What is Supply Chain Finance?

Supply chain finance (SCF) or reverse factoring is an arrangement between the buyer, the supplier and a financier or factor by which the payment for the receivables by the supplier is received in advance, thereby benefiting both the buyer and the supplier.

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 as that would mean fewer funds getting blocked and more funds being available for the business. However, the supplier wouldn’t consider this condition ideal and the terms of business with the buyer might be affected if the delay is too large.
In order 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 actually 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 the supply chain finance enables both the parties to fulfill their objectives without proving disadvantageous to the other.

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 is initiated by the supplier, this is initiated by the buyer. Hence, sometimes it is also referred to as reverse factoring. So, unlike factoring which is directed just towards the objectives of the seller, the SCF fulfills the objectives of both the buyer and the seller.
Since the SCF works on the basis of the invoices raised by the seller on the buyer, it comes into consideration after due diligence of the creditworthiness of the buyer. If the buyer does not have good credibility, the financier may refuse to fund the supplier in advance.

How Does it Work?

Supply chain finance works in the following ways:

The buyer and the seller enter into an agreement with each other and with a supply chain financier.
The transactions between the buyer and the seller take place 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 payment for the said invoices from the financier. The payment received is the invoice value less than the financing charges 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 of them.

Example of Supply Chain Finance

Let’s say customer A buys goods worth $1000 from B on 31^st August which is due in 2 months. Now, A would want to make the payment as later as possible to utilize the funds therefrom in his business, whereas B would want 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 transfer the whole of the amount less the financing charges to B, let’s say $990. B can now utilize the payment that it received in advance. Also, after 2 months when the invoices actually get due on 31^st 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 levy on the basis of the agreement. B gets the advance payment even though it might have to forego 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 in financing the trade between an importer and an exporter. Also, trade finance might involve a bank guaranteeing 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 the invoices rather it utilizes other forms of payment terms like the letter of credit (for import-export transactions) or bank guarantees (for domestic payments)
Trade finance generally is an agreement between the buyer and the bank, a however supply chain is an agreement between the buyer, supplier, and financier.
Whereas trade finance is a form of loan or credit that is extended by the bank, supply chain finance is merely funding the receivables based on the invoices and the creditworthiness of the buyer.

Advantages

It works to the mutual advantage of both the supplier and the buyer, extending the credit line as well as 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 creditworthiness of the buyer and gives the liquidity advantage to the seller
Unlike the involvement of the banks who charge a higher rate, the financing cost in the case of supply chain finance is relatively small

Disadvantages

Since a financier is not a bank, there is an element of 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 the 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.

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