Supply Chain Finance: Main Drivers of Treasury Involvement

Online, July 25, 2012 (Newswire.com) - Treasurers are playing a more important role in supply chain finance (SCF) and as a result are improving risk management procedures, while creating cash and working capital optimisation.

Treasurers have become more involved in supply chain finance (SCF), as part of a strategic shift in the treasury team's responsibilities within an organisation. The trend has largely arisen since the financial crisis of 2008 when risk management, including supplier and counterparty risk, became more of a priority for the C-level and boards of almost all organisations.

This changing role for treasury has coincided with the movement towards global trade on open account terms; that is without trade finance instruments. The Society for Worldwide Interbank Financial Telecommunication (SWIFT) reports that more than 80% of global trade is now done on open account terms, a percentage that appears to grow each time a new study is conducted.

This combination of factors increases the responsibilities placed on an organisation to support its business trading relationships and, where there is a financial component, the requirement for the treasurer to be involved. Depending on geographic region, treasury either is involved with or actually leads SCF programmes at least 50% of the time and this involvement is growing every year.

Treasury's involvement results from the increase in trade with suppliers worldwide which, in turn, means an increased demand for financial tools to support those trading relationships. Traditionally, those tools were trade finance instruments such as letters of credit (L/Cs) or business guarantees. While they continue to exist, especially where required by regulation in certain markets, open account trading necessitates a different set of financing arrangements that aren't necessarily balance sheet items. As such, SCF is often the answer.

From a treasurer's perspective, there are two primary reasons to be involved in SCF:

- The opportunity for cash and working capital optimisation.
- The opportunity to improve risk management.

Cash and Working Capital Optimisation

Suppliers represent an excellent source of liquidity, which can result in a win-win situation for both the buyer and supplier. The two most popular techniques that treasury uses to optimise cash flow are called dynamic discounting and reverse factoring (also known as payables financing).

Dynamic discounting is where the buyer implements a programme that offers payments to suppliers early, in exchange for cash discounts. It is a buyer-led, buyer-funded programme that standardises the terms for suppliers when they elect to receive cash earlier than the contracted payment date. Suppliers are offered a discount rate by the buyer that is dynamically calculated for the term of the invoice, meaning the earlier the payment the greater the discount. This is a voluntary election by suppliers, meaning they can more effectively plan for their own working capital needs and, because the buyer uses their own cash, it represents a 'cash optimisation' opportunity for the treasurer. In today's low interest rate environment, it is generally the best return on cash the treasurer can find. Mature programmes with significant supplier involvement can also aid cash forecasting, as statistical analysis and trending can offer predictions on future cash returns from the programme.

Reverse factoring, aka payables financing or third party payables financing, is more of a working capital technique rather than a cash optimisation tool. However, the impact to the treasurer is no less significant, simply because managing liquidity through working capital improvement is a core metric for most. In reverse factoring, the buyer again leads the programme but involves a third party to finance the early payment of invoices. The third party is typically a bank and that institution will, along with the buyer, create a programme that offers early payment at a minimal financing cost to suppliers.

When suppliers are smaller and less able to secure reasonable financing, the credit relationship between the buyer and the bank allows funding on better terms than the supplier could achieve on their own. The bank will also offer an improvement in payment terms to the buyer, which may be in the form of extending days payable outstanding (DPO) or potentially offering a payment discount. This arrangement can offer a win-win for the buyer, supplier and bank. Each sees advantages in terms of an improvement in working capital or, in the bank's case, new business that may be Basel II and III 'friendly' due to the nature of the business relationships.

Risk Management

From a buyer's perspective, SCF programmes can often be justified on the risk management benefits alone. SCF can help buyers minimise disruptions in the supply chain by offering cash early at a reasonable financing cost or discount. By improving working capital, any supplier that faces potential disruption due to lack of liquidity is handed a lifeline which could represent the difference between meeting production requirements and being replaced. Eliminating this potential disruption may produce immense value, depending on just how strategic a supplier is to the buyer. On the flipside, a supplier that is in high-growth mode will also benefit as their return on investment (ROI) on cash may be significantly higher than the buyer-arranged discount, thus making it a savvy financial decision to enable further growth.

Another risk that the treasurer may face is that the programme becomes too successful and introduces funding risk into the equation. Financing isn't limitless, and if too many suppliers participate in a programme it may outgrow the funding limits of the buyer (in dynamic discounting) or the bank (in reverse factoring). In the case of outgrowing a self-funded dynamic discounting, a buyer can simply introduce a third party and move towards a reverse factoring/payables financing model. Should the programme outgrow the bank, then a multi-bank approach may be the answer. Many buyers choose this multi-bank route simply to diversify the business when maintaining bank accounts, for using bank services across different partners, or to take advantage of geographic specialisations which may encourage supplier participation in those regions.

The benefits of employing SCF for the organisation are obvious. The opportunity to extract liquidity from the supply chain without adversely affecting the financial health of the supplier is almost a dream come true for many treasurers, which is why reverse factoring has recently become so popular. If working capital improvement isn't the priority, or if better returns on cash balances are more in focus, employing a dynamic discounting programme as a cash optimisation tool may be in the treasurer's best interests, during the present tough economic environment.

Formalising the programme can increase adoption by suppliers, meaning the opportunities to increase cash returns through supplier discounts may increase dramatically. This alone drives many treasurers to push for involvement in SCF. In those situations, the risk management benefits derived from a successful SCF programme end up being a bonus. The advantages of mitigating supply chain risk are still significant, but sometimes not quite as interesting to treasury as the opportunity to optimise the use of cash and/or improve working capital.

To achieve the expected benefits, the treasurer's role in facilitating these programmes is important as they have the financial expertise, banking relationships and, often, the financial systems in place to manage a global SCF programme and measure its on-going effectiveness.

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