From the October 2009 issue of Treasury & Risk magazine

Shoring Up the Weakest Link

Supply chain efficiency, one of the great success stories of the past two decades, is breaking down as liquidity shortages hit the weakest links. "When the credit markets seized up last fall, there was a frenzy, and treasury staffs held onto cash as long as they could, extending [days payable outstanding] and hurting suppliers," reports Drew Hofler, senior manager for working capital solutions at Sunnyvale, Calif.-based Ariba. "Now things have stabilized within a tight credit zone, which means greater liquidity risk for the supply chain."

So far, bold, innovative solutions have come from governments, but corporate treasuries, on full risk alert, are cautiously exploring constructive ways to spread available liquidity up and down the supply chain when doing so can keep a critical player in the game and also bring direct benefits to their own companies.

"We've had to address distress in our supply chain," explains Lorraine Weber, treasury manager at $1.4 billion Recreational Equipment Inc. (REI) in Kent, Wash. "A couple of our vendors were caught in a cash crunch. When that happens, treasury works with [accounts payable], sourcing and merchandising to see how we can help and get something in return," typically a price discount for paying early. But it's just for a few vendors and only for short periods of time, Weber adds.

Rather than bring in a lending partner, REI uses its own cash. "We're in a pretty comfortable position," notes treasurer Russell Paquette. "But we think carefully about what we'll do. We're not trying to be best friends to our vendors. It's a business transaction." Since cash squirreled away in short-term investments is earning about 60 basis points, while the price discounts mean a return on cash equivalent to 100 basis points to 300 basis points, "we're really improving our margins," he says.

REI is also selectively taking delivery of goods early, using available space in its distribution centers to alleviate cash flow for vendors, Weber says. That has meant some increase in inventory but also price discounts. "It hasn't drastically affected our inventory carrying costs," she notes.

Canton, Ohio-based Diebold has a planned program for discounting that's based on its weighted average cost of capital. Diebold knows what price discounts will beat that hurdle rate and offers suppliers a schedule of payment terms linked to discounts it considers satisfactory, explains Steve Wolgamott, director of global treasury. But when the economy tanked, $3 billion Diebold also started to offer emergency, one-off early payments for a few suppliers struggling with liquidity. That flexibility usually applies to one supplier at one time for one amount owed and ties discounts to a spread over Diebold's cost of debt, not its higher cost of capital, Wolgamott says. "There are one-off opportunities to help our partners, and we are looking at them," he notes. "It helps that we are in a strong liquidity position."

It also helps, Wolgamott says, that well before the crisis developed, Diebold took a holistic approach to supply chain management that involved centralized distribution centers, counterparty risk assessments and some use of vendor-managed inventory. "In some cases, we consolidated our suppliers. In other cases, we saw too much risk and diversified suppliers," he says. "We are always looking for just the right balance between savings and risk."

Clearly yesterday's smart supply moves have contributed to today's liquidity stress. Years of procurement-driven supply chain "rationalization" allowed many organizations "to reduce the number of suppliers to gain leverage," reports Chris Sawchuck, procurement advisory practice leader at the Hackett Group in Atlanta. Leverage meant lower prices, extended payment terms, more collaborative operations and increased dependence, he explains.

Globalization also played a role. As procurement strategists turned more to foreign sourcing to take advantage of lower prices, goods took longer to deliver, which stretched the procure-to-pay cycle and created a "need to forecast further out into the future," Sawchuck says. When fuel costs spiked and then the economy collapsed, "supply chain costs rose significantly and many companies were caught off guard."

"In my nearly 40 years, I've never seen a recession like this," observes Gene Dixon, director of credit for $3 billion ThyssenKrupp Materials NA in Southfield, Mich., a provider of commodity metals. "Sales just hit a wall in December. The recession started in the financial sector but spread quickly and affected our whole supply chain."

ThyssenKrupp's customers, which include auto manufacturers, requested extended terms, but the company couldn't oblige. "We had a lot of internal discussions about working with customers," Dixon says. "We wanted to be creative, but we had our own needs and decided to stick with 30-day terms." That meant some orders were placed on credit hold and some accounts sent to collection, he says. The slowdown stuck ThyssenKrupp with above-average inventories to finance, he adds.

Suppliers also got little help from $4.1 billion Hanesbrands in Winston-Salem, N.C., which had its own agenda. The credit crunch caught Hanesbrands, a highly leveraged spin-off, in the middle of a balance-sheet cleanup designed to increase cash, decrease debt and extend accounts payable terms to 55 days. "We're in full deleverage mode," says Rick Moss, the company's treasurer and senior vice president of finance. "We had increased inventory right after the spin-off to assure service levels to our customers as we moved operations offshore, but now we're reducing it aggressively and disposing of surplus assets, closing facilities where we can. That plan was in place before the crisis, but it became more urgent after last fall."

Offering liquidity to suppliers would thwart that plan, reports Moss. "We choose our suppliers, many of them located in countries like Bangladesh and Vietnam, for their ability to accommodate our standard terms," he says. "We have a customer concentration with the big-box retailers but no supplier on which we depend in a critical way."

Hanesbrands has made exceptions for some suppliers, he says, "but those have been rare and have to be approved by the CFO or me. Once you start making exceptions, you can get a lot of leakage. Exceptions are usually to help a supplier transition to our standard terms."

At $4 billion Stanley Works in New Britain, Conn., the long-time strategy has been to leverage accounts payable and offer supply chain financing through a bank. In fact, Citibank and Stanley Works originated that program almost a decade ago, says Craig Douglas, vice president and treasurer. And the company is not budging from that strategy except in very special cases, he says.

Instead, Stanley Works, through its enterprise risk management program, has been identifying all suppliers that are the single source for a vital product, material or component, watching their financial health carefully, and lining up backup suppliers when it seemed prudent, Douglas reports. "We found situations where we definitely had to find backup," he says. "Most of our suppliers are below investment grade."

Dixon, Moss and Douglas have a lot of company in choosing to hoard liquidity rather than spread it around. With the premium on cash that comes in a serious credit crunch, even cash-rich companies would continue to stretch suppliers when possible and sock away all the cash they can get in ultra-safe, low-return investments, reports Paul LaRock, who advises corporate treasuries for Treasury Strategies in Chicago. Only when a supplier is absolutely critical and can't get liquidity any other way will the buyer pay early, he says.

"If a supplier needs liquidity badly enough and you need the component badly enough, you'll pay early or put a bank in the middle," agrees Elyse Weiner, global product head of liquidity and investments at Citigroup. While that is happening more than usual, companies are still very reluctant to part with cash, she reports. "Statistics show that treasurers are continuing to build buffers due to what-if concerns. Even the strongest companies are doing all they can to grow cash internally and avoid borrowing, especially short-term borrowing. The time will come when they start to spend that money on really good deals, but for most companies that time has not yet come."

Sometimes treasurers don't have much choice. "Your first reaction as a treasurer in a financial crisis is to protect your company," notes Jim Graves, head of the core products group at KeyBank, "but with supply chain dependencies, you have to be more collaborative. You have to ask first if you think the supplier or customer is viable, and if they are, how badly do you need them to perform."

It's not prevalent in the current economy, but a buyer with funds occasionally may keep the supply chain functioning by buying a troubled supplier, Treasury Strategies' LaRock notes. While liquidity was not cited as the main reason, in July Boeing Corp. bought Vought Aircraft Industries' South Carolina operations, a primary supplier for its 787 program. Boeing paid Vought shareholders $585 million and erased any obligation by Vought to repay cash previously advanced by Boeing.

It has long been recognized that there are win-win situations, when the buyer can borrow at a lower rate than the supplier can, to swap early payment for a price discount. The reduced price costs the supplier less than it would pay to borrow the funds, and the discount is worth more to the buyer than its cost of borrowing or return on invested cash. Such programs, sometimes called dynamic discounting, were in place before the crisis and now are being tested under stress. When the buyer remains healthy, these schemes still work but usually within tight limits.

Increasingly, whatever deals are offered to liquidity-strapped suppliers are offered jointly by treasury and procurement, Citi's Weiner says. "Procurement is after the best price, and treasury is looking out for the balance sheet. Whatever they do can affect relationships and balance sheets."

"Treasury is definitely more involved when supply chain strategy is discussed," Diebold's Wolgamott reports. Two phases of the cash conversion cycle--accounts payable and inventory--figure in those discussions, he says.

Still, squeezing suppliers as a tactic may have reached its limits. Procurement organizations often had a mandate from the CFO to drive down prices and cut the supplier base, says Brian Lee, co-lead of U.S. banking and spend management practices at SMART Business Advisory and Consulting in Devon, Pa. "Now that's proving hard on relationships."

If you have a tight-liquidity supply chain, this is a bad time to try a me-first strategy of unilaterally delaying supplier payments, says consultant Craig Jeffery, managing partner of Atlanta-based Strategic Treasurer. "There is distress out there, and if you try to optimize your own working capital by squeezing suppliers, you can make a bad situation worse."

In fact redistributing cash within a supply chain finishes a distant second to bringing in more liquidity by attracting third-party lenders. Classic supply chain finance occurs when a buyer with a strong credit rating makes a purchase, receives its order, does its matching and inspecting and approves an invoice for payment. At that point, a third party steps in and offers the seller the option of discounting the invoice in return for quick payment. Such programs, active before the economic crisis, are surviving the stress test remarkably well.

"Our financial supply chain management offering is one of the fastest growing transaction banking product areas that we've seen in the last two decades," says Jon Richman, global product head for trade and financial supply chain activity at Deutsche Bank. "We've had a dramatic increase compared to even a year ago."

Lenders typically will advance 95% to 100% of the amount of the approved invoice if the lender has a high level of confidence in the buyer's ability to pay, says John Ahearn, global head of trade financing at Citi. Pricing works off the arbitrage between the buyer's cost of funds and the supplier's, and the bigger the gap, the greater the potential benefit. If the buyer borrows at Libor plus 50 basis points, for example, and the supplier borrows at Libor plus 400, the bank financing is likely to work out to Libor plus 200 or 225, he explains. Buyers steer clear of the interest-rate negotiations because they don't pay the interest and because they don't want auditors to require them to take the supplier financings as balance sheet debt, he says.

Some suppliers go on auto discount and get paid for all their receivables with an eligible buyer as soon as they qualify, explains Paul Johnson, trade product manager at Bank of America. Others gauge their liquidity and decide whether to take early payment depending on their need for funds, he explains.

The big advantage of bank financing is that it "decouples the supplier from the buyer and puts the supplier in control of when they get paid," Johnson says. With normal terms or even expedited payment from the buyer, suppliers still don't get paid until the buyer makes it happen, he notes.

While funding has to come from the same lenders that are causing the credit crunch, supply chain programs are favored by banks, Johnson says. "If you'd lend to the buyer at Libor plus 50 and you can lend on the buyer's approved invoices at Libor plus 200, you're taking the same basic risk and getting 150 more basis points." This is exactly the kind of lending banks are looking for, he explains--short-term credit at a high reward relative to the risk.

But getting funding isn't necessarily easy. "We are still very focused on risk," Johnson explains. "We're quite selective and only offer this solution when we are very close to the buyer."

Most receivables are funded at par, but they aren't always funded, explains Mike Quinn, product manager for global trade services at J.P. Morgan Treasury Services. "We have limits. Even in good times, we might not take a particular receivable at a particular time because of those limits."

In many cases, taking advances from the third-party lender may be cheaper for the supplier than giving a price discount, Lee says. "They've already been pushed to reduce prices. They can't afford to cut them further."

What started out as an advance on approved invoices when the bank liked the buyer has evolved into much more, Deutsche Bank's Richman says. Supply chain financing is available whether the "anchor" player is a buyer or seller. It can be available as soon as a purchase order has been approved, although the amount advanced typically will grow and the interest rate will fall after the lender sees an approved invoice.

It may also be available in cases where the anchor is below investment grade. "Loans based on transactions in a healthy supply chain are intrinsically less risky than a straight loan to one company," Richman observes. Additionally, as automation makes the flow of trade documents quick and certain, funding can be expedited, he adds.

Sometimes the programs even work in reverse when investment-grade suppliers have struggling customers, Johnson reports. They might monetize receivables even when they could borrow the money at a lower rate to protect against a customer going bankrupt. There is no recourse to the supplier in such cases, he says.

The approval of an invoice by a creditworthy buyer is still a key event. "The earlier the buyer commits to paying, the sooner options open up for the supplier to get funding," notes Mike McDonough, head of trade product management for Bank of New York Mellon. But the commitment to pay can affect the buyer's balance sheet negatively and could increase leverage ratios and make it harder or more expensive for the buyer to get its funding, he says. Increasingly, even in today's tight credit markets, lenders are advancing funds before the buyer commits to paying. "They use logistical tracking models to gain confidence that an invoice approval is coming," McDonough says.

A sophisticated supply chain finance operation usually involves four parties, Lee says: the buyer, the seller, the lender and the technology firm that provides the communication platform. When all parts are humming, approved invoices can be seen in real time, and cash can flow to suppliers almost as quickly, he explains.

In this crisis, funding for suppliers doesn't just come from buyers or lenders. "There's a lot of government assistance now," Weiner notes. The government doesn't just guarantee loans but provides part of the liquidity. There are more ways now for a bank to spread parts of a trade financing deal among government agencies and other lenders, she says.

In the troubled auto supply chain, the government stepped in to provide assured but expensive financing to suppliers when pending bankruptcies by General Motors and Chrysler threatened to throw the suppliers into bankruptcy as well, Ahearn says.

When the buyer has cash and a cash-strapped supplier produces mission-critical components that may not be readily available elsewhere, all kinds of deals are possible. "It's not about being nice," McDonough says "A cash-rich buyer may take equity in the supplier, take ownership of a patent or specialized equipment--whatever they consider valuable."

Monetizing receivables has become ubiquitous in the U.S., says Nic Perkin, co-founder and president of the Receivables Exchange in New Orleans. "Liquidity is like air--you don't notice it until there isn't enough."

"Both buyers and suppliers are approaching supply chain liquidity in bold new ways," Ariba's Hofler says, describing the exceptions more than the rule. "We've seen a significant pickup in interest in the past eight months. They are collaborating to support nontraditional solutions. A new 'normal' is emerging."

Suppliers Find Fast Relief in Auctions on the Receivables Exchange

Business is booming for Atlanta-based Mason-Grey Corp., a 20-person engineering firm that specializes in automating process plants. Lack of credit had been a drag on the company's growth until recently, says Joe Reini, president. Now Mason-Grey can auction receivables from its generally blue-chip clients on the Receivables Exchange and get cost-effective, hassle-free liquidity.

"If we put up an invoice one day, the funds usually will be wired to our account by the next business day," Reini reports. "It's an incredibly powerful liquidity tool." Mason-Grey chooses which invoices to auction not by the credit quality of the buyer but by the availability of electronic documentation. The cost is comparable to bank financing but "with a bank, you're constantly renegotiating and refiling," Reini says. "With the auction, we just post what's for sale week after week and move on. And we've never run into a limit in what we can bring to market. Until last year, we were hamstrung by what we could raise through traditional channels."

The Receivables Exchange, based in New Orleans, is a fairly new online marketplace that offers receivables--individually or as portfolios--for auction to banks, investors and nonbank lenders. "It's quite different from factoring, and it doesn't require banks or buyers to be involved," explains Drew Hofler, senior manager for working capital solutions at Sunnyvale, Calif.-based Ariba, which offers the Exchange as one liquidity option for suppliers on its network.

While supply chain finance programs are mostly buyer-centric, the Receivables Exchange is supplier-centric and lets suppliers control the process, explains president and co-founder Nic Perkin. It's used primarily by small and midsize suppliers that are not publicly traded. And it's fast. "Trades happen in 15 seconds," Perkin says. "You could sell a $1 million receivable within 15 minutes."

In this market, suppliers are cherry-picking their receivables from investment-grade customers to sell, he says. "That's where they can get the lowest cost of capital." Less than 0.1% of the receivables offered fail to sell, Perkin notes, and 85% are auctioned at the buy-out price set by the seller.

Because of Ariba's substantial communications network, a supplier on the Ariba network can quickly shunt receivables with all the supporting documentation onto the Exchange, says Ariba's Hofler. Ariba also provides ways that buyers and sellers on the network can negotiate directly with each other to trade early payment for a price break, he notes.

A supplier on the Ariba network can log on and see which receivables have been approved for payment and what discount the buyer may be requiring for early payment, Hofler explains. The supplier can see its options and decide when it wants to get paid and what it is willing to give up for the funds. It can also make a counterproposal, or forward the receivables to the Receivables Exchange for auction. --Richard Gamble

Emergency Measures for Ailing Partners

Liquidity droughts can hit customers or suppliers. When an important customer runs dry, it may be necessary to extend payment terms and dust off some old risk-mitigation tools that are better understood by credit managers than treasury staffs, explains credit and collections consultant David Schmidt, principal and founder of A2 Resources in Yardley, Pa.

"By doing a purchase money order security UCC filing, you can become a secured creditor in a first position on the goods you ship and the proceeds derived from those goods," he explains.

Or you might ship smaller orders and wait to get paid before shipping more. That sets you up for a "contemporaneous exchange of goods defense should the customer go bankrupt and the trustee come after you with a preference claim," Schmidt notes. --Richard Gamble


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