How To Manage A Financial Supply Chain

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2 ICR (2011) 10:32 44 DOI /s ICR 2011 Published online: 8 March Financing the Chain Ralf W. Seifert seifert@imd.ch Lausanne, Switzerland Daniel Seifert daniel_seifert@mckinsey.com Berlin, Germany We know good supply chain management produces competitive advantage. But lack of coordination on financial management can limit it. A new strategy on trade credit is needed. Is reverse factoring the answer? VOLUME 10 N 1 SPRING 2011

3 34 FINANCING THE CHAIN Supply chain management is widely accepted as a way of gaining competitive advantage. Carmaker Toyota, for example, outpaces rivals by mastering product flows. In a peer group of Nissan, Honda, Ford, Chrysler and General Motors, Toyota boasts the lowest inventory costs, lowest defects per vehicle, and highest pre-tax returns. Its suppliers excel, too. Toyota s network creates outstanding value by, among other things, maintaining higher levels of equipment specificity, worker Ralf W. Seifert is Professor of Operations Management at IMD and directs the Chair of Technology & Operations Management at the Swiss Federal Institute of Technology in Lausanne (EPFL). This article summarizes the key results of Daniel Seifert s dissertation at the Swiss Federal Institute of Technology in Lausanne (EPFL). Daniel is now a Senior Associate at McKinsey s Berlin office. multi-skilling, and geographic co-location (Dyer, 1996). Convenience-store chain Seven- Eleven Japan is similarly successful, using information flows to outclass its competitors. Real-time systems track sales and customer data at every store to detect changes in consumer preferences. Satellite connections link stores to warehouses, suppliers and logistics providers, and information exchanges enable inventory to be re-allocated between stores, and shelves to be reconfigured, frequently. The result is a share price performance surpassing even Dell Computer (Lee, 2004). Established success stories involving financial flows are conspicuously absent, however. The reason may be the relative novelty of coordinating financial decisions across firms. Unilever, for example, long urged its suppliers to reduce working capital. Reacting to the pressure, suppliers pushed working capital on to other suppliers, some of which were in fact Unilever subsidiaries. Recently, however, the company realized its subsidiaries often had better access to capital than its independent suppliers. It is now encouraging working capital re-allocation between suppliers and even works with its banks to ensure suppliers access credit at Unilever rates. The result is an overall working capital reduction by about 40 percent US $2 billion from 2001 to In another recent example, truck maker Volvo launched a central payments platform to connect suppliers and banking partners. Participating suppliers enjoy improved invoice visibility and the option to sell receivables to Volvo s banking partner Nordea. This has improved Volvo s working capital, its supplier relations and service levels, and has propelled the truck maker to the front of financial supply chain management. For most firms, however, business realities look different. When we recently polled companies about their financial supply chain management practices, 77 percent said they received less than a third of their invoices electronically. Nevertheless, these companies perceived the use of electronic invoice presentment and payment (EIPP) as a top priority. While 39 percent said they considered their supplier s financial situation during purchasing negotiations, the majority reported that they followed the traditional mantra of cash conversion collect early and pay late. One manager from a global automaker, for example, said his company had recently convinced suppliers to accept payment after 180 days. While such behaviour may be extreme, the fact is that firms have to bear the costs until such time as the customer pays. This financial gap is known as net trade credit, which together with inventory and cash forms the major component of working capital. Working capital is a significant driver of profitability. In an average company, decreasing working capital by 30 percent leads to a 16 percent increase in after-tax returns on invested capital.

4 FINANCING THE CHAIN 35 No change on payment times Lead times Payment times Days inventory Days receivable Days payable Figure 1: Working capital over time. Deutsche Post, for example, announced a programme to reduce working capital by 700 million. Others, such as Tesco, have managed to push trade credit below zero by getting paid by their customers before they have to pay their suppliers. So it is hardly surprising that the traditional view has been to reduce working capital. Indeed, there have been plenty of recent major initiatives. Deutsche Post, for example, announced for 2008 a programme to reduce working capital by 700 million. Others, such as Tesco, have managed to push trade credit below zero by getting paid by their customers before they have to pay their suppliers. Yet, taking the US economy as a whole, companies seem to have paid more attention to inventory than to trade credit. While lead times have been continuously cut, payment times have essentially remained flat (Figure 1). Shouldn t all suppliers be squeezed? It is questionable whether an all-encompassing squeeze is the right approach. First, payment processes and times differ vastly between countries, industries and even companies. And the rationale for these differences has only partially been understood. A comparison of accounting data of industrialized nations shows that median accounts receivable ranged from 14 percent to 33 percent of sales in With the exception of Italy, these levels were stable over time. Moreover, trade credit varies across industries. US data suggest that relative accounts receivable and payable increase the further upstream they are in the supply chain that is, the further away they are from the end consumer (Table 1). While it seems firms generally adhere to industry norms, there is evidence they vary credit terms from customer to customer. One of the roughly VOLUME 10 N 1 SPRING 2011

5 36 FINANCING THE CHAIN Sector Retail Wholesale Transportation Agriculture Manufacturing Construction Services Mining Table 1: Trade credit across industries managers whom we interviewed for this article volunteered: When we began [our project] last year, we discovered we had over 1,000 different credit terms globally! This is not an isolated case. In many The arguments from both sides Supply-side theory Competitive pressure Credit information Price discrimination Demand-side theory Transaction pooling Control protection Credit rationing How the sectors compare Days Sales Outstanding Median Table 2: Main trade credit theories. IQR Days Payable Outstanding instances, firms accumulate payment terms as they add supply chain partners and do not consolidate them regularly. Median IQR Financial researchers have extensively investigated these differ ences and developed theories as to why companies offer trade credit. Some of the most prominent reasons are competitive pressure, credit information and price discrimination on the supply side, and transaction pooling, control protection and credit rationing on the demand side (Table 2). Credit rationing in particular appears to be a strong argument against uniformly reducing credit. Because some customers may be more credit constrained than others, trade credit may represent a greater purchasing incentive than an equivalent price reduction. Description Firms have to offer trade credit because their competitors do so Firms have better information on buyers than banks Firms use trade credit when direct price discrimination is prohibited Description Buyers demand trade credit to pool payments and reduce cash balances Buyers prefer trade rather than bank credit because suppliers are less likely to liquidate Buyers cannot obtain bank finance and therefore turn to suppliers Also, trade credit impacts supply chain relations, and managing it aggressively might damage these relations. In pressing suppliers for cost reductions and treating them more as adversaries than trusted partners, General Motors and Ford, for example, have consistently lost ground in Planning Perspective s Working Relations Index over the past few years and with it, market share. Companies that antagonize suppliers by paying late not only risk missing

6 FINANCING THE CHAIN 37 The credit choices companies make Adapt strategy based on segmentation of supplier or buyer Win-win 22% Examples Manufacturer: Coordinate payments along chain to reduce supply risk 36% 64% Follow single strategy Follow 56% Retailer: Follow industry average Squeeze 22% Global pharma player: Reduce Days Sales Outstanding, increase Days Payables Outstanding Figure 2: Three trade credit strategies. Note: The results are based on 28 in-depth field interviews. out on innovations and losing capacity, but also risk encountering supply chain disruptions. All of these consequences can have a detrimental effect on the financial bottom line. Publicly traded firms experiencing supply chain disruptions, for example, have reported negative stock market reactions to such announcements, with a decline in market capitalization as high as 10 percent. These stock market reactions are far stronger than for other corporate news. Financial announcements such as share re-purchases, for example, cause abnormal returns of around four percent, while marketing-related announcements such as firm name changes cause abnormal returns of around just one percent (Hendricks and Singhal, 2003). Three trade credit strategies Given these two risks of hurting sales and damaging relations, it seems companies should take a differentiated approach to managing trade credit. And while in-depth interviews indicate that roughly two-thirds of companies still apply a single trade credit strategy (Figure 2), building a strategy portfolio is quite straightforward. Companies that antagonize suppliers by paying late not only risk missing out on innovations and losing capacity. They also risk encountering supply chain disruptions, with a detrimental effect on the bottom line. VOLUME 10 N 1 SPRING 2011

7 38 FINANCING THE CHAIN Three series of questions can help (Figure 3). First, managers should think about what kind of relationship they want to build. Is the supplier a strategic partner? Is the customer a key account? Will this partner be around for more than a year? If there will be repeated, prolonged interactions, companies should take the time to understand their partner s cost of capital and try to create win-win situations. Second, if the relationship is of a more transactional nature, managers should determine their company s competitive position. Are the company s goods or services innovative and unique? Has the company done well in past negotiations? If the answer is no, then there is little margin for actively shaping credit terms. The negotiation should be based on industry-standard terms. Third, even if the company is in a strong position, it should still consider its cost base. What proportion of costs varies with production? If, on the one hand, most costs are fixed, then companies should nevertheless rely on trade credit to entice customers. If, on the other, costs are mostly variable and the company can risk losing the sale, it should minimize its working capital and squeeze. The win-win approach The win-win approach in particular has received much attention at recent treasury conferences. Going beyond the simple adaptation of payment terms, finance professionals have combined financial insights with electronic payment platforms and thus created reverse factoring solutions. Finance professionals have combined financial insights with electronic payment platforms and thus created reverse factoring solutions. The questions to ask Question tree Relationship? Long-term Trade credit strategies Win-win Use trade credit to broker advantageous capital access to supply chain partners or reduce outstanding days to eliminate unnecessary costs Transactional Weak Market position? Strong Capital intensity? High fixed costs Low fixed costs Follow Squeeze Offer industry standard terms to attract customers Use trade credit to attract additional customers once sales slow down Ask customers for direct payment or use discount schemes to speed up payments Negotiate long payment delays with suppliers Figure 3: Credit strategy decision tree.

8 FINANCING THE CHAIN 39 Going into reverse 1 Buyer issues purchase orders to supplier and bank 4 3 Citibank checks documents and notifies buyer Supplier delivers goods and presents documents 2 Buyer accepts Citibank 5 Citibank advises acceptance 7 Citibank debits buyer at due date Electronic platform 6 Supplier requests early payment Figure 4: Example of a reverse factoring process. As the name reveals, reverse factoring solutions are based on factoring a transaction in which suppliers sell receivables to factors for immediate cash. Because the receivables are sold rather than pledged, traditional factoring is different from borrowing there are no liabilities on the suppliers balance sheet 2. Typically, suppliers sell receivables from more than one buyer. Thus, factors have to evaluate buyer portfolios before entering an agreement. This has made factoring an expensive source of finance in emerging markets. A lack of historic credit information or credit bureaux, as well as fraud and weak legal environments, have meant high operating costs. Reverse factoring, however, is different in three important aspects. First, since the technique is buyercentric, factors do not have to evaluate heterogeneous buyer portfolios and can charge lower fees. Second, since these buyers are usually investment grade companies, factors carry less risk and can charge lower interest rates. Third, as the buyers participate, factors obtain better information and can release funds earlier. As a process, reverse factoring is slightly more complicated than traditional factoring. Citibank s process, for example, involves seven steps. First, the buyer sends a purchase order to the supplier and notifies Citibank. Second, the supplier delivers and presents documents to Citibank. Third, Citibank checks the documents and notifies the buyer. Fourth, the buyer approves or rejects. Fifth, Citibank notifies the supplier of the buyer s acceptance. Sixth, if the supplier requests early payment, Citibank credits the supplier s account. Finally, when the invoice is due, Citibank debits the buyer s account (Figure 4). VOLUME 10 N 1 SPRING 2011

9 40 FINANCING THE CHAIN Reverse factoring s positive results Buyers Suppliers % 10 20% 20 30% 30 40% >40% 0 10% 10 20% 20 30% 30 40% >40% Average: 13% Average: 14% Figure 5: Average working capital reduction from reverse factoring. The advantages of this technique are clear. Truck maker Scania, for example, helped its suppliers finance growth when demand surged in Magnus Welander, Head of Cash Management, explained: Our suppliers had difficulties financing the increased demand. The situation was especially tense because Scania didn t encourage traditional factoring. The implementation helped them especially the smaller ones to enjoy unprecedented liquidity levels. Now, they sometimes receive payment after as little as five days. Yet the technique is far from being a mainstream phenomenon. Some companies have hesitated to adopt reverse factoring because it is unclear how much buyers and suppliers really save. Innovators treat their figures confidentially or report numbers that are hard to compare. Additionally, it has not always proved to be a fail-safe solution. Stories about companies failing to implement reverse factoring successfully have left other firms in the dark about what it takes to succeed. What is it worth? In collaboration with Springer and the International Institute for Management Development (IMD), we conducted a worldwide survey of executives who use reverse factoring solutions as buyers (Seifert, 2010). Some companies hesitate to adopt reverse factoring because it is unclear how much buyers and suppliers really save. Innovators treat their figures confidentially or report numbers that are hard to compare.

10 FINANCING THE CHAIN 41 By how much were they able to reduce their working capital? Which approaches to implementing reverse factoring made most sense? The survey s aim was to assess the benefits of reverse factoring, quantitatively and qualitatively, and to derive the key success factors. Our data paint a fairly positive picture. savings of around 16 million (Table 3). This compares with an investment of million in information technology, as suggested by the Aberdeen Group in its Technology Platforms for Supply Chain Finance report (Aberdeen Group, 2007). Even if the savings are lower than suggested by the above business case, the programme should still break even in less than a year. By how much were they able to reduce their working capital? Which approaches to implementing reverse factoring made most sense? The survey s aim was to assess the benefits of reverse factoring, quantitatively and qualitatively, and to derive the key success factors. We received 213 replies from executives in 55 countries, covering all major industries. Of the respondents, 23 reported using a reverse factoring solution. The following analyses are based on their answers. Assets Working capital Annual cost of working capital Annual savings Our data paint a fairly positive picture. The 23 executives using a reverse factoring solution reported an average reduction in working capital of 13 percent (Figure 5). Based on average assets of around 8.5 billion, an assumed working capital ratio of 30 percent and an average cost of capital of five percent, these reductions represent annual How the savings stack up Risk premium Smallest Average (0%) (2%) 8, , , , Table 3: Reverse factoring business case Largest (9%) 8, , Similarly encouraging is the observation that reverse factoring seems to help suppliers too. The same 23 executives report that, on average, their suppliers were able to reduce working capital by 14 percent by participating in reverse factoring. Asked about other VOLUME 10 N 1 SPRING 2011

11 42 FINANCING THE CHAIN benefits, more than half of the respondents 57 percent say that reverse factoring helps standardize payment terms and 52 percent say reverse factoring helps improve supplier relations (Figure 6). Asked how reverse factoring links back to other projects, 68 percent say its implementation improves Purchaseto-Pay processes; 14 percent say it improves Orderto-Cash processes; and 14 percent say it improves Record-to-Report processes. Other benefits attributed to suppliers include more transparency and fewer disputes (65 percent and 52 percent respectively of these respondents). Finally, executives seem to perceive the drawbacks as limited. Thirty percent perceive no drawbacks at all. Of the rest, 44 percent report reduced credit availability, 31 percent report pressure to guarantee payments, and 25 percent report other drawbacks. We found implementations to be more than twice as successful when the CEO rather than CFO leads them. The message is clear although it might be tempting to delegate, CEOs should lead the effort. Three distinguishing factors Given the wide range of outcomes it is legitimate to ask if there are differences in the way businesses implement reverse factoring. What distinguishes a successful from a less successful implementation? Our data reveal three key success factors. How they rated the gains Standardization of payment terms Improvement of supplier relations Reduction of prices Percentage of respondents using reverse factoring solution, n = 23 26% 57% 52% First, the majority of executives 65 percent say the banking partner is a key success factor (Figure 7). Thus, executives should invest sufficient time in selecting a banking partner. Important criteria that we determined during in-depth follow-up Information gain about suppliers finances None Other interviews included the bank s geographic reach, its legal expertise and its financial muscle. Second, roughly half of these respondents 52 percent say internal sponsorship plays an important role. Consistently, we found implementations to be more than twice as successful when the CEO Figure 6: Benefits of reverse factoring. 4% 9% 17% rather than the CFO leads them. The message is clear although it might be tempting to delegate, CEOs should personally lead the effort. Individual departments do not seem to have the required leverage to keep the stakeholders especially suppliers at the table.

12 FINANCING THE CHAIN 43 Finally, some executives (17 percent) stress the need for supplier involvement. Our in-depth interviews suggest companies face difficulties in convincing suppliers to participate in reverse factoring Banking partner Internal sponsorship Other (mostly supplier involvement) IT implementing partner Technology platform Figure 7: Key success factors. What s important? Contrary to our expectations, cross-functional teams do not appear to play a role. Statistically at least, it does not matter which or how many departments a company involves. The most successful implementations involve five departments (finance, Percentage of respondents using reverse factoring solution, n = 23 0% 17% 13% 52% 65% purchasing, supply chain management, IT, legal), but implementations that involve only two departments (finance, purchasing) closely track their performance. This finding is consistent across different lifecycle stages, namely implementation and operation. Outlook Given the attractive benefits and clear key success factors, we recommend executives take a closer look at reverse factoring. It may not solve all liquidity issues that companies face when credit is tight. But it seems a sustainable approach to reducing working capital in the long run. Provided companies focus on the key success factors choosing the right banking partner, ensuring CEO sponsorship, and involving at least 60 percent of the supply base our results suggest they should be able to reduce working capital by 13 percent. programmes. One executive reported that suppliers would rather accept late payment than be involved in a seemingly complicated programme they did not understand. Executives should, therefore, critically assess which suppliers to include in the first wave and which to include in the final roll-out. Our tests suggest implementations are most successful when they include at least 60 percent of the supply base in the first wave. Reverse factoring may not solve all liquidity issues that companies face when credit is tight. But it seems a sustainable approach to reducing working capital in the long run. VOLUME 10 N 1 SPRING 2011

13 44 FINANCING THE CHAIN Although suppliers benefit from similar working capital reductions, they do not enjoy comparable autonomy and access. In today s reverse factoring programmes, suppliers are forced to work with financial institutions designated by the buyer and are rarely eligible to implement reverse factoring solutions of their own. Industry observers therefore predict that reverse factoring solutions will evolve over coming years to create more value for suppliers. Three trends in particular will shape future implementations and the reverse factoring industry: Run a pilot. Select a country and subsidiary, mobilize a team, and measure the improvement (What s the baseline? Which performance metrics?). Admittedly, these steps are only a rough guide and need to be detailed. But they will get companies moving in the right direction. And while today s options of implementing win-win approaches are still sparse, we believe the field of supply chain finance is set to prosper. Buyers will increase the number of financial institutions they work with to allow suppliers to choose from competing lenders; Banks will increasingly use secondary markets to resell receivables and control their exposure to specific buyers; Suppliers will exhibit demand for reverse factoring, too, and cause banks to develop offerings for non-investment grade buyers. Industry observers predict that reverse factoring solutions will evolve over the coming years to create more value for suppliers. Companies should keep in mind that there are other tools in the supply chain finance toolbox. Not only are collaborative solutions not always needed, but there are also other collaborative solutions such as prepayment and consignment inventory. So how should companies get started? We suggest three steps: Clarify organizational responsibilities. Determine who sets and who monitors payments and decide how much these activities should be centralized; Define the strategy. Decide between the single and the portfolio approach and, as the case may be, detail each strategy (How many payment terms? Which negotiation priorities? Which tools?); References - Aberdeen Group, Technology platforms for Supply Chain Finance, Technical report, Aberdeen Group, Jeffrey H. Dyer, Specialized supplier networks as a source of competitive advantage: Evidence from the auto industry, Strategic Management Journal, 17(4), , Kevin B. Hendricks and Vinod R. Singhal, The effect of supply chain glitches on shareholder wealth, Journal of Operations Management, 21(5), , Leora F. Klapper, The role of Reverse Factoring in supplier financing of small and medium sized enterprises, The World Bank, Working Paper, Hau L. Lee, The Triple-A supply chain, Harvard Business Review, 82(10), , Daniel Seifert, Collaborative Working Capital Management in Supply Networks, PhD thesis, Ecole Polytechnique Fédérale de Lausanne, Endnotes 1 DSO is Accounts Receivable / Sales x 365. DPO is Accounts Payable / Sales x 365. IQR is interquartile range (25 th to 75 th percentile). Median is the 50 th percentile. Data are based on financial statements from Compustat. 2 There are, however, variants. Recourse factoring, for example, creates a liability that is contingent upon the buyer s payment. For further information see Klapper, Data are in EUR million and based on the averages of 23 companies using reverse factoring solutions. We assume a working capital ratio of 30% and a risk free rate of 3%.