Reinforcing supply chain links

James Binns is head of working capital, EMEA, Deutsche Bank

Despite the squeeze on capital created by the increased global regulatory burden, treasurers must still provide ample working capital for daily commercial flows, with minimum damage to their balance sheets. At the same time, the continuing rise in cross-border trade – frequently with relatively unknown and distant markets – increases exposure to geo-political and environmental risks. In such an environment, and particularly in light of post-crisis sensibilities, liquidity is more of a concern than ever, both to lubricate the daily machinations of trade and to act as a buffer for potential financial or supply-related shocks, writes James Binns

And yet, not all sources of liquidity are created equal. Dependency on external sources for working capital or funding is a risk in itself – subject to the lending environment, interest rate volatility and a corporate’s own credit rating. But the alternative – looking within the corporate body to generate capital – generally means shortening the cash conversion cycle. Furthermore, this is achieved by imposing harsher payment terms on trading partners, which can also create a sustainability risk.

Into this struggle entered supply chain financing offerings, some fifteen years ago – and due to the nature of the financial environment and treasury concerns around risk and working capital, they have enjoyed increasingly widespread interest and adoption. Financial Supply Chain (FSC) solutions are “win-win” arrangements that lower financing costs – for the implementing corporate and for onboarded trading partners – by improving payment terms in both directions, with a banking partner bridging the gap.

Best interests

In essence, in order to generate additional cash, a corporate treasurer will look to reduce Days Sales Outstanding (DSO) and increase Days Payable Outstanding (DPO). However, in doing so, they will also decrease the DPO and increase the DSO of their trading counterparties. Introducing one or a combination of FSC solutions, such as Accounts Receivable Finance, Supplier Finance, or Distributor (Channel) Finance, allows corporates to shorten the cash conversion cycle on one or both sides without the disadvantageous effects for counterparties. In fact, such solutions have equal advantages for counterparties, sharing the benefits of internal lower cost funding by leveraging the strength of the implementing corporate.

The benefits are numerous. The primary and most direct benefit is access to a liquidity source that is cheaper, more secure, and does not manifest as debt on the balance sheet. Secondly, successfully “win-win” FSC schemes strengthen rather than weaken the supply chain by boosting counterparty health and relationships, preventing knock-on effects along the supply chain from trading partners being squeezed, and increasing a corporate’s attractiveness as a trading counterparty. This in turn lowers supply chain risk – future-proofing, for example, against a day when interest-rates rise and suppliers’ operational costs jump in parallel, increasing the cost of goods. The reduction in operating costs extended to a corporate’s suppliers has a further benefit, as it will potentially come full circle and benefit the first corporate through the lowered cost of goods.

Finally, FSC programmes, by unlocking greater liquidity, support corporate growth through placing a corporate in a strong position during mergers and acquisitions, for instance, to outbid rivals or make an offer with a great proportion of cash. Similarly, the improved efficiency and lowered operating costs created by such programmes can be shared across the new corporate group following a merger or acquisition, and the additional cash can reduce the amount of funding needed, or be used to repay debt, improving the group’s credit rating.

Seeing clearly

It is through improved visibility that supply chain financing achieves many of these benefits. Suppliers may already be discounting receivables without a buyer’s awareness, resulting in higher operational costs (due to performance risk and potentially weaker borrowing power) and the depletion of potential credit lines for the buyer. By implementing an FSC solution, a corporate gains a more granular overview of their supply chain environment, including the cost of funding throughout the chain, how it impacts on their margins, and any points of vulnerability. With such visibility, the corporate with the highest credit rating can leverage it to the benefit of the chain as a whole, lowering overall costs by exploiting the arbitrage between their borrowing power and the current cost of funding to themselves and their trading partners.

While some benefits, like supply chain health, are harder to quantify, a corporate can measure the key benefits of these programmes exactly. One day’s improvement in DSO can be calculated by dividing one by total annual sales and multiplying by 365 (for days in the year); the extension of DPO by one day is equal to one divided by total cost of goods sold and multiplied by 365. The daily value of an FSC solution would be the sum of these improvements.

This figure in turn can be converted into an ‘applied worth’ of the alternative funding it has replaced (e.g. the cost of short-term debt, a commercial paper or Revolving Credit Facility) or the increased value to shareholders (in terms of returns or share prices).It can also be used to benchmark treasury efficiency against industry peers and measure efficiency improvements, aiding treasurers in strategic planning.

In all, FSC schemes strengthen and harmonise supply chain relationships to share information and lower operating costs, leveraging access to liquidity and reducing the risk of supply-chain shocks. They have been proven as a tool for ensuring ethical trading and facilitating growth – and through the use of granular metrics their application can be honed to further enhance their benefits.