The cooperation between procurement and finance can go beyond joint initiatives within the organization. In today’s network, economy parties must see beyond the borders of their own organization to discover opportunities to increase their competitive edge. Reverse factoring (RF) offers new possibilities for this. This fits into a broader trend of competition, shifting from individual organizations to chains of organizations. Smart competition in the supply chain will become a necessity to survive in the era of globalization.
Supply chain finance (SCF) enables organizations to extend already existing forms of cooperation in the supply chain with financial cooperation to achieve cost reduction by more effectively managing working capital. Despite the fact that SCF is about financial aspects, it is based on the underlying transaction between buyer and supplier, which is usually managed by procurement. An optimized relationship between finance and procurement is a prerequisite for this.
Supply chain finance
Supply chain finance is characterized by a different position for the bank in the supply chain. Usually the bank is not part of the chain, but with SCF the bank becomes an essential partner, helping the other parties in that chain to improve the competitiveness. Figure 1 illustrates this shift and unveils the main difference between the old and new situation. The amount of shared information increases, allowing the different parties to make better financial decisions. In the current situation, banks base their decision to allocate or refuse a credit application on information provided by the supplier (or buyer). In a supply chain finance deal, banks base their decision on information from both the supplier and the buyer. An IT-platform facilitates the exchange of information between the involved parties. Hence, SCF is about a form of cooperation between the buyer, the supplier and the bank. Reverse factoring is the most common product form.
Figure 1. The difference between ‘financing the supply chain’ and ‘supply chain finance’
Since Reverse Factoring (RF) is the most common product form we will use it as an example in this article. The main source of information in RF is approved invoices. Figure 2 gives a schematic view of the RF process. In this example the basis for the construction is again the underlying transaction between the buyer and the supplier (1). Subsequently the invoice for this transaction is submitted through the IT platform by the supplier (2), enabling the buying party to receive it into its ERP system (3). As soon as the buyer has approved the invoice, it is communicated via the platform, allowing the supplier to see it. It is up to the supplier to either wait until the payment term expires and the buyer pays the invoice, or to request a credit grant from the bank (5). The bank receives this request via the IT platform (6) and pays the supplier for the invoices, withholding the agreed fees (7). When the agreed payment term expires, the buyer makes a payment to the bank, after which all obligations have been met. The finance risk of the bank is transferred from the bank-supplier to the bank-buyer because the approval of the invoice by the buyer forms the basis for the decision of the bank to grant a credit.
Figure 2. Schematic view of the RF-process
The reason that RF is attracting a lot of attention is that a well-designed deal between buyer, supplier and bank provides advantages to all. Figure 3 gives a simplified example of the potential financial benefits that can be obtained from an RF agreement. The original idea behind RF was to allow suppliers to utilize the better credit rating of the buyer. Because of this construction the costs to finance an invoice should be lower if the finance risks rest with the seller. In figure this is presented as follows: if the supplier is not taking part in the RF agreement, he must finance the nominal value of the invoice with a regular working capital facility (e.g. 4%). With an RF agreement the finance costs will be calculated based on the credit rating of the buyer, lowering the interest rate (e.g. 1.5%). Assuming that the bank charges handling fees, in addition to interest, it is favorable for suppliers to quickly finance their invoices via the buyer. Hence, the longer they will be able to take advantage of the lower interest rate, the lower the total costs will be. The blue field in figure 3 represents the total benefits that can be gained, although this must be spread among the different participants.
Figure 3. The Financial benefits of RF
The buyer can achieve both financial and non-financial benefits from an RF agreement. As a consequence of the (in)direct support of the supplier by the buyer, the supply chain stability is increased due to the lowered risk of bankruptcy or failure to deliver of the supplier. A direct result of this support will be that the relationship between buyer and supplier grows stronger, resulting in a better negotiating position for the buyer in return for the opportunity to take part in the RF-agreement. An often neglected advantage of RF for the buying party is the fact that internal processes need to be optimized to be able to swiftly approve invoices. This is pivotal for gaining results from the underlying RF-agreement.
For the supplier the benefits of participating in a RF-agreement are financial(e.g. the financing expenses will be lower because of the lower interest rate that the bank will charge). From practice we know that this is not the only reason for suppliers to participate in an RF program. Convenience is another reason. In addition, it is easier to estimate and influence the cash flow, which allows for a decrease in working capital. Furthermore, this type of financing enables the handling of more orders. Faster payment decreases the upfront demand for capital.
In the sketched out scenario, the bank is providing the IT platform. Obviously the bank would not do this without a good reason. Firstly, it enables the bank to obtain a better position in the chain, as a result of which it can reach more potential customers. It will also improve the bank-customer relationship because both parties have a better insight in the circumstances and each other’s motives. For the bank, financing against a better creditrating has the obvious advantage that the loans can be classified differently. This classification allows banks to have lower capital reserves following the solvency requirements of the central bank (ECB, FED). Setting up reverse factoring services would be a good starting-point for banks to offer more supply chain financing products.
The above clearly demonstrates that RF can lead to a win-win-win situation, but also raises the question why RF has not been adopted yet on a large scale. Four reasons can be pointed out for this: technology, laws and regulations, dynamics in buyer-supplier-bank relationship and the unfamiliarity with RF to banks and business partners. Until recently it was technically not feasible to run a full-scale RF program. Due to the emergence of e-invoicing, e-processing and changes to ERP functionality within the supply chain domain, that problem has been solved. Laws and regulations remain a point of attention, especially because of new rules impacting the solvency requirements for RF agreements.
For a long time buyers have been trying to stretch the (payment) terms and conditions, but seem to have reached a point where further actions lead to no or negative results. Both banks and suppliers were not focused on cooperation with each other. Banks were mainly concentrating on cooperation within their own column and suppliers considered the bank an outsider. The current economic circumstances have made it clear to both parties that a good cooperation can be essential to compete in the current market. Due to the removal of obstacles we see a significant growth in both demand and supply of reverse factoring services.
To successfully expand the RF business it is likely that at first some large buying parties will set up RF deals with some suppliers. These suppliers will have the following characteristics: large volumes, strategic importance and a long and steady relationship between buyer and supplier. The future of supply chain financing lays then in the design and launch of other SCH products like, order financing and enabling smaller parties to engage in these type of deals. Over a longer period of time total financing of the total supply chain might be a possibility. It is conceivable that other financial institutions like pension funds will discover RF as an investment opportunity.
This post was written in cooperation with Steven van der Hooft – Managing consultant at Capgemini Consulting The Netherlands