From the October 2010 issue of Treasury & Risk magazine

A Lifeline for Suppliers

Supply chain finance programs flow into the mainstream as a working capital solution that keeps suppliers afloat in a rough credit environment.

As supply chains become more interdependent, skirmishes over working capital advantage are taking a toll. It's time for a new approach, says Wayne Evans, vice president for procurement at DHL Global Business Services, a Plantation, Fla.-based subsidiary of Germany's $66.2 billion Deutsche Post. DHL had a plan to optimize working capital in its supply chain: push terms out to 60 days. Now it's changing that plan. "Initially, we thought that 60-day terms would be the solution, but we're finding that it's not that simple," Evans says. "There's benefit to extending terms, but also a cost. If we pay for our suppliers' cost of financing their extended [days sales outstanding], and their cost of financing is higher than ours, we're not getting such a good deal.
 
"We're still shooting for 60-day terms where possible, but we're trying to understand the implications of extending terms, and that is not simple," he explains. "We're analyzing those consequences case by case, looking at the total cost of ownership and trying to make the best business decisions. We're having conversations with suppliers to better understand their situation and maybe find better solutions together."

Supplier pricing is not very transparent, he adds. "You often don't know how they build in their cost of credit, so you don't know what that is costing you."

DHL exemplifies a shift among leading supply chain thinkers--influenced by the credit crunch--toward a more balanced approach that exploits suppliers less and assists them more.

Pre-crisis supply chain finance (SCF) programs were largely efforts to push out the buyer's days payable outstanding (DPO) to maximize its working capital, while offering stretched suppliers a way to stay liquid as the buying corporation stripped as much value as possible from the relationship, notes John Ahearn, global head of trade at Citi Global Transaction Services. Now there is greater concern about supplier viability, and companies are launching programs largely to support vendors.

"There have been studies of what it costs a buyer when a supplier goes bankrupt, and it can be expensive," Ahearn says. "It can be cheaper to pay early to keep suppliers in business than it would be to pay slower and have them go bankrupt. People are having a lot of conversations now about what is the right model."

The financial crisis brought increased attention to counterparty risk within supply chains, says Shawn Taoufiki, source-to-settle practice leader at REL, the supply chain consulting division of the Hackett Group, an Atlanta-based performance benchmarking company. "There's more concern about supplier viability and capacity," Taoufiki notes. "Chief purchasing officers, anticipating an improved economy and seeing some uptick in demand, want to be sure that their suppliers have the resources to ramp up when they need to increase their orders."

That has set off a boom in SCF programs, which have surged into the mainstream with the financial crisis, says Mike McDonough, executive director of the global trade finance group at J.P. Morgan. "In the past two years, it has gone from a niche product offered by a handful of industry players to a working capital solution that almost everyone is aware of," McDonough says. "More companies are doing it, and companies that were doing it are expanding their programs to cover more suppliers. Corporations are pushing their banks to be innovative in structuring the programs."

As part of its new collaboration, DHL is shaking up its competitive bidding process by introducing "suggestive bidding," in which suppliers suggest ways to handle purchasing that would reduce their costs and lower their bids. "The supplier knows what is efficient or inefficient for its operation," DHL's Evans explains. "We ask them to tell us how we can make our purchasing more efficient for them so that they can give us the lowest price. For example, we may be buying regularly in $200 increments, and they might say they could reduce the price if we ordered in $400 increments.

"We still standardize the front end of the bidding documents, but then open up the process," he says. That sounds free-form and manual, but it's not, Evans insists. "We link the suggestive bidding to a technology tool called Emptoris that runs a back-end optimization engine that uses a lot of automation to point us toward our best choices," he says. "The optimization engine can quickly identify the best options based on the supplier's input. Inflexible competitive bidding misses opportunities for continuous improvement, and now we have the technology tools to do it better."

"We're moving to an elegant financing solution that can work at the specific invoice level and offer very flexible financing quoted in basis points per day," says Kurt Adams, senior vice president of strategy and program management for U.S. Bank Corporate Payment Systems. "Today's systems provide a high degree of visibility and certainty around such transactions."

SCF platforms like those offered by Prime-Revenue and Orbian have brought a "communications breakthrough," claims Bob Kramer, vice president of working capital solutions at PrimeRevenue in Atlanta. "There has been a tremendous increase in the visibility into cash flow. Once an invoice has been approved, it's posted for suppliers to see. They know right then when it is scheduled for payment. They know if it has been approved for the full amount or less. Knowing in advance that payment is guaranteed on a definite date is a big advantage for suppliers."

Just ask Jim Crews. When Toledo, Ohio-based Revere Industries sells its ejection-molded plastics to Whirlpool, CFO Crews watches for his approved invoice to show up on the PrimeRevenue Web site. He checks his cash forecast to see how much cash Revere needs for the week, then decides whether to accept a discount and take the cash immediately or wait for payment in full in 90 days.

Crews likes having that option. "It's very convenient, and the cost to use it is actually a bit lower than using our revolving line of credit to fund our working capital needs," he says. "It's very flexible. We can let the invoice go to full maturity or pick the point at which we get paid. We can trade some or all of the available invoices. We can pick a dollar amount for early payment."

Technology makes it easy, Crews says. "PrimeRevenue has upgraded its platform over the past three years, which has meant that we get better visibility into all our funding possibilities."

The link between technology and working capital is important. "It's all about visibility and connectivity among trading partners," Taoufiki says, adding that it's stimulating growth in electronic invoice presentment and payment (EIPP). Buyers receiving electronic invoices take discounts almost three times more often than those getting paper invoices, he reports. "Once you have electronic invoices coming in, you have greater visibility and control over discounts," Taoufiki says. "EIPP solutions open the door to greater discounting opportunities, including dynamic discounting."

That is leading companies to add SCF programs on top of EIPP programs. "The more you automate the processes and link the data of buyers and suppliers, the more you can optimize supply chain financing," Taoufiki observes. EDI works for large suppliers, but the new technology, including data-rich XML formats, will bring more small and midsize suppliers onto technology platforms, and allow those in greatest need of supply chain financing to participate efficiently, he says.

Today's technology is still imperfect, though. E-procurement systems still kick out exceptions that have to be resolved manually, DHL's Evans points out. "We need to get to the root cause of those exceptions and fix the problems before we will see the full benefits of automation."

DHL is among the companies looking at SCF programs that would "offer our credit source to suppliers so we could extend DPO and they could contract DSO at the same time," Evans says. "This could be especially helpful for small and midsize suppliers with limited access to credit. We have the model for third-party supplier financing and have begun discussions with suppliers who might be most likely to take advantage of it." DHL uses third-party financing in other parts of the world but is just introducing it in the U.S.

While supply chain finance (SCF) programs are proliferating, they are still more the exception than the rule. "Fifty-nine percent of the companies we benchmark are not using them significantly," reports Kurt Albertson, procurement advisory practice leader at the Hackett Group.

In addition to the impact that SCF programs have on both the buyer's and supplier's working capital, the programs affect the buyer's spending, in that early-pay discounts reduce its costs, as well as the efficiency of the settlement process, Albertson says.

He notes that procurement and treasury have different priorities. For procurement, controlling supplier risk and reducing spend may be most important. For treasury, improving working capital by extending DPO and getting an efficient payments process may matter more. Since these goals can conflict, it's important to align them with corporate goals, he says. "Historically, the players have been parochial, looking out for their own stake," Albertson explains. "Lately, leading companies have taken a deeper dive into supplier payment strategy to get all parties on the same page."

Treasuries are debating whether it is better to pay discounted invoices with the company's own cash, which may be abundant and earning minuscule returns, or to get banks to put up the funds. So far, bank funding is winning. REL research shows that although buyers can earn a return of more than 18% by paying early, in the wake of the liquidity crisis the trend is still to delay payment and pass up discounts to hoard cash, Albertson reports.

Both buyers and sellers can initiate discounts, and between 2007 and 2009, buyers cut back on the discounts they accepted by a third, he notes. "They pulled back on using their own funds and looked more to third parties to provide the funding," he says. "Conserving cash has been a top priority, and we've seen that extend well into 2010."

Some sophisticated corporations are using a back door to self-funding. They are pushing out their DPO aggressively, getting a bank to advance the payment and take the supplier's receivables onto its own balance sheet. The companies then buy back their own paper from the bank, Citi's Ahearn reports. "They're regarding it as AAA paper on which they can earn Libor plus 100 or 150 basis points," he says. "If they invested in Treasuries or bank paper, they'd earn practically nothing.

"Some want to buy it back on demand. Some want to buy it all. Others want to buy back only parts of it, but they want banks to be in the middle in case the economy changes," Ahearn explains. "And they don't necessarily want their suppliers to know what they're doing. With so much corporate liquidity, the logic is compelling. It's a roundabout way of self-funding a program."

"Even though short-term investment rates are low, those investments are pretty liquid," notes PrimeRevenue's Kramer. "If you finance your suppliers with early payments, it's hard to pull that money without consequences in the supply chain," he adds. "We saw in the automotive supply chain that when supply chain financing was pulled, a number of suppliers attributed their Chapter 11 filings to the sudden withdrawal of financing. You really can't look at supplier financing as a short-term use of cash if you consider your supply chain a long-term asset."

Traditionally, cash-rich companies did not use third-party financing for their supply chains, but that's changing as working capital management has risen in prominence, J.P. Morgan's McDonough says. "Companies like the major pharmaceuticals that never used bank programs for their suppliers in the past are now using them where it makes sense," he says. "They're using bank programs for one segment of suppliers and dynamic discounting with their own cash for another segment. The two are not mutually exclusive."

Segmenting suppliers and steering them to three complementary programs--purchasing cards, buyer-funded dynamic discounting and third-party financing--is emerging as a best practice.

"Each has its place. Sophisticated treasurers are adopting all three programs, segmenting suppliers and sometimes shifting among the options as market conditions and their need for cash change," McDonough explains. SCF and dynamic discounting are favored for primary suppliers, and p-cards for secondary suppliers, he says.

One way to optimize an SCF program is to resegment your supplier base, Taoufiki says. "It might reflect market complexity. Segmentation might reflect the size of spend or critical vs. noncritical suppliers. We've seen a few purchasing organizations optimize the purchase-to-pay process by tailoring their offerings to their suppliers."

Multibank SCF programs may turn out to be an intermediate step to capital markets funding, McDonough says. "Eventually, we'll tap a wider investor base by issuing notes in the capital markets, somewhat like commercial paper," he says. "Banks would be the issuers, using a conduit, and investors, including banks, would buy notes according to their appetites. The big banks--Citi, Deutsche, us--are all looking at this now."

Meanwhile, there's a tug of war going on over SCF business between banks that use their platforms and relationships to keep the business for themselves, and solution providers, like Orbian and PrimeRevenue, whose technology platforms provide multibank programs. "We've seen the role of the solution providers grow, and some movement to the multibank programs," Albertson reports.

A bank-sponsored program has two advantages, McDonough claims: Banks and their balance sheets are viewed as more stable providers than smaller, privately held software companies. And banks make money on the advances but usually don't charge for administering the program, while software companies add a spread.

While much of the tactical attention has centered on using third parties to finance trade payables, strategic treasury staffs are starting to take a broader approach, notes Taoufiki.

"The real goal of supply chain finance should be to inject liquidity into the whole supply chain and optimize working capital end-to-end across all the players," Taoufiki says. "That goes well beyond financing trade payables."

 

For more on innovative techniques for financing suppliers, see Shoring Up Supply Chains.

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