benefits of SCF vs invoice finance for the supplier 

  • Cash flow – SCF ordinarily provides a superior level of funding against specific invoices, resulting in payment against the supplier’s entire invoice value, minus a fee.
  • Administrative benefits – SCF facilitates the acceleration of customer receipts and therefore reduces the supplier’s credit control and administrative burden.
  • Mitigants – SCF reduces the supplier’s reliance on alternative forms of finance and in turn reduces the supplier’s financial leverage risk. 

Whilst SCF should expedite payments, in our experience there can be some financial disadvantages and practical challenges for the supplier:

Control – When using SCF, the supplier is not in control of the invoice certification process, which involves the buyer approving the invoice for payment – this can typically take around a week or longer.

Costs – Whilst a SCF facility can provide cash flow benefits (as close to 100% of the supplier’s invoice is paid), this can leave the buyer eligible for early payment discounts that can eat into the suppliers’ margins.

Withdrawal risk – An invoice finance provider will offer a minimum commitment term to suppliers, whereas an SCF facility can be withdrawn with little notice to the suppliers as the lending relationship is between the buyer and the lender. If the buyer has its SCF facility withdrawn, the supplier could seek to discount the invoices with its own invoice finance provider, but this will typically see a reduction in funding and a potential risk of “double funding” for the lenders.

Drawbacks to SCF

From an accounting perspective, one of the most controversial aspects of SCF is that substantial amounts of lending do not have to be classified as debt. This type of accounting can be optically problematic, and in the case of Carillion shortly prior to its collapse in 2018, up to £500m of debt due its SCF lender was categorised as trade payables, whereas loans and overdrafts on the balance sheet were reported in the region of only £150m. It is arguable that this accounting treatment masked Carillion’s true overall debt levels and understating its gearing, in turn enhancing the appearance of Carillion’s balance sheet.

The post-mortem of Carillion’s downfall disclosed that payment terms with its suppliers were an average of 120 days (this was also the terms on which the SCF lender was repaid). In December 2017, Carillion’s SCF facility was withdrawn. The liquidity effect for Carillion and its supply chain was disastrous, resulting in the almost immediate failure of the construction company and terminal collateral damage through its supplier network.

Carillion is just one example. There is a plethora of examples of similar failures which has brought the subject of SCF regulation into sharper focus. It is widely reported that the accounting treatment ought to be revised given the debt-like features of SCF, to report the true nature of the borrower’s indebtedness. As the access to SCF is diverse through digitalisation and fintech’s, there have also been calls for a wider interrogation and formalisation of SCF lending across the board.  

The road ahead

Given the economic slowdown due to Covid-19, it is widely publicised that demand for SCF has soared to combat liquidity contraction. With SCF seemingly becoming more popular, this may be a symptom of management teams prioritising cash flow headroom over short-term profit. However, SCF may be being used as a sticking plaster where more acute structural challenges exist.  

An SCF facility is only as strong as its lender and its borrower. Covid-19 has left a damaging imprint on many of the strongest of pre-pandemic debtor covenants and as the ongoing economic uncertainty continues, the lasting longer-term impact on the users and purveyors of SCF remains unclear.

The saying “a chain is only as strong as its weakest link” speaks volumes, and as recent history has shown, if the SCF train derails, the resultant pile-up will bring widespread casualties.

Further information 

www.kroll.co.uk 

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