In the aftermath of the pandemic and its aftershocks, small and medium-sized businesses have been facing difficulties collecting their payment dues and maintaining liquidity as cash trickles in after the 30-day or 60-day period. The slack in cash flow has badly affected their ability to shore up critical raw materials and spare parts to manufacture new products.
Fortunately, many small companies in India have found relief in Supply Chain Finance (SCF)- a new credit financing solution that ensures consistent cash flow for working capital and long-term growth. What is SCF, and how does it benefit small businesses? Read on for in-depth insights into this topic.
Supply Chain Finance: A Blessing For Cash-Strapped SMBs
By definition, Supply Chain Finance (SCF) is a set of solutions that allows buyers and suppliers to optimise their working capital by speeding up cash flow. Also known as reverse factoring or supplier finance, SCF is set up by the buyer instead of the supplier, which is the case in most business finance transactions. Based on the buyer’s credit rating, suppliers can also gain access to SCF at lower costs than traditional banking institutions.
Supply chain finance may superficially appear similar to traditional finance but has evolved since its beginnings. Unlike conventional financing methods, SCF uses third-party funds or platform-aided solutions to open a trade account between buyers and sellers who already enjoy well-established relationships.
Two distinct but interconnected supply chains drive all commercial activities:
Physical supply chains
Financial supply chains
It involves cash flow from customers back to raw material suppliers and runs counterclockwise to the physical supply chain.
Generally, SCF is used by large buyers to cover supplier financing. However, since the pandemic, SCF has served as a timely blessing for SMEs hoping to bypass the limitations of traditional banking institutions. Once they forge a supply chain financing arrangement with a reliable lender, they can acquire the raw materials and goods because the relationship itself assesses their creditworthiness.
In this scenario, supply chain financing professionals also opt for other financing methods to help SMEs with better cash flow. Here’s a compilation:
Financing Options Gaining Popularity with SMEs
It is a funding option where both buyers and suppliers transact on a platform run by banks or fintech organisations. Money is lent on buyer-approved invoices.
In this option, buyers and suppliers strike a deal on a fintech-backed or independent platform to negotiate invoice discounts and payment terms. There is no third-party funder involvement.
To secure fast funding, companies discount their receivables, all or in part, to their finance provider.
A bank or factoring house pays seventy per cent to ninety per cent of outstanding invoices in advance, and the remainder is paid upon payment, excluding fees. SMEs use factoring to establish creditworthiness for long and short terms.
Forfaiting is the exchange of receivables for cash without a claim for recovery. In other words, financial institutions lend money in exchange for promissory notes or invoices guaranteed by the buyer’s financial institution. Forfaiting transactions are typically high-valued.
Financing of payables
Various banks offer sellers discounts and financing fees for unpaid invoices, which the bank can pay before their due dates.
Distributors receive funds for protecting liquidity and covering the costs of the goods they will resell until clients or retailers generate receivables.
Understanding How Supply Chain Finance Works
Supply Chain Finance is a series of steps involving the buyer, the SCF provider (like banks and other financial institutions), and the buyer. Here’s what happens when the process is up and running:
- The buyer (the SME) signs a deal with the SCF provider, who will cover the costs it owes to the supplier.
- Next, the buyer contacts the seller or supplier to place an order for goods.
- The supplier delivers the goods, and the buyer agrees to make the balance payment between thirty days to six months.
- The supplier sends an invoice to the SCF provider for the goods dispatched to the buyer.
- Based on the risk incurred, SCF providers pay the money with a discount.
- The buyer pays the SCF provider on or before the specified time.
SCF is a simple, win-win process for everyone involved. The process is gaining immense popularity because of its many benefits, which we have listed below.
The Top 7 Benefits of Supply Chain Finance
- SCF boosts liquidity, especially when the buying company is short of working capital and is pressured with account payables. SCF injects timely cash flow and helps the buyer refocus on the business.
- Unlike traditional banking, SCF does not require collateral for securing the funding because the pending bill serves as surety for releasing the money.
- The interest rates are significantly lower than traditional banking rates, making SCF a more sustainable financing option.
- An SCF permits large companies to take advantage of their relatively higher credit ratings to provide credit to SMEs.
- SCF provides strategic flexibility for SME buyers to source products at lower rates. Sometimes, suppliers may offer cash discounts for timely payment. With SCF, the buyer can avail of these discounts and improve their margins.
- SCF fuels the business cycle for SMEs and allows them to seize better opportunities.
- Supply chain finance is critical in restoring lender confidence leading to increased credit volumes and growth.
Despite all these benefits, SCF, like many other financial solutions, has several drawbacks. SMEs banking on the promises of Supply Chain Finance ought to be aware of the flipside before taking the plunge.
Challenges & Risks Of Supply Chain Finance: Why SMEs Need to Tread with Caution
Let’s look at the SCF provider’s perspective to understand the risks involved in this funding solution.
The SCF’s financial institution bears the transactional risk of funding the buyer or the SME. They require accurate and complete information to ensure risk-free funding to stay on the safer side.
On the other hand, buyers also need transparency in expenses to plan their ease of liquid cash and repay the lender without disrupting their finances or jeopardising their ties with the lenders and suppliers. In short, SCF is a delicate balancing act where the significant risk lies between the lender and the buyer.
Transitioning to digitisation with new APIs, automation tools and lending practices remains another major challenge for SCF still relies on manual methods. It’s also time for SCF to get a makeover with their accounting practices.
Regardless of how supply chain finance evolves in the coming years, it will likely remain an attractive option for SMEs seeking flexibility, speed, and resiliency. So, SMEs should weigh the pros and cons of SCF and leverage this funding option to improve their cash flow management.
The MSMEBlog provides expert solutions and guidance for financing small and medium-sized businesses. Visit https://www.msmeblog.com/ for more information on MSME finance.