– by Jonathan Vojtecky, Managing Director, Global Trade & Supply Chain Finance, Bank of America and Dr. Nick Vyas, Founding Director Randall R. Kendrick Global Supply Chain Institute, University of Southern California
To be successful, today’s finance and treasury leaders must balance the key elements of the “magic triangle” that every company, whether a startup or a century-old legacy business, must navigate. This triangle consists of cost, service, and cash, and failure to execute one of these three elements can potentially lead to financial struggles. Indeed, free cash flow is critical, and this underscores the importance of driving improvements in end-to-end procure-to-pay processes to maximize working capital.
Analyzing the Metrics
Optimizing the cash conversion cycle can improve the income statement and balance sheet. Companies should closely monitor their DPO (Days Payable Outstanding), DSO (Days Sales Outstanding), and other variables to understand their cash flow dynamics and direction. These metrics should also be subject to competitive and industry analysis. Companies need to be aware of what others in their industry or similarly sized companies are doing, particularly regarding how they manage their global operations. This analysis can provide valuable insights into the business’s strategies and potential improvements. From these insights, a strategic approach to payables and receivables can unlock hidden cash.
The Need for Supply Chain Finance
In recent years, there has been a shift in payment terms between buyers and suppliers. For instance, terms that used to be net 15—meaning payment is due 15 days after the invoice—now extend to net 30, 45, or even 60 days. This trend is more common with larger companies, who have the leverage to impose longer payment terms on their suppliers. As a result, suppliers may face cash flow challenges and lack the capital needed to fulfill orders. Without sufficient working capital, suppliers may struggle to produce the goods required by their buyers or even meet payroll obligations. In these situations, rather than waiting 60 days for payment, a supplier might seek ways to accelerate the receivable. Likewise, a key area of focus for buyers in managing working capital is improving their DPO, essentially negotiating extended payment terms in order to hold onto cash longer. However, this must not negatively impact their supply chain or supplier relationships.
One way to address this challenge is by leveraging a bank’s supply chain finance (SCF) program. Fundamentally, supply chain finance is an evolution of traditional trade financing methods, like letters of credit, which have been used for centuries. However, supply chain finance has emerged as a viable solution in the last 25 years, gaining significant traction, especially after the financial crisis of 2008-2009. Today it is widely viewed as having the best efficacy at extending DPOs vs other alternatives.
Through a supply chain finance program, once a buyer approves an invoice, the enrolled supplier has the option to sell its receivables at a discount much earlier in the payment cycle. This allows supplier to bridge the gap between the buyer’s working capital goals and their own need for cash. For example, if the buyer approves the invoice on day 10 of a 60-day cycle, the bank can purchase the receivable and provide the supplier with payment at a discount, effectively advancing payment 50 days earlier than the original maturity date.
For many suppliers, especially small-to-mid-sized ones, this accelerated payment can make a significant difference, helping them operate more efficiently and maintain steady growth. For the buyer, it allows them to manage their cash flow without disrupting the supply chain—a win-win scenario for all parties involved.
Supply Chain Finance and Interest Rates
Another benefit for the supplier is the cost-effective discount rate. Smaller suppliers often encounter significantly higher borrowing costs compared to larger, more creditworthy companies. For example, a smaller supplier may struggle to secure financing at affordable rates, whereas a large corporate buyer with a strong credit rating can access funding at a much lower cost. Supply chain finance allows suppliers to leverage the corporate buyer’s credit profile to obtain financing at a much more favorable rate. This can result in significant savings for the supplier compared to what they would pay if they sought funding directly from their bank.
SCF is advantageous when considering the broader economic environment, interest rates, and the cost of capital. In a rising rate environment, the cost of goods, currency risk, and capital flow can all be affected. Despite these pressures, the flexibility offered by supply chain finance remains valuable. Even in periods of higher interest rates, suppliers find supply chain finance advantageous because they can leverage their buyers’ creditworthiness to access cheaper financing. This flexibility and the ability to quickly access cash—especially at month-end, quarter-end, or year-end—make it an attractive solution, even when rates are elevated.
Flexibility in Discounting
Suppliers remain interested in SCF during rising interest rates. When suppliers enroll in these programs, they typically have three options: automatic discounting, where any approved invoice from a buyer is immediately discounted and paid to the supplier; manual or selective discounting, where suppliers can decide on a case-by-case basis which invoices they want to discount; and scheduled discounting, where suppliers set a calendar for when their receivables will be discounted, often aligning with month- or quarter-end activities. When interest rates were lower, most suppliers (more than 90%) chose automatic discounting. However, as rates increased, many investment grade suppliers started opting more for selective or scheduled discounting, seeking more control over when funds were disbursed.
In summary, small to mid-sized suppliers often face higher borrowing costs due to their lower credit ratings. In contrast, larger companies can borrow at more competitive rates, due to their higher level of creditworthiness. By leveraging supply chain finance, these suppliers can essentially “arbitrage” the difference in borrowing costs, using the cost-effective discount rate that is tied to the credit profile of their corporate buyer to manage their cash flow more efficiently.
Trade finance continues to be the driving force behind the entire ecosystem of global trade and supply chains, and its importance varies depending on the size and maturity of the business. Understanding trade finance is crucial for those in smaller startups, mid-sized companies, or large multinational corporations because it drives business operations and sustains supply chains.