Part 1 

Last week GXS announced that it was selected by BB&T to power the financial institution’s new “Integrated Supply Chain Finance” solution.  And since then our phone has been ringing off the hook with calls from other banks, analysts and partners interested in learning more about this topic of Supply Chain Finance.  This is a fascinating area and one that I have been studying for about 24 months now, so I thought I would offer my perspective on the topic.

Supply Chain Finance is part of a broader trend in the market, which involves the convergence of the physical and financial supply chains.  There is much more to be shared on this topic than I can offer in just one post so let’s start with the topic of supply chain finance as it relates to international trade.  

History 

Historically, many of the international trade transactions between large buyers (based in the US or Europe) and small suppliers in emerging markets (China, India, Southeast Asia, Latin America) have been conducted using a letter of credit.  When a dispute arises in trade between two parties located in different countries with different legal systems, resolution can be timely, complex and expensive.

This is where a letter of credit can provide significant value by simplifying international trade terms and providing risk mitigation against default by the buyer.  The letter of credit offers a guarantee to the supplier that they will be paid for goods delivered to a buyer if they meet all of the terms and conditions outlined in the purchasing agreement.  The guarantee is made from the buyer’s bank to the supplier’s bank, both of whom facilitate the transaction on behalf of the buyer and supplier.  The commitment in a letter of credit is very strong.  In fact, with most letters of credit the buyer’s bank will make payment even if the buyer goes bankrupt or is for some other reason unable (or unwilling) to pay. 

While letters of credit provide strong risk mitigation for the seller, they are viewed by many buyers as costly, slow and inefficient.  As a result, many large US and European buyers are moving their international sourcing relationships away from letter of credit towards “open account” terms.  With open account there are no bank guarantees.  Payment terms are negotiated directly between buyer and supplier.  Critical to such an arrangement is the assumption of trust between both parties. 

Cash Rules! 

In addition to changing to open account, buyers are also extending their payment terms with international suppliers.  Buyers want to hold onto cash as long as possible.  As a result, they would prefer to defer payment to suppliers for 60 to 90 days so they can put their cash to use in other ways.  Other uses of cash might include 1) short term investments to generate interest income or 2) cash outlays for capital projects requiring immediate funding.  On the other hand, suppliers want to be paid as quickly as possible for the goods and services they provide to their customers. 

 

Suppliers must purchase raw materials and to pay their labor force to manufacture the products.  In international trade, the time between when a purchase order is first issued and payment is received may be 120-150 days.  Extended payment cycles with customers force suppliers to seek out financing from third parties to keep their business operating.  These competing priorities of buyers and suppliers are a growing source of tension in the supply chain.

Source of the Tension 

Some of you may be wondering, why is this tension around payment terms a new phenomenon?  International trade scenarios such as the example above have been common for decades.  This is true.  But, the migration towards open account and the extension of payment terms have combined to exacerbate the working capital challenges of exporting suppliers.  Why?  Because, historically, exporters in emerging markets had the security of a letter of credit, which could be used as the basis for a working capital loan to fund their manufacturing activities.  A letter of credit backed by a major financial institution (and buyer) in the US or Western Europe was viewed very favorably (less risky) by banks in emerging markets.  As a result, exporters in these countries could receive a cash advance against the value of the purchase order from their local bank.  The cash could be applied to purchasing, payroll or other operational activity until the payment from the buyer was received.

In an open account world, the supplier in the emerging market only has a purchase order.  A PO is relatively easy to counterfeit.  And even legitimate POs lack any firm payment guarantee from the buyer.  As a result, open account transactions are viewed as having a higher risk by banks in the exporter’s home country.  Financing is therefore more difficult to obtain.  When financing is available to a supplier, it is often for substantially less than the full purchase order value.  Even more problematic is that financing is offered with relatively high, credit card level interest rates.

A Lose-Lose Situation 

Few buyers have considered the full implications of the new terms of trade they are negotiating with suppliers.  Extending Days Payable Outstanding (DPO) and reducing banking fees may seem like a winning proposition to the buyer.  However, the overall cost and risk introduced into the supply chain may offset the other benefits.  By having to borrow money at a higher interest rate to fund manufacturing operations, the supplier’s cost structure has now effectively increased.  These higher costs will undoubtedly be passed onto the buyer in the form of higher prices.  Furthermore, suppliers who are not able to obtain timely financing, may be at risk of financial insolvency.  Others may be forced to cut costs resulting in unexpected manufacturing delays or lower quality products. 

Dr. Hau Lee of Stanford University has recently introduced a new theory that I think is very insightful articulation of today’s international supply chains.  He stated:  “Instead of company to company competition, we are now in an era of supply chain to supply chain competition.”  If companies are going to compete on the strength of their supply chains, buyers must find a more supplier-friendly approach to international trade. 

So what is the solution? 

An innovative new concept called Supply Chain Finance, which is a topic I will explain further in an upcoming post.

Steve Keifer

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