Eight points on supply chain financing
ICAEW Financial Services Faculty commissioning editor Brian Cantwell talks to a supply chain finance expert to get some technical advice on best practice with supply chain finance.
Factoring and invoice discounting are well established to manage cash flow and keep businesses liquid, but reverse factoring or “supply chain financing” has only developed over the last 15 years.
It is a buyer-lead financing that results in rapid payment of receivables to the supplier at a lower discount than traditional financing based on the insured credit risk of the buyer.
For example, a major supermarket will arrange for their suppliers to be paid by third-party financing, backed by an irrevocable payment undertaking of the supermarket to make payment when due.
The discount to the full amount otherwise payable to the supplier covers the cost of funding, insurance and a fee.
Supply chain finance requires a robust IT platform to ensure the whole system is subject to checks and balances. Given the number of parties and payments involved it is imperative to enable real time recording and leave an audit trail. A third party financier will rely on a robust structure; that the invoices are legitimate; the buyers’ businesses are going concerns and that there is insurance to cover buyer defaults.
Supply chain finance is, in principle, a relatively straight-forward product, but the risks can become complex if the basic model is expanded and used in a way that was never originally intended. The recent high profile collapse of a supply chain finance platform and insolvency of buyers utilising supply chain finance has shown what can happen if a straight-forward structure is corrupted in the search of enhanced returns.
ICAEW spoke to an industry expert who was deeply involved with the use of the finance product at a major international bank, to consider some technical advice that can help best practice.
- Selecting the right insurers is of chief importance. This covers the main risk of buyer default in payment and is one of the fundamental requirements. Do not rely on one or a limited number of insurers. Diversify your insurance coverage. An insurer may change their risk appetite or not renew a policy. Credit default swaps can be used for entities that have a credit rating to further diversify risk. With diversified and sufficient coverage, trade credit insurance policies will cover those losses.
- Is the use of the product appropriate for the supplier or buyers involved? The larger and more established the buyers and suppliers are, the easier it is to use supply chain finance. Smaller or less-established businesses may require greater due diligence and insurance coverage and may be less sophisticated, in which case other financing may be more appropriate.
- Diversification of exposure is extremely important. As well as diluting risk, insurance should be cheaper for a diversified pool not reliant on the credit risk of only a few companies. “You need to control your diversification risks,” said our source. “So clearly if 50% of your financing is with one company or related companies and they go insolvent, you’re in trouble. There should be clear limits as to how much of the total amount funded can relate to a single buyer; you need a diverse set of buyers. Insurance will be based on a broad exposure and concentration limits. Once these are breached there is a risk of loss”.
- Be cautious with future receivables. While future income and business financing can be attractive to plug cash flow problems in the present, it is inherently difficult to model accurately and any true-up mechanics rely on all parties being solvent. There is also a greater risk of fraud as the receivables do not exist at the time of funding.
- Manage your due diligence carefully. Recent experience has highlighted hidden risks, for example there have been suspicions that junior underwriters have been tempted to over-step their responsibilities or that certain suppliers or buyers have misrepresented invoices or work done. If there are political links, be aware of the relationships and strength of any perceived endorsement. Could there be undue influence on credit decisions?
- Be aware of fraud vulnerabilities. False invoices, fake suppliers or financial inducements to arrange insurance cover have all been weaknesses in the system to date. The proliferation of online businesses will also demand greater vigilance without physical premises or assets to assess authenticity.
- Due diligence on the buyer - is it utilising other supply chain financing? If it is, establish how the product is accounted for, and how the receivables are measured. This will help to provide a clearer view on the health of the companies involved. Some businesses can take out huge supply chain financing facilities that are not on the balance sheet. Extensive use of supply chain financing, off-balance sheet, can make a company look a lot stronger than it is.
- A clear credit position of the buyer to fund the process is vital. Is the buyer in receipt of government funding? In the pandemic era, are there CBILS or BBLS loans that have added extra debt to the balance sheet, or has the company applied to such schemes?