The New Battle Rhythm
for A Smooth Business
Vendor Side Supply Chain Finance
By Shashank Pimpale
Before jumping into it, let’s just understand what a generic supply chain finance (SCF) solution is. According to PrimeRevenue, supply chain finance is a set of solutions that optimizes cash flow by allowing businesses to lengthen their payment terms to their suppliers while providing the option for their large and SME suppliers to get paid early. Let’s understand this by a simple example: Company ‘A’ purchases goods from supplier ‘B’ with the decided credit period to be 30 days. But if B’s in an urgent need of cash, he can request for an immediate payment. In this case A’s affiliated financial institution comes into play and it pays B immediately against a discounted invoice and allows A 30 more days (60 days in total) to repay it. Sounds flawless right? Unfortunately, this is just an ideal scenario. A lot of factors affect this process and we’ll be talking about them in detail here.
I’ve observed that there is a prominent polarity in the Indian economy when it comes to working capital. On one end of the spectrum, there are large corporates with high debt and stressed balance sheets forcing them to think of ways to release cash trapped in working capital by increasing their Days Payable Outstanding (DPO) or reducing Days Sales Outstanding (DSO). There’s a scope to unlock up to INR 4 Lakh Crore (~US$60 billion) in excess WC, according to a research report by EY in 2016 which is 1/5th of the 20-lakh crore fiscal package announced by the Indian Government in May to revive the economy.
On the other end of the spectrum, there are large corporates with healthy cash positions, roughly INR 8 Lakh Crores (±US $120 billion) worth at an aggregate level, but earning a modest but stagnant 6-8% p.a. For them, Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA) improvements hold more value when compared to Days Payable Outstanding (DPO) extension as they can easily leverage their treasury funds.
How these companies adapt to either of these strategies is entirely a time-based approach. For companies looking to book high revenues and have a good financially backed report at the end of a quarter, they go for EBITDA increase. Other times of the year, DPO extension holds importance. Let’s look at these problems in detail.
The first problem is cash trapped in working capital. Buyers (corporates) usually resort to DPO extension to release cash in working capital. However, credit period negotiations between buyers and suppliers are contentious and time-consuming with the upper-hand being with the buyers. The buyers stretch their credit periods incessantly to improve their cash liquidity. As a direct effect, suppliers face existential crisis due to a complete halt in their business. A study by Fundbox states that about 32.3% of firms say trade credit makes their day-to-day operations difficult. While the buyers see an initial upside to extended credit periods, they neglect their supplier’s financial conditions and the consequent effect on their own business. I just like to see it in this manner: Suppliers health=Buyers health. If a business doesn’t get a good price on its raw materials or sometimes doesn’t get them at all, how does it propose to function and grow?
The second problem is stagnant returns on free cash. The treasury functions of most organisations have a mandate to maintain liquidity and a sufficient working capital. This function keeps a check on the cash inflows and outflows to fund company operations and hence they’re very sceptical on letting go of money. Investment done by these treasuries are on debt funds and on low-yielding instruments which have lower risk. These investments are roughly equal to the number of payables outstanding with their vendors. You see what these corporates did there? They have created a risk-free asset class for themselves by following this measure. Corporates have tried to unlock this value by using cash discount programs but returns have always been modest.
So why haven’t the traditional SCF programs been able to solve these problems? I believe there are 4 main problems.
The first being scalability. The traditional SCF programs have a limited range of expansion and they are mostly implemented by cash-rich corporates and even in those companies, only the top 100-250 suppliers who account for 15-20% of the procurement spends, are covered. Expansion of the SCF program is practically impossible as each vendor has a different credit availability, priorities and access to capital whereas the SCF is standardised and more inclined towards the buyer’s comfort. Such programs don’t have the ability to cover the whole vendor base.
The second problem is flexibility. Apart from covering the vendor base, an effective SCF program should also tend to specific needs of all vendors depending on their requirements at that point in time. Typical cash discount programs do not offer this feature and have remained rigid and archaic. Let’s take an example. Vendor ‘A’ may have a good working capital position and sufficient liquid cash to sustain his business therefore a 60-day credit period without any discount on his invoice, is the ideal scenario for him. Now take a look at vendor ‘B’. He has a cash strained business and functions on a hand-to-mouth basis. For him, even a 30-day credit period can prove fatal to his business. He would prefer a 10-day credit period at say a 10-15% discount on his invoices; he just needs liquid cash to function. These variations are coupled with seasonal differences making it extremely difficult for cash discount programs to get a hold of.
Coming to the third problem, it’s the risk of discounts being passed off in future pricing. These programs only take into consideration select vendors while the majority of the vendor base still has to struggle with the extended credit periods. To avoid dissolution, these smaller vendors who get neglected borrow from the informal market at rates as high as 30-36%, with these costs getting gradually passed into the buyer’s pricing. Without proper expansion and data analytics of vendor behaviour, this continues to remain a serious problem unattended by cash-discount programs.
Finally, the last problem being trust. Vendors often feel aggrieved when they realize buyers negotiated a credit period despite having cash on balance sheet, and then later offered that cash in return for a discount at a rate of the buyer’s choosing. They may feel buyer is trying to exploit their circumstances and as a result the relationship deteriorates, adversely impacting buyer’s business with the vendor. Even if the buyer somehow decides on differential rates for all suppliers, there will be an imminent backlash from vendors when they see that their peers are offered lesser discount rates.
If you notice closely, all of these problems are related to the vendors, whose ill-health will have second-order effects on the buyers (corporates) too. One thing is definitely clear, the success of a cash discount program is inextricably linked to vendor satisfaction. This is precisely why a vendor side supply chain finance is the need of the hour.
After considering a lot of factors, I think these are some salient features of a good vendor-based supply chain finance program:
i) Vendor onboarding- Vendor onboarding and education is considered to be the most important reason for failure of supply chain finance programs globally, according to Mckinsey. Nearly 80 percent of suppliers’ rate onboarding support through documentation, training and tools as key to determining their participation in a program. A vendor-based supply chain finance program lays emphasis on extensive awareness campaigns, physical meet-ups with vendor for education, constant assistance during the process and customary phone calls as well as emails to ensure seamless onboarding and service to all vendors. A robust on ground team needs to be working well to do justice to this activity. This instils a feeling of trust among the suppliers and strengthens vendor-buyer relationships.
ii) Customizable approach- Every supply chain is unique. Anyone claiming that a standard one-size-fits-all product can solve the problem is grossly under-estimating what it takes to deliver value. Ideally, a program must take into consideration the supply chain profile of the corporate and devise a sound go- to-market plan that captures vendor segment- wise sales & distribution channel strategy, pricing strategy, funding requirements, vendor level discounting limits, discounting processes and a comprehensive communication agenda for every different corporate.
iii) Effective Performance Tracking- A digital Vendor-based SCF tracks the program real-time on a device while keeping in mind certain key parameters such as vendor profiles, incomes, discount rates and historical data to make accurate analyses. These programs employ an efficient Management Information System (MIS) which lends that extra flexibility of a true marketplace where the businesses can switch between treasury and external funds in real time. These allow the suppliers to choose their own rates and credit periods with the information staying confidential.
Although a vendor-based SCF sounds great but there’s a reason why these kinds of programs have not had much success in our country as compared to Western counterparts. And that’s because of less digital sophistication. SME vendors who mainly operate out of rural areas have problems adjusting to new technology and do not want to change their current modus operandi even though the conventional process proves to be tedious. Being in favour of digital transformation, RBI even launched its own online marketplace to facilitate the financing/ discounting of its trade receivables called Trade Receivables Discounting System (TReDS) to give a boost to MSMEs and urging their whole supply chain to go digital. I believe this attitude of negligence towards technology is going to change post-Covid. This pandemic has reinforced the importance of digital payments and has reduced the incidence on physical money. If this shift to digital payments becomes imperative for people like you and me, can you imagine how a small vendor, who has 50-100 crores stuck in working capital would benefit from applying a technology-driven SCF program? Only time and the willingness to adopt technology will tell.