Adjusting to the “new reality,” many companies have focused on all aspects of their balance sheets to improve performance for stakeholders. Companies have realized that material extensions of credit terms regarding accounts payable result in dramatic improvement to cash flow and working capital. Changing terms from 30 days to 75 days, for example, not only frees up cash for working capital, it also reduces the need for bank-financed working capital, which is more expensive than “borrowing” from suppliers.
To make the extension of payment terms more appealing to suppliers, buyers have partnered with their lenders to offer a “supply chain finance” solution that allows suppliers to be paid timely if not early, despite the stated payment term extension, such that a supplier’s Days Sales Outstanding (DSO) is actually reduced.
The Trade Credit Association of the United States reported that in the U.S. approximately $20 trillion of annual sales are made on trade credit, resulting in $2.8 trillion of trade credit outstanding in the U.S. economy, which creates a substantial market opportunity for banks to generate interest and fee income.
Supply Chain Finance (SCF) is an opportunity for banks to generate interest and fee income, at a low cost and risk. Typically, SCF programs are provided to a bank’s existing and best customers who pose little credit risk. The advances by the bank can be folded into an existing credit facility, are short-term exposures, and are backed by an assignment or pledge of the customer’s obligation to pay its supplier.
Not only can the bank generate fee income from its borrower for providing the facility, the bank also makes a .5 percent or so spread on the invoice amount in 60 to 120 days, since the bank pays the supplier a discounted amount, and collects 100 percent from its borrower at invoice maturity.
From the Buyer’s perspective, the “new normal” economy has resulted in more expensive and less accessible capital, demand for goods is not as brisk as before, customers are paying more slowly, and capital is tied up longer in inventory and slower moving accounts receivable. Yet, companies remain under pressure from stakeholders to manage their balance sheets and cash to generate revenue.
For example, in April, 2013, The Wall Street Journal reported that Proctor & Gamble would extend payment terms of suppliers from 45 to 60 days to 100 days. Given Proctor & Gamble’s procurement spend of $50 billion annually, that would improve Proctor & Gamble’s cash flow by $2 billion. By extending Days Payable Outstanding (DPO), a buyer not only improves cash, but reduces working capital costs and bank charges.
With low interest rates, the cost to the buyer for its bank to facilitate an early payment option for suppliers is low, especially if it is an add-on to an existing credit facility.
Buyers should understand the impact on its suppliers as extended payment terms can adversely impact the supplier’s revenue and perhaps overall financial health, heightened if interest rates increase. Prudent buyers should monitor their supply chain more closely to ensure a healthy supply chain to provide an uninterrupted flow of goods to the buyer.
A supplier wants to be paid for the goods it sells, on a timely basis. Prices charged by a supplier reflect the company’s cost structure, including the cost of extending credit to customers. A powerful customer’s unilateral extension of payment terms increases a supplier’s cost, which increase may or may not be passed on to the customer.
If not, there is a reduction of the supplier’s revenue, exacerbated by having its working capital tied up in slower paying accounts receivable, and an increase in DSO. Historically, a “good paying customer” was one who paid within invoice terms, often taking a 1-2 percent discount for paying within 10 days.
Suppliers tend to initially reject the extension of payment terms, which may depend on the parties’ relative bargaining position. If a supplier is part of a diverse supply chain that sells products readily obtainable from a competitor, a supplier may acquiesce to keep sales. On the other hand, if the supply chain is limited, such that there is little risk of a losing business, or if the goods sold are unique to that buyer and seller, the supplier may have leverage to “just say no.”
All participants in SCF programs should consider the potential advantages of SCF programs in foreign sales transactions, and the impact if interest rates increase materially.
Regardless of the varying perspectives of the participants in SCF, it appears to be a fast-growing part of domestic sales transactions and international trade. SCF programs will no doubt evolve to meet the changing dynamics of its participants, but appears to be poised to take a prominent role in facilitating global trade.
Content contributed Shumaker, Loop & Kendrick, LLP, a full service law firm founded in 1925 with more than 240 attorneys practicing in Toledo and Columbus, Ohio; Tampa and Sarasota, Florida; and Charlotte, North Carolina. Content written by David H. Conaway, Partner, whose principal area of practice is bankruptcy. For more information, contact him at 704-945-2149 or email@example.com or visit www.slk-law.com..