Why Supply Chain Finance’s Struggles Have Only Just Begun

Here's why supply chain finance will continue to underwhelm in the present business climate:

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Tech-enabled supply chain finance has been around for over 20 years, promising the release of huge amounts of locked-up working capital from the supply chain. Big companies can use their credit to fund the supply chain finance programs, but medium-size buyers find this difficult or too expensive. This restricts supply chain finance to large buyers; very few programs are offered by mid-sized companies. And, with historically low interest rates making the cost look expensive, together with seemingly endless contract complexity, suppliers remain uninterested.

There are efforts underway by the supply chain finance service providers to de-risk transactions for mid-sized buyers with deeper levels of integration -- using sales order information, historical trading data and even receivables to strengthen their credit rating and secure competitive funding. But, while supply chain finance remains a luxury only offered by top-tier buyers and the cost and complexity of the programs outweigh the obvious benefits, we are not going to see widespread take-up any time soon.

Suppliers have always looked for ways of getting their money earlier than their buyers were prepared to release it. Whether it is via factoring, invoice discounting or supply chain finance, the business world has come up with a myriad of ways of getting the money in quicker. Indeed, many “modern” businesses seem to have forgotten the purpose of commercial payment terms.

Commercial payment terms were originally put in place so that the receiving party could verify that their goods had been delivered successfully before they paid for them. Commercial payment terms were never meant to be a complex arrangement enabling buyers to hang on to cash for an extended period and starving their supply chain. Nevertheless, that is where we are today, and unfortunately the issue appears to have become embedded into standard business practices.

In an era of very low interest rates, extending payment terms is an odd thing to do. Why would buyers want to hang on to cash and not earn any interest on it, while their suppliers are left waiting for payment? Low interest rates also mean that supply chain finance has become too expensive, but its problems do not end there.

Here are several reasons why supply chain finance will continue to underwhelm in the present business climate:

Firstly, interest rates are very, very low. As a result, supply chain finance as a way of funding invoices has become very expensive for a supplier. Cost of funds are typically only 1-2% APR, but supply chain finance companies are adding high overheads often resulting in supply chain finance, costing more than 10% APR. That is prohibitively expensive for many businesses in the new normal.

Supply chain finance’s second problem is that there is an awful lot of money around, and banks are currently very keen to lend to businesses. A business that has a reasonable track record can usually borrow the money it needs quickly, so supply chain finance is tending to be used more and more by businesses that have serious financial issues. Even though most of the credit risk is borne by the buyer, high-risk suppliers also add transaction risk, which is making supply chain finance riskier for its lenders. This means lenders have increased their interest rates even further, creating a vicious circle where higher levels of risk are driving up interest rates on an already expensive service. 

Supply chain finance’s third major problem is that it is a relatively low-margin business model. The pressure caused by low interest rates, plus the fact that the sort of suppliers who are short of cash tend to be smaller suppliers, means you need an awful lot of people opting for supply chain finance to make a supply chain finance business viable. And, each of these suppliers needs a complex service contract, increasing cost of service adoption.

As a result, we end up with the worst of all worlds, where supply chain finance providers must charge interest rates that are too high, meaning providers only attract high-risk users and the cost of bringing them on to their service is too high. Users also tend to be quite small, so the supply chain finance business needs a very large number of them to become viable.

Of course, things could change if borrowing (on the supply side) becomes more difficult, or if base interest rates rise to make supply chain finance more competitive against alternative funding methods. However, the other fundamental issue with supply chain finance is the contracts used to define the agreements themselves. Increasing complexity and the amount of accounting involved in setting up most supply chain finance deals means that many do not even get past the first hurdle of signature.

In short, many supply chain finance contracts are too complex and arduous to be put into place. There are many reasons for that, but supply chain finance is a contract between two or three or even four parties, including:

·        The supplier, who gets its money early.

·         The buyer, who extracts some discount on the total price paid for the goods or services.

·         The financier, who may add liquidity to the transaction at an interest rate proportional to the risks they are taking on the transaction.

·         Finally, the supply chain service provider who acts as an intermediary, usually tech-based in the cloud these days, who allows the transaction to take place and earns a small margin on the transaction.

These parties need to be “glued together” using a legally binding contract. However, without careful attention, supply chain finance services can get bogged down in the terms and conditions.

Here are some of the typical problems that can arise:

Like most B2B e-commerce services, supplier adoption of a supply chain finance system is a major concern. Each supplier is presented with a contract setting out the obligations, terms and even penalties for non-conformance. Unfortunately, the need to sign a complex contract immediately escalates supplier adoption from the supplier’s finance function to senior management. Most small suppliers, who are often the ones wanting to do the supply chain finance, hate big contracts. Good supply chain finance service providers do their best to make this as painless as possible. For example, some service providers have managed to condense the supplier contract to simple click-through terms, but this is far from straightforward. Let’s not forget, the supplier is being “lent” money, and with all loans, there are always conditions where repayment can be demanded.

If the buyer is funding the supply chain finance themselves, then all they are really doing is basic invoice discounting, and you wonder if all the complexity of supply chain finance is worth it. It might be simpler to negotiate a good price with your suppliers and implement touchless e-invoicing to pay them on reasonable terms reliably. The money that can be made from discounting invoices is limited by the willingness of suppliers to pay over-the-odds interest in exchange for the convenience. Those buyers who extend payment terms and then force supply chain finance on their suppliers are in real danger of alienating the same suppliers on whom they depend.

However, if the buyer is using third party to finance the supply chain finance, then they need to think very carefully about how the transactions get accounted for. Changing trade payables to hard, short-term debt to a finance house could have a significant effect on the balance sheet. Some supply chain finance providers have imaginative methods of working around the reclassification of debt, but any buyer embarking on supply chain finance should have this clear before they start.

For the financier, it is the risk of “who carries the loss if a transaction goes wrong?” Who is the counter party? Is it the supplier, the buyer or the supply chain finance service provider? Or is it all three? How many contracts do we need? Financial service companies love complex contracts. One of the biggest pitfalls is getting buried in financial contractual terms. There is no easy answer to this, although the supply chain finance provider can sometimes cushion the worst from the suppliers and buyers.

Finally, there’s the supply chain finance service provider sitting in the middle of all this trying to make it happen and glue it all together. But, even the supply chain finance provider is a counter party risk to the financier. And, of course, margins are squeezed with those pesky low interest rates. All of this makes supply chain finance fiendishly difficult to work at scale, and in most cases not cost effective. It is not for the faint hearted.