( This article is excerpted from the report: “Reinventing Supply Chain Finance: Unlocking Strategic Value for Procurement, Supply Chain, and Finance Professionals” available for download here. )
In Part 1 of this series we looked at what it means to take a holistic approach to supply chain finance, encompassing the full P2P lifecycle, using a unified and connected network of trading partners. Here we discuss how this approach impacts margins and profitability by lowering risk for lenders, thereby lowering the cost of capital for suppliers and COGS for the buyer.
Increasing Margins—Lowering Risk, Cost of Capital, and COGS
Interest Rates on the Rise—
The ‘Free Ride’ is Over
We are coming out of a period when interest rates have been much lower than historical norms. Interest rates globally will rise as the U.S. winds down its bond purchase program (“quantitative easing”) and other central banks start to tighten their money supply as well. This can hit emerging economies especially hard, as increasing yields on US assets attract international capital. The cost of capital for suppliers in these regions will inevitably rise, in some cases abruptly and painfully high. Prudent buyers will be aware of these stresses on their suppliers and adopt strategies to help lower the cost of capital for their supply base.
Profitability is top of mind for most senior executives, being one of the key metrics of success for the firm, and one that the leadership team is often personally measured on.1 Procurement and supply chain professionals in particular have accountability in the cost-reduction side of the profitability equation. They are tasked with finding ways to reduce the cost of materials and operations. However, they often miss significant opportunities from the cost savings that are made possible by reducing the cost of capital for their suppliers. The suppliers’ cost of capital is often ultimately passed along to the buyer. Holistic supply chain finance provides a number of ways to reduce the cost of capital.
Traditionally if a supplier needs pre-shipment financing, they have to approach their bank or other lenders within their own country. The loans are based on the supplier’s credit rating and the going rates in their country. For small or medium sized suppliers in emerging economies, these rates can be exorbitant. Radically lower interest rates occur when a holistic supply chain finance approach is used. The underlying unifying network platform, connecting all of the participating parties, provides a number of ways to lower risk for lenders and dramatically lower the cost of capital for suppliers:
Milestone progress visibility—Lenders can get timely, high-confidence visibility into progress against milestones, such as when the PO is issued, amendments issued, raw materials ordered, production milestones occurred, order shipped, inspection completed, order received, and invoices approved. This reliable direct visibility makes it much simpler for lenders to tie payment to achieving certain milestones.
Past performance visibility—The lender can see exactly how the supplier has performed in the past, including metrics such as on-time delivery rates, inspection failure rates, and so forth. This is particularly critical for pre-shipment financing. The legal framework described below removes the supplier’s credit risk from the equation. The primary risk left for the financial institution is supplier non-performance. Consistently performing suppliers can thereby obtain much lower interest rates, since lenders will see by the past performance data that the risk is low.
Legal framework/Automated payment—This is critical for lowering risk for the lender, who no longer has to rely on the supplier to pay them back the loan. Instead, the buyer has committed to pay according to the agreed terms and the money is automatically transferred on the due date, independent of any commercial disputes the buyer may have with the seller. The lender gets date-certain payment and, with visibility into supplier’s past performance, knows the probability of non-performance. Disputes between buyer and seller are much less likely, since everyone is working off of the same data and single-version-of-the-truth, with the network platform acting as the agreed system of record between trading partners. This results in far fewer disagreements on what was ordered, what was shipped, and what was received, when, and in what condition.
Competitive lending marketplace—Instead of relying exclusively on their local bank or a small handful of in-country lenders, the supplier gets access to an international marketplace of potential lending institutions. A much broader pool of lenders are competing for the supplier’s business, hence the supplier gains access to competitive rates around the globe.
Accurate and timely data/documents—In a highly secure electronic network, data from the original PO flows automatically to create shipping documents which are used to create the invoice. This virtually eliminates the numerous errors that occur when each company rekeys all the data as documents flow between the different entities involved. Status is updated electronically, much closer to real-time, without the cost and delay of sending physical documents all over the world via courier.
As a result of all these factors, suppliers gain access to cash not previously available to them, at considerably higher advance rates, and lower discount rates than typically available in their local markets using traditional methods. The impact is truly significant.
Columbia Sportswear’s Early Payment Program
Columbia Sportswear is a $1.6B outerwear and sportswear manufacturer. They have been using the supply chain finance capabilities available on the GT Nexus platform to offer early payments to their suppliers at a discount. About 25%-30% of their vendor base is taking advantage of this program. Columbia discounts at the equivalent of about 4% per annum, which is win-win for both Columbia and the supplier. Most payments are auto-approved, so the supplier gets paid the next day and Columbia gets the maximum discount rates. Columbia runs about $800M of payables through the platform. The automation of the network platform has also streamlined accounts payable operations—Columbia only has 1.5 FTEs in their AP department.
Early Payment Discount Programs—Interest Rate Arbitrage Opportunities
Connecting through a common network platform creates a convenient mechanism for suppliers to receive accelerated payments and for buyers to receive discounts for those early payments. Buyers that have available cash can fund the program themselves. Alternatively, these programs can be funded by financial institutions. Suppliers can opt in to be automatically paid early at a discounted rate. These can include dynamic discounting, where the discount rate depends on how early the payment is made.
Early payment is a win-win for both parties. These days corporate treasury managers struggle to get even 0.5% interest for the cash they have on hand. On the other hand, their overseas suppliers are often paying 10% or more for short term loans to provide cash for their operations. By splitting the difference, the supplier gets early funding at rates that can be less than half of what they are currently paying, while corporate treasurers get 5X or even 10X their current rates for cash on hand. Furthermore, with an automated electronic platform, the procure-to-pay process is streamlined, and payment approvals are made much more quickly (often weeks earlier). For example, the platform can approve invoice payment based on e-POD (electronic proof-of-delivery) from a third party logistics provider scanning and verifying the goods delivered right there at the receiving dock, instead of waiting for a goods receipt document to be issued by the buyer’s systems. This acceleration of invoice approval enables longer discount windows and hence higher returns for the buyer, and earlier access to cash for the supplier.
Figure 1 - Arbitrage Opportunity: Delta Between Buyers’ Returns from Cash and Suppliers’ Borrowing Costs
Adding Sustainability into the Mix
The IFC has a program which pre-qualifies the supplier for early payment discount programs, to certify that the supplier is socially and environmentally responsible. The lending rates for these programs are extremely low—as little as 3.5% at today’s rates.
Even if the buyer does not have or want to use their cash this way, suppliers can turn to a financial institution connected to the network. Because of the legal framework explained earlier, the risk to the lender is significantly reduced. Because it is an open and competitive marketplace, lenders will provide very competitive rates, especially compared to those provided by traditional factors who purchase receivables (usually at a very steep discount).
When suppliers’ borrowing costs are reduced substantially (up to 50% or more in some cases), those lower rates can translate directly into lower prices for the buyer. How much the cost of goods to the buyer is actually reduced depends on many factors, such as the competitive landscape and price elasticity for those particular goods, the nature of the relationship between buyer and seller, the type of commodity2 or item being sold, and more. In any case, it takes cost out of the supply chain, which can be used to increase supplier health, reduce the buyer’s COGS, or both.
In Part 3 of this series, we will look at several other impacts of holistic supply chain finance to improve continuity of supply, time-to-market, and postponement of differentiation.
1 The price of fungible commodities is typically tied to market pricing, independent of the financial condition of any particular supplier. -- Return to article text above
2 In particular for public companies, their stock valuation is often highly influenced by earnings, the P/E ratio being one of the most widely used metrics. Stock often accounts for the majority of compensation for top executives, so the value of the stock means a lot to them. Further, they are answerable to shareholders and the board who have the power to remove underperforming executives.
To view other articles from this issue of the brief, click here.