As per a survey report by the Consortium of Indian Associations (CIA), 73% of Indian SMEs failed to make profit during FY21. Only 13% were able to manage ground and break even. 42% were unable to retain their employees, whereas 59% had to lay off their staff.
The pandemic led to a scenario where many businesses, especially MSMEs, struggled to find the funds they so direly required for expansion owing to low credit scores.
The increasing trade finance gap is also a concern for the MSMEs. In 2019, it stood at USD 1.5 trillion and will likely reach USD 2.5 trillion by 2025. If this problem persists, it could have a spiraling effect on the business and the economy as a whole.
Nonetheless, to regain growth momentum, MSMEs, in the post-COVID phase, are exploring tech-enabled financing solutions. Supply Chain Financing emerges as a top choice for them as it offers to solve their liquidity problems at a low or negligible cost.
As per Gartner, 23% of the surveyed organizations employed supply chain finance to improve their cash flow and manage the uncertain economic situation in 2020.
The idea of supply chain finance has been around since the 1800s, and businesses with limited resources find it attractive to optimize their cash flow and working capital requirements.
This article walks you through the basics of supply chain finance.
There are three primary parties in an SCF arrangement –
· The buyer
· The supplier &
· The financial counterparty
Here is how it works –
· The supplier sends their invoices to the buyer under a pre-approved arrangement
· The buyer then approves the invoice and agrees to make the payment to the financial counterparty on maturity
· The supplier offers a discount against the release of early payment
· The supplier receives the net invoice value immediately
· On maturity, the buyer clears the lenders’ dues
Here is an example of how a supply chain arrangement works –
A mid to large-size enterprise buys goods worth USD 10 million from an SME. Given that the SME requires cash for managing its cash flow urgently, it requests immediate payment by offering a discount.
Suppose the transaction does take place. It will benefit both parties. The seller gets access to the funds immediately, and the buyer secures a valuable price bargain.
As per the World Supply Chain Finance Report 2021, the estimated global SCF volumes stood at USD 1311 billion at the end of 2020, a growth of 35% compared to 2019 figures.
As per a McKinsey report, up to 4.6 trillion global exports could relocate by 2025. While it comprises up to 26% shift for some markets, others can even experience a 60% shift in the coming years.
This structural shift will require the help of modern financing solutions like supply chain financing to enable effortless execution.
Here is how SCF is beneficial for buyers –
With SCF, buyers can improve their working capital position seamlessly as it allows them to integrate supplier payment terms. Thus, enabling them to manage their cash flow better.
When buyers provide their suppliers with low-cost financing solutions, it paves the way for improved relations between the two parties.
The buyers also gain a superior position on the price front for any negotiation if required.
When buyers offer supply chain financing to suppliers, they secure their future by ensuring reduced chances of supply chain disruptions that affect their operations.
There are many supply chain finance techniques, but buyers can avail of the one that suits their use case the best. Here are the different SCT techniques followed –
Here, a factor (a bank or specialized factoring houses) is involved, and they pay a major value of the invoices due as advance to the supplier. The remainder is paid after debt clearance net of factoring charges.
Receivable discounting is a process whereby a major corporate house discounts all or part of the receivables, through invoices, to the finance provider. The finance provider, in return, provides a one-off cash advance as part of a continuous arrangement or for covering seasonal demand fluctuations.
Forfaiting refers to a non-recourse purchase of a future payment obligation. Here, the factoring house or the bank advances cash to the seller in return for promissory notes or invoices due and guaranteed by the buyer. The bank pays the advance net of their commission for taking over the payment responsibility and advance receipt of funds.
Here, buyers have an agreement with the bank to support their relationship with the suppliers. The banks then enable the sellers to receive the discounted receivable value in an advance net of financing charges levied by the payer.
In this technique, the seller receives a loan or an advance from the finance provider against the due invoices. These loans are backed by buyer guarantees and help the seller improve their cash flow position.
Here, sellers receive an advance during the pre-shipment phase after raising the invoice. The bank usually provides pre-shipment finance on a per transaction basis or based on the commercial contract they sign with the buyer.
Liquidity is crucial for every business’ smooth functioning, and it is no different with a seller. In the modern-day, lenders are reluctant to extend financing to most MSMEs, and there are reasons for it.
The primary reason is the inability to assess the creditworthiness of these businesses because of the lack of regular flow of financial and business data regarding these businesses. It is why most SMEs and MSMEs have moved to SCF plans where they get seamless access to credit and help them bridge the trade gap along with lower financing costs.
With buyers being mid to large size enterprises, who take the responsibility of managing the risk side of things, the banks find it easier to trust them and forward an advance to the seller. But for that to happen, they need to get the basics right.
With timely payments to suppliers, you can get rid of the inherent bottlenecks of the supply chain process. Besides, improve the ability to undertake on-time scheduling of orders, manage credit cycles better and help enhance the production planning capabilities of the sellers.
Once you have optimized your supply chain, the next step is to develop a robust supply chain finance plan. Here are the steps for you to get started –
The first step to developing a robust supply chain finance plan is to set a working capital goal that will form the basis for all your future cash flow decisions. For starters, you can have a five-year working capital goal that accounts for profitability and health, allowing improved resilience and growth positioning for the vendors.
The next step is to understand the options you have. For this, you can start by segmenting your suppliers into different categories to determine which solutions are best for what categories of suppliers. You can differentiate your suppliers in the following categories –
· Strategic suppliers - These are vital for the business to attain long-term goals and maximize the value offered to their customers. These suppliers are capable of replenishing supplies at the earliest and go beyond contractual terms to match your need.
· Leverage suppliers - These are suppliers with multiple sources, which allow for price negotiations and better services, thereby creating a greater impact on your overall value proposition.
· Bottleneck suppliers - These are suppliers specializing in offerings that have a high dependence on the buyers’ ends.
· Routine suppliers - These are non-critical suppliers who are easily replaceable and do not offer services or offerings that are vital to the organization’s existence.
The next step is to ascertain where and how working capital is trapped. Once you figure it out, you can then leverage an SCF plan that caters to different supplier types and also takes into account the amount of cash trapped for improved positioning and performance.
Now that you understand where your capital is trapped, the next step is to figure out ways to streamline the process to enable improved liquidity. For this, calculate material gains across each of these categories and the organization as a whole. Then create a roadmap that prioritizes action areas with suitable solutions. The last phase is to undertake a feasibility study that helps in comparing the potential benefits with the cost incurred for implementing the program.
Once you have the blueprint in place and have already tested it for its feasibility, it is time to implement the plan. Make sure that the implementation is such that it allows you to dynamically switch between internal and external funds as per the needs, keeping in mind the best interest of the overall business.
It is essential to understand that SCF is a continuous process, and you will have to periodically assess and restrategize the chosen approach. For this, you need to be flexible as an organization and ensure taking the course of action that is in line with the changing business goals.
Hiring the right third-party specialist will help you streamline your sourcing via early payments to suppliers. It enables you to maximise profit margins through cash discounts as a result of upfront payments, and improve supplier relations for an efficient, smooth, and resilient sourcing practice.