What is Supply Chain Finance?

Explanation

  • When conducting a transaction, it becomes vital for the buyer to extend the working capital line by paying the supplier as late as possible. That would mean fewer funds getting blocked and more available for the business. However, the supplier wouldn’t consider this condition ideal, and the terms of trade with the buyer might be affected if the delay is too large.To help with this issue, the buyer and supplier get into a mutual agreement with an external financier who uses the invoices raised and grants the supplier credit on that basis. When the invoice payments become due, it gets the payment from the buyer. Through this, the supplier got early access to his receivables, and the buyer also did not have to compromise his payment window. This way, supply chain finance enables both parties to fulfill their objectives without proving disadvantageous to the other.

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Features of Supply Chain Finance

  • Supply chain finance involves the participation of a third party or supply chain financier who assists in completing the model.It is not a loan. It is just the extension of credit for mutual assistance of both the buyer and the supplier.Unlike factoring, which the supplier initiates, this is initiated by the buyer. Hence, sometimes it is also referred to as reverse factoringReverse FactoringReverse Factoring refers to a concept when a firm reaches out to a financial institution to pay its suppliers at a faster rate in exchange for a discount thereby reducing the account receivables time for the suppliers without any credit crunch for the firm which in turn will be paying out to the lender at the end of predefined time duration.read more. So, unlike factoring, which is directed just towards the seller’s objectives, the SCF fulfills the objectives of both the buyer and the seller.Since the SCF works based on the invoices raised by the seller on the buyer, it comes into consideration after due diligence of the buyer’s creditworthiness. If the buyer does not have good credibility, the financier may refuse to fund the supplier in advance.

How Does it Work?

Example of Supply Chain Finance

  • Let’s say customer A buys goods worth $1000 from B on 31st August, which is due in 2 months. Now, A wants to make the payment as soon as possible to utilize the funds in his business, whereas B wants to get the payment immediately. They then approach financier F and get into a mutual agreement.Now, after the invoices worth $1000 have been raised by B on A, it transfers them to F. After due diligence and vetting, F transfers the whole amount less the financing charges to B, let’s say $990. B can now utilize the payment that it received in advance. Also, after two months, when the invoices get due on 31st October, F approaches A to get the payment for the invoices. In this scenario, it will get a total payment of $1000. The financier earns the charges of $10 plus any other interest that it might levyLevyA levy is a lawful process where the debtor’s property is seized when the debtor cannot pay the outstanding debts. It is different from liens, as a lien is only a claim against a property, whereas a levy is an actual property takeover to fulfill the obligation.read more on the basis of the agreement. B gets the advance paymentAdvance PaymentAdvance payment is made by a buyer to the seller before the actual scheduled time of receiving the goods and services. It protects the seller from the risk of non-payment. Additionally, it helps sellers financially in the production of the goods or rendering of services.read more even though it might have to forgo a small amount, and A still pays on the actual due date of the invoices.

Supply Chain Finance vs Trade Finance

  • Unlike a supply chain finance that takes the help of an external financier and the invoices raised to get funds flowing between the concerned parties, generally in trade finance, a bank is involved, which helps finance the trade between an importer and an exporter. Also, trade finance might involve a bank guaranteeingBank GuaranteeingThe term “Bank Guarantee,” as the name suggests, is the guarantee or assurance given by a financial institution to an external party if the borrower cannot repay the debt or meet its financial liability. In such an event, the bank will repay such an amount to the party that has been issued with the guarantee.read more the payment from the buyer in case there is a default from the buyer’s side or whenever the supplier demands the payment, as the case may be.Trade finance is not based on invoices. Rather, it utilizes other payment terms like the letter of creditLetter Of CreditA Letter of Credit (LC) is issued by a buyer’s bank to ensure timely, full payment to the seller. If the buyers default, the bank pays the sellers on their behalf.read more (for import-export transactions) or bank guarantees (for domestic payments).Trade financeTrade FinanceTrade Finance is the funding of trade transactions (both domestic and international). It is conducted in the presence of both buyer and seller and can be facilitated with the help of various intermediaries like banking and financial institutions.read more  generally is an agreement between the buyer and the bank. However, the supply chain is an agreement between the buyer, supplier, and financier.Whereas trade finance is a form of loan or credit that the bank extends, supply chain finance is merely funding the receivables based on the invoices and the buyer’s creditworthiness.

Advantages

  • It works to the mutual advantage of both the supplier and the buyer, extending the credit lineCredit LineA line of credit is an agreement between a customer and a bank, allowing the customer a ceiling limit of borrowing. The borrower can access any amount within the credit limit and pays interest; this provides flexibility to run a business.read more and getting the funds available to the supplier.It improves the relationship between the buyers and sellers and paves the way for future trades.Improves the creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more of the buyer and gives the liquidity advantage to the seller.Unlike the involvement of the banks who charge a higher rate, the financing costFinancing CostFinancing costs refer to interest payments and other expenses incurred by the company for the operations and working management. An enterprise often borrows money from different financing sources to run their operations in return for interest payments and capital gains.read more in the case of supply chain finance is relatively small.

Disadvantages

  • Since a financier is not a bank, there is a risk in dealing with a third party.It is used as a tool to cover payments for dubious goods.It can only be used to finance finished goods which has a readily available market value.

Conclusion

Supply chain finance is an innovative way to help with the credit requirements of both buyers and sellers. It is an extension of the factoring form of financing that has been used for a long time by the suppliers. With the agreement entered into by both the suppliers and the buyers, there is a reduction of uncertainty and would be adopted by more and more partners in the future.

  • The buyer and the seller enter into an agreement with each other and supply chain financier. The buyer and the seller’s transactions occurs and the seller raises invoices on the buyer. The buyer then has to upload the invoices into a cloud facility of the supply chain financier. The seller approves the invoices and gets said invoices from the financier. The payment received is less invoice value than the financing chargesFinancing ChargesThe finance charge, also known as the cost of borrowing or cost of credit, is the accrued interest or fees that have been charged on the approved credit facility. Usually, this charge is a flat fee, but most of the time it is a percentage of the amount borrowed on an extended line of credit.read more for the early payment. The financier then approaches the buyer and gets back the payment for the invoices on the actual due date of the invoices. Depending on the nature of the agreement the financing charges might be borne by one of the parties or by both.

This has been a guide to supply chain finance and its definition. Here we discuss features, examples, and how supply chain finance works along with advantages and disadvantages. You may learn more about financing from the following articles –

  • Personal Finance TypesPrincipal Payment FormulaTrade CreditTrade Receivables Examples