How Does Supply Chain Financing Work?

Last Updated July 20th 2021
7 Min Read

Every business transaction that involves a sale has the buyer, the seller and the financial settlement to seal the deal. In an increasingly globalised scenario with business partners spread in a multinational market, the challenges too get bigger. 

On one hand, goods need to change hands from the seller to the buyer without breaking the supply chain. On the other, sellers need to get paid so that there is no cash flow and working capital pressure at their end. 

It is in the best interests of both parties that the sale goes through without any complications and the payment settlement happens on time. The solution that helps these problems comes in the form of supply chain financing, one that blends technology and finance to lend operational stability to the ecosystem. 

What is Supply Chain Financing?

Supply chain financing, also known as supplier finance, is a form of supplier finance where suppliers receive a cash advance or an early payment on their invoices which is similar to invoice financing. This technology-enabled solution is based on the credit rating of companies in the supply chain. Both businesses and buyers can benefit from this process. While businesses can profit from the higher credit scores of their buyers, buyers can extend their payment terms. Suppliers are also able to receive supply chain finance at a lower cost.

The supply chain financing solution is designed to lower financing costs and improve business efficiency. Here, the buyer has to approve a supplier’s invoice for financing from a third-party intermediary, usually a bank or a financial provider, so that the supplier gets paid more quickly than they would, instead of waiting for the payment. It also helps businesses to manage cash flow to increase stocks or to pay salaries and the buyer’s working capital is untouched until their extended payment terms are over.

Supply chain finance is also known as reverse factoring because it encourages collaboration between buyers and sellers. It is a win-win situation for both suppliers and buyers, as suppliers gain quicker access to money that they have spent, while buyers can extend their payment terms.

Supply chain financing is ideal for smaller enterprises to do business with partners with a good credit rating. But for supply chain financing, they might be limited in their selection of buyers. All of this occurs without negatively impacting the company’s or its suppliers’ balance sheets.

The Evolution of Supply Chain Financing

Today, supply chain financing is used across multiple industries across all continents. The concept has been around in various forms through the ages but the practice under this umbrella term got acceptance in the early 1980s. 

Given the nature of the industry and the business, there was a huge reliance on components in the supply chain being made available on time and regularly. With vendors of automotive parts all over the globe, car manufacturers had a pressing requirement for the supply chain to function smoothly. Also, the payment cycle also had to be favourable to both. 

The automobile manufacturer needed the parts on time but also required time to make the payment while the vendor needed the payment at the earliest. After all, they had to ensure that their cash flow position was good and did not impact their working capital requirements. So, it was the automotive industry that was one of the first to actually pick up the idea of supply chain financing and to adopt it widely. That was followed soon by other sectors of a supply chain nature and a dependency on financing to keep the chain unbroken. 

Companies in manufacturing, retail, electronics, household furniture, besides others, are users of supply chain financing in a big way. With buyers being able to get an extension of their payment period and suppliers getting the advantage of receiving payment early, this is an ideal solution for all trading partners. 

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How does Supply Chain Financing Work?

As an important element in the overall supply chain, the financing aspect is what oils the overall machinery. To make sure that both the supplier and the buyer have a win-win arrangement, the financial side of the deal gets taken care of by the lender. 

It is this tripartite nature of supply chain financing that actually makes the process complete. Here, the buyer, the seller and the financier come together to help complete the transaction. The whole deal is done through an agreement and on a common platform. As the underlying foundation is the creditworthiness of the buyer, his credit rating is of particular importance. Understandably, he needs to have a higher credit rating as compared to the seller. 

Typically, the process begins when the buyer starts looking for sellers for his requirement. In a situation where the buyer does not have a need for finance from external sources, he can start identifying sellers straightaway. 

But if a buyer needs financial support, he will approach a supply chain finance provider and enter into an agreement with him. Once this is done, he can seek suppliers to send in their quotes. 

The steps involved in the supply chain financing process can be broken down as follows:

  • The buyer, after making a purchase decision, places his order with the supplier, who, in turn, fulfils the purchase order. This can be a domestic supplier or an international one.
  • The supplier then goes on to ship the goods to the buyer and raises an invoice in his name.
  • Once the buyer approves the payment of the invoice, he confirms the payment to the financer upon the invoice maturing. This is where the supply chain sees the lender or the financer enter the picture.
  • Now the payment to the supplier happens from the financer who buys the invoice from the supplier at a discounted rate and gets immediate access to the funds. 
  • The buyer then, upon the invoice maturing for payment, pays off the financer with the invoice value. 

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Benefits of Supply Chain Financing

Let us take a look at the benefits of supply chain financing.

 Facilitates business

For a typical business deal where a buyer buys commodities from a seller, there is a payment settlement to be done or a credit period applicable. Without the required funds to pay off the seller, the buyer would have to put his business plans on hold. This could lead to delayed deliveries or having to buy from lesser-known suppliers or those with lower quality records. Likewise, if the payment gets delayed, the seller too would have a cash flow issue. 

This is where the concept of supply chain financing helps make the transaction happen with the pumping of money into the seller-buyer midst. The role of this lending ensures that both ends of the business deal take place. 

 Lends protection to the deal

Along with the funds that exchange hands, there is also an element of protection that the supply chain financing lends to the transaction. With a third party lender stepping in to fund the transaction, the seller gets his payment upfront and the buyer too is able to procure the goods in time. 

This creates a climate of assurance and safeguards the business interests of both parties involved. Without this facility, many transactions may not have been even fructified.

 Helps the cash flow of the seller

The seller gets quick access to the sale proceeds unlike the usual wait period that can run into weeks and even months. It is common, otherwise, for a seller to face cash flow challenges that could impact his ongoing production requirements. This is especially helpful during tough economic conditions where funds are difficult to generate. 

 Authenticates the buyer

This added layer of a third party who acts as an intermediary business facilitator helps accord a stamp of authenticity to the buyer and his creditworthiness. As only a buyer with a good credit record gets eligible for financing, his getting access to such loans enhances his reputation in the market. 

 Creates a climate of trust between sellers and buyers

Supply chain finance can be the ideal solution for both buyers and sellers, bringing them on to a common platform with a common goal. A mutually beneficial arrangement like this can foster more business opportunities and improve trust and cordial relations between both. 

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Drawbacks of Supply Chain Financing

Not a mass-market solution yet

For large, reputed organisations, access to funds and business opportunities are usually not so much an issue as it is for smaller and growing companies. The irony is that it is usually a smaller business that has the potential but has to struggle that is in need of such solutions. 

But supply chain financing is still not a mass-market solution. It is still available only to established enterprises with a proven operational history and credit record. Thereby, a large segment of the market gets deprived of the facility. 

Supply chain financing is a popular financing method among small to medium enterprises. The growing technology is likely to increase the efficiency of this financial solution in future.

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