What is Supply Chain Finance?

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Summary

Supply chain finance is a fast growing option for businesses. But what is it and should you consider it? We explore this growing area of finance.

Supply chain finance has the potential to increase cash flow and liquidity in international trade. There are several variations on the supply chain finance model, but the basic idea is that suppliers sell their “receivables” to banks or other financial service providers (which are often called “factors”). In return, the suppliers get faster access to the money they are owed, enabling them to use it for working capital, while buyers generally get more time to pay.

According to McKinsey & Company, there is considerable potential for broader adoption of supply chain finance, with an estimated $2 trillion in readily financeable payables worldwide.³ However, while the use of supply chain finance is expected to continue to grow, only about a tenth of the market is currently tapped, the management consulting firm says.⁴

Some experts say that confusion is one factor holding businesses back from using supply chain finance, and that a lack of standard terminology is contributing to that confusion. “Fast and largely uncoordinated growth [of supply chain finance] across the globe has led to practitioners using an array of different terms to describe the same techniques and processes,” according to Alexander R. Malaket, Deputy Head of the Executive Committee of the International Chamber of Commerce (ICC) Banking Commission. “For example, ‘payables finance,’ ‘reverse factoring,’ ‘confirming,’ ‘approved payments finance,’ ‘confirmed payables,’ ‘trade payables,’ ‘supplier finance’ and ‘supply chain finance’ have all been used to describe the same technique or solution.”⁵

To clear up that confusion, the ICC and other business groups that make up the Global Supply Chain Finance Forum proposed standard definitions in a document published in 2016.⁶ The forum has continued to lobby for their uptake this year at venues including the European Commission⁷ and the ICC’s Supply Chain Finance Summit in London in May.⁸ It is also seeking input to further develop the definitions.

The forum’s publication says that the current inconsistency in definitions and nomenclature creates significant problems. According to the document, “This issue has immediate implications for the accounting and regulatory treatment of supply chain finance structures, and by extension, impacts market uptake and the engagement of traditional as well as emerging providers of SCF [supply chain finance] solutions.”

However, as the ICC’s Malaket observed, “Publishing the new terminologies is just a first step – the next challenge will be to ensure their widest possible adoption by the industry.”⁹ One finance industry publication underlined that point, saying that the ICC definitions “will need to be adopted widely by the industry if they have any chance of clearing the existing levels of confusion in the marketplace.”¹⁰ The publication suggested, however, that some providers of financial services and technology platforms might be reluctant to give up their existing terminology. More recently, World Supply Chain Finance Report 2017 noted that “The ICC’s definition of supply chain finance is still young, and it is possible that we will see greater compliance with this particular definition in the future.”¹¹

What is Supply Chain Finance?

The Forum’s detailed definitions document classifies and defines numerous types of supply chain finance. It includes a proposed high-level definition of supply chain finance: “the use of financing and risk mitigation practices and techniques to optimize the management of the working capital and liquidity invested in supply chain processes and transactions. [Supply chain finance] is typically applied to open account trade and is triggered by supply chain events. Visibility of underlying trade flows by the finance provider(s) is a necessary component of such financing arrangements which can be enabled by a technology platform.”¹²

Among the supply chain finance practices described in the document is factoring, which is defined as a form of receivables purchase in which suppliers sell their receivables (represented by outstanding invoices) at a discount to a finance provider. “A key differentiator of factoring is that typically the finance provider becomes responsible for managing the debtor portfolio and collecting the payment of the underlying receivables,” the document adds.¹³

Factoring is a fast-growing practice, according to the ICC’s 2016 Global Survey on Trade Finance, which says that “Factoring and variations of the product have been leading the charge in the expansion of trade and supply chain finance in recent years.”¹⁴

Still, as international trade growth lagged in 2015, supply chain finance overall grew only 1.1 percent, much slower than the average 10 percent annual growth seen over the previous two decades, the survey says. A new survey is expected to report recent developments in supply chain finance, performance and definitions in June 2017.

While supply chain finance terminology is a complex issue, supply chain finance is only a subset of trade finance, which also includes letters of credit, collection of bills, bank guarantees, trade loans and trade credit on open account transactions, where the buyer is simply given a period of time to pay for the goods and services supplied. Adding to the potential complexities, new forms of supply chain finance are also expected to arise.

If clearing confusion facilitates growth in the supply chain finance market, proponents say both suppliers and buyers could benefit – particularly as finance automation increases. “Where small suppliers are struggling to prosper, or even to survive, because of cash flow problems brought on by payment delays, the buyer’s interests may be compromised,” said one platform vendor. “By working together using innovative financing solutions and digital technologies that promote supply chain visibility, buyers and suppliers alike will both secure short-term gains – cash flow benefits – and long-term advantages – supply chain resilience.”¹⁵

The Takeaway:

Supply chain finance has the potential to address cash flow and liquidity in international operations and trade, but some experts say confusion in the market is impeding progress. The ICC-led Global Supply Chain Finance Forum has proposed standard definitions to clear the confusion and is lobbying for their uptake.