ContextIn a globalising economy, industrial value chains are becoming more complex, spanning more countries and providers than ever before. While the flow of goods are increasingly integrated and optimised, information and finance flows are often fragmented. The credit crisis has revealed structural weaknesses of this system.
During the recent credit crisis liquidity dried up (Ellingsen & Vlachos, 2009) and many companies adopted aggressive cash management strategies to safeguard their cash levels in the face of declining credit from financial institutions. One aspect of these new cash management strategies included extending payment terms with their suppliers. Companies have continued to push payment term extensions with suppliers as a means of freeing up cash for purposes such as investment, dividends and share buybacks (Wall Street Journal 2013). Another reason for the continued pursuit of aggressive cash management strategies is that companies feel that they do not have sufficient working capital to take advantage of an economic upturn.
Suppliers to these companies are now feeling the effects of extended payment terms by having to obtain more and more financing to continue operations. To address these costs and the risks of supply disruption, large corporates and policy makers are increasingly interested in managing the financial supply chain with an equally integrated view similar to what they apply to the physical supply chain.
Supply Chains in manufacturing industries can reach up to 25 tiers, often including hundreds of part suppliers spanning the globe. Such chains involve an equally complex string of financing arrangements and interdependencies between suppliers, buyers and banks. This large network of agreements creates a clear IT challenge, whereas currently data is fragmented and lacks common sharing and interface.
The latest study in France (Roubert, 2013) has shown an excess of Working Capital of more than 200 billion Euro due to poorly managed inventories, payment terms and delays. Inefficiencies in inter-company processing mean that significant amounts of working capital is locked in delivered products and services not yet paid for by the client. With an average payment period of 56 days in Europe, despite formal payment terms of 30 days, the liquidity position of the supplying companies is negatively influenced. Many companies need to obtain trade credits to overcome this cash flow problem. Whereas large corporates often are ‘investment grade’ with AAA to BBB ratings and related credit terms, their direct and indirect suppliers face relatively high financing costs while credit rates soar as the distance from their large, credit-worthy end buyers increase (NG, 2013).
At present, for such non-investment grade suppliers, the Weighted Average Cost of Capital (WACC) approaches 20% or more(Gustin, 2006) – 10 to 50 times the rate of the end buyer – causing high overhead costs which affects the whole Supply Chain. In addition, finance organizations which provide trade credit have so far mostly targeted their services on businesses in familiar markets and industries where transactional terms are relatively unambiguous.
Currently there is little supply chain finance provision to developing economies in Asia, Africa and Eastern Europe. This creates an entry barrier for many industries to the global market. Such financial inefficiencies are increasingly becoming a strategic risk factor in supply chain management for the end buyers.
Preliminary research indicates that late payments contributed to about 25% of bankruptcies in Europe (Muriel, 2006). More often, lack of cash could prevent a company from achieving desired production capacity. This can be illustrated by the widely published case of Caterpillar (Timothy, 2010), the world’s leading manufacturer of construction equipment. When it wanted to ramp up production in 2010, some of its top 500 suppliers could not deliver due to insufficient working capital. This had a ripple effect throughout its supply chain and limited growth. Such risks therefore force companies to maintain expensive stock or to support supplying companies with working capital.
Supply Chain Finance (SCF) deals with financial arrangements in the form of debt, equity or financial contracts used in collaboration by at least two supply chain partners and facilitated often by a “focal” company. The aim is to improve the overall financial performance and to mitigate the overall risk of disruption in the supply chain. New models could significantly improve access to finance or reduce the need for external financing by unlocking the potential liquidity from within supply chains.
Large buyers typically control and steer supply chain improvement processes. Reverse Factoring is a quite commonly used tool. An early adopter example of successful Reverse Factoring implementation is that of Unilever (Seifert & Seifert, 2011), which has freed up 2 billion USD overall working capital. First movers in SCF, located mainly in Europe and the United States, are experimenting with more complex SCF models and instruments on an international scale, reaching beyond their larger second or even third tier suppliers. In 2012, pilot projects were announced by companies like Airbus (FR/DE), Mercedes-Benz (DE), Volvo (SE), ASML (NL), Sainsbury (UK) and others. The experiments aim to improve operational aspects such as; efficiency, inventory optimisation and risk reduction. Underlying strategic questions focus on the stability of the chain, the potential to support business growth, and loyalty of suppliers.
SCF arrangements are often linked to ‘preferred buyer’ arrangements. Use of SCF tools is still in a very early stage, and limited to large corporates. To facilitate this market, specialist service providers are appearing. SMEs and companies outside the OECD (Organisation for Economic Co-operation and Development) are involved to a limited extend. It is assumed that far less than 1% of the market potential is realised so far.
Recent estimates show the total economic potential of optimisation of SCF could globally free up 1.250 billion USD (Hofmann & Belin, 2011) and 368 billion Euro in Western Europe(Hieminga, 2012) .