TMI ING Guide to Financial Supply Chain Optimisation 29. Creating Opportunities for Competitive Advantage. Section Four: Supply Chain Finance

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1 TMI171 ING info pat :Info pat.qxt 19/12/ :02 Page 29 ING Guide to Financia Suppy Chain Optimisation Creating Opportunities for Competitive Advantage Section Four: Suppy Chain Finance Introduction Gregory Cronie, Head Saes, Payments and Cash Management, ING In the ast edition of TMI, we expored the eements, which comprise the financia suppy chain. We ooked in some detai at the order-to-cash (receivabes) and purchaseto-pay (payabes) processes and how these can be optimised to create interna efficiencies, reducing the number of cash days for a company and therefore working capita requirements. The benefits of automating interna processes are not restricted to interna efficiencies. Reducing the working capita requirement enhances the baance sheet and reduces the need for short term borrowing, improving financia ratios and therefore increasing the abiity to obtain financing for more strategic purposes. Furthermore, once a company has achieved good visibiity over their order-tocash and purchase-to-pay processes, particuary the former, receivabes at different stages in their ife cyce, incuding purchase orders and invoices, can be used as a source of financing. With risk pricing very high for many corporates, and demand for credit vasty exceeding suppy, particuary for ower-rated firms, tapping into the financia suppy chain is an increasingy important means of sourcing finance. At ING, we have over 40 years experience of providing both pre- and post- shipment financing to corporates of a sizes and industries. One of the important distinguishing factors of our financing services is that we assess our cients not just on their past, but on their future too is ikey to be a difficut year for virtuay every organisation, which coud further damage corporates abiity to raise finance. However, at ING, we recognise the chaenging environment in which every company is operating and ook at their strategy and prospects as we as recent and onger term performance. In consequence, suppy chain financing with a financia partner that has the vision and baance sheet to support a company over the ong term coud mean the difference between success and faiure during the months ahead. In this section of the Guide, we expain some of the different ways of unocking vaue from the financia suppy chain and how they can contribute to an appropriate and fexibe financing strategy. In addition, we ook at some of the new and evoving opportunities for suppy chain financing Types of Suppy Chain Finance The term suppy chain finance itsef is used in various ways within the industry and can be used to describe: Asset-based Financing The process of using the assets created through the suppy chain to unock working capita. This can take various forms, such as seing receivabes at a discount to a financia institution or using different stages in the With risk pricing very high for many corporates, and demand for credit vasty exceeding suppy, particuary for ower-rated firms, tapping into the financia suppy chain is an increasingy important means of sourcing finance. TMI ING Guide to Financia Suppy Chain Optimisation 29

2 TMI171 ING info pat :Info pat.qxt 19/12/ :02 Page 30 Fig 1: Traditiona and Innovative Approaches to Suppy Chain Financing Source: ING suppy chain, such as purchase orders, receivabes or inventory as assets for oan coatera. Buyer-Led Financing Financing provided by arge buyers to their smaer suppiers, working with a financia institution to everage the buyer s credit standing to enabe suppiers to be paid earier, supporting suppiers and therefore enhancing the stabiity of the financia suppy chain. It is this type of financing that we wi refer to as Suppy Chain Financing or SCF during this section of the Guide. Suppier-Led Financing Financing provided by arge suppiers to their smaer customers, working with a financia institution to everage the suppier s credit standing to enabe customers to access more favourabe payment terms, whist not jeopardising the suppier s working capita. In this way, suppiers can encourage customer oyaty and create competitive advantage. Asset-based financing inked to the physica suppy chain is not a new concept. As iustrated in fig 1, there are a variety of traditiona techniques for accessing finance both pre- and post-shipment, of which inventory financing, factoring and invoice discounting are we-estabished methods. However, with the deveopment of ecommerce, which is having an increasing impact on processes in the financia suppy chain, such as einvoicing, there are increasing opportunities avaiabe for suppy chain financing, particuary in buyer-ed financing as we sha expain ater in this section. Asset-based Financing: Traditiona Mode Factoring Factoring, or accounts receivabe financing, is a we-estabished method of business financing, traditionay used by companies with a ower credit rating. Increasingy, however, we are seeing customers across a wide spectrum of credit quaity seeking accounts receivabe financing as a fexibe means of maintaining working capita without affecting capita ratios. Factoring is seer-ed i.e. the company which has provided the goods/services and is awaiting payment decides to enter into a financing arrangement with a financia institution. Rather than waiting for the due date for payment, which may then be ate or the timing unpredictabe, the company may seek to receive the amount due earier, which they pay for in the form of a discount to the receivabe. This improves the firm s abiity to forecast cash fow accuratey so they can manage their working capita requirements more effectivey. Unike a oan, where the assessment is based on the company s credit status, factoring invoves the direct purchase of the firm s receivabes. Therefore, it is based on the vaue of the receivabes, as a financia asset, rather than the company s credit worthiness. Typicay, companies can factor between 70% and 90% of the vaue of their receivabes, according to criteria such as the percentage of non-payment of invoices etc. Unike borrowings, which are subject to a credit imit, the amount avaiabe to a firm through a factoring arrangement varies according to the vaue of receivabes due. There are ways of increasing the proportion of receivabes which can be factored, incuding outsourcing credit management to a speciaist provider such as ING Commercia Finance. A typica factoring arrangement takes pace as described in Fig 2 beow. In some cases, specific arge invoices are factored, or invoices due from one or more specific customers; however, in most instances, companies aim to factor a arge proportion of their receivabes. Usuay, but not aways, customers are notified of the sae of the receivabe, and amounts are then paid directy to the financia institution (factor), but this is not aways the case. For exampe, ING Commercia Finance has a confidentia arrangement in which customers are not made aware that the invoices are being sod to a financing company. Invoices are coected into the company s account as usua and then debited or paid on to ING. As the financia institution takes on the risk of non-payment by customers, 30 TMI ING Guide to Financia Suppy Chain Optimisation

3 TMI171 ING info pat :Info pat.qxt 19/12/ :02 Page 31 factoring can prove a reativey expensive financing option for some companies where they do not have a record of payments from reguar, reiabe customers. However, credit insurance can mitigate this risk and therefore reduce the cost of factoring programmes. Athough credit insurance has a cost, in the form of a premium, many companies find that the reduction in the cost of the factoring programme more than compensates for the cost of taking out the credit insurance. Fig 2: Typica Factoring Arrangement Invoice Discounting In many respects, invoice discounting cosey resembes the factoring process. However, there is an important distinction to be made: whie factoring is non-recourse financing i.e. the rights and risks associated with the invoices are passed to the buyer, invoice discounting is a secured borrowing where the invoice vaue is used as coatera i.e. the company utimatey takes responsibe for payment by its customers as opposed the financia institution. Consequenty, invoice discounting can be a more economica option for companies ooking to enhance their working capita, as they are not paying the bank to take on the credit risk. Again, credit insurance can reduce the risk of non-payment by customers for many companies. Inventory/Asset Based Financing Aongside accounts receivabe financing programmes such as factoring or invoice discounting, companies can increase the amount of cash avaiabe by borrowing against assets such as inventory, and in some cases pant and machinery, and and buidings. Purchase Financing Purchase financing is a fexibe form of financing suited to companies that have strong seasona peaks in both procurement and saes. For companies that may need to pay for orders in advance, purchase financing offers a form of bridging oan, covering the period between procurement of inputs and sae of outputs. Purchase financing can be combined with a Letter of Credit, and affects a company s credit utiisation far ess than an unsecured oan as the stock is used as coatera. New Demands for Financing The techniques described above can be very hepfu for companies which are ooking to acceerate cash fow and use their financia assets for oan coatera. With traditiona forms of financing becoming ess easiy accessibe and more expensive, these types of financing soutions can be extremey vauabe in maintaining working capita eves. Addressing imbaances in the Financia Suppy Chain However, as we saw in the previous section of the Guide, the financia suppy chain does not simpy refer to the financia processes which take pace within the company, but extends to suppiers at one end of the chain, and customers at the other. In many cases, there wi aso be a variety of other payers such as distributors, which aso fufi an essentia roe in the suppy chain. Whie a firm may be everaging their assets very successfuy to optimise working capita internay, treasurers and CFOs aso need to recognise that their suppiers, customers and distributors may: Source: Asymmetric Soutions Ltd be experiencing simiar pressures on cash fow; and be in a weaker position to obtain financing. This creates instabiity for both buyers and seers. In the case of buyers, there is the risk of interruption to essentia suppies, which coud jeopardise the company s own production, distribution to customers and therefore customer satisfaction. For seers, revenues and working capita coud be put at risk, and cash fow tied up in surpus inventory. However, despite the importance of shoring up the financia suppy chain, corporates do not want to become a bank to the partners in their suppy chain. Consequenty, companies with a stronger credit rating are increasingy seeking to work with a financia institution to find ways of everaging their credit rating to provide more favourabe terms to their customers and suppiers, thereby enhancing the stabiity of their suppy chain. Coaboration in the Financia Suppy Chain Another way in which financing within the suppy chain is changing is in response to the evoution in technoogy. Many firms have highy sophisticated technoogy, such as ERP appications, which cosey aign the physica TMI ING Guide to Financia Suppy Chain Optimisation 31

4 TMI171 ING info pat :Info pat.qxt 19/12/ :02 Page 32 Fig 3: SCF in Practice Source: ING and financia suppy chain. Furthermore, with the continued expansion of ecommerce, companies are increasingy demanding webbased appications, which aow greater coaboration between parties to a financia transaction. For exampe, as we described in the previous section of the Guide, einvoicing enabes a common version of information to be imported/exported into both buyers and seers systems and manua processing or paper invoices is substantiay reduced. This same objective: to work more coaborativey to promote a common view of information and better integrate this information into each party s interna systems aso extends to financing. Consequenty, we see the deveopment of initiatives where financing is triggered by events in the physica and suppy chain, as iustrated in the ower part of fig 1. This requires the use of technoogy patforms accessed by buyers/seers and financia institutions to ensure the timey, consistent and automated processing of transactions. A New Era of Financing Suppy Chain Financing (SCF) These new demands are eading to innovations in suppy chain financing, which we beieve is just the start of a transformation in...with the continued expansion of ecommerce, companies are increasingy demanding web-based appications, which aow greater coaboration between parties to a financia transaction. the way that such financing takes pace. In this section of the Guide, we wi focus mosty on buyer-ed financing which we beieve offers the most significant opportunities. Unike traditiona factoring, this type of financing, which we are describing as Suppy Chain Financing or SCF, is ed by buyers (customers) rather than seers (suppiers) athough there are benefits to both. It invoves buyers offering financing and information reconciiation services to key suppiers based on approved invoices. Buyers, suppiers and the financia institution are connected through a centra technoogy patform to faciitate invoice and credit note reconciiation, invoice trading and settement between the parties. SCF can aso be described as reverse factoring, which is a famiiar financing mechanism; however, whie reverse factoring coud be paper-based, SCF reies on automated business processes such as reconciiation, einvoicing and payment and uses a centra technoogy patform. An exampe SCF process is shown in fig 3. The main difference between SCF and factoring is that the financia institution s risk is concentrated in a singe buyer, as opposed to one seer and many buyers. This is an 32 TMI ING Guide to Financia Suppy Chain Optimisation

5 TMI171 ING info pat :Info pat.qxt 19/12/ :02 Page 33 important distinction in the way that risk is priced, and therefore the feasibiity of such a soution for companies ooking to strengthen their financia suppy chain. Benefits of SCF for Buyers The primary benefits for buyers incude working capita efficiency, suppy chain stabiity, ower cost of capita and the abiity to focus on core skis, as foows: SCF creates a true win-win for a the parties invoved and therefore coud be considered the biggest financia innovation since the invention of the L/C. Within the context of the current market conditions, SCF may be one of the most attractive toos for companies to diversify funding basis, enrich and soidify their reationships with suppiers and their core banks. Michie Steeman, Head of Internationa Business, Commercia Finance, ING Working capita and free cash fow improvements Longer payment period eading to greater working capita fexibiity; Reduction in the cost of goods by negotiating higher discounts; Effective contro over the financia input cost of the suppy chain; Diversification of sources of funding to add strength and fexibiity in the suppy chain. Suppy chain stabiity Better coaboration and partnership with suppiers, and harmonised ways of doing business Cost savings Reduction of Invoice settement costs and number/cost of payments Focus on core skis The financia institution acts as an externa payments manager, aowing buyers to focus on their core business. Benefits of SCF for Seers Seers benefit primariy from access to capita and cash fow certainty: Additiona access to capita Diversification of funding sources, particuary in the current environment where enders are cautious, funding is scarce and costs can be high; Fexibe invoice management and financing service. Rate arbitrage Favourabe SCF rate compared with aternative financing options, which may be avaiabe. Transparency and cash fow certainty Create visibiity and improve status transparency of receivabes; Quicker resoution of payment disputes and easier reconciiation; Improved cash fow forecasting and baance sheet management. Off baance-sheet benefits Sae of receivabes, converting these to cash, potentiay improving credit standing. Additiona savings on costs and fees Automated payment processes; No commitment fees or audit fees; On-demand financing without minimum commitment; abiity to match tenor and amount to exact need; Focus on core skis Cash fow certainty and increased transparency of the suppy chain heps companies focus on their core business activities and enabes them to pan their strategy with greater confidence. Win-Win for Buyers and Seers Many soutions caim to provide equivaent benefits for both buyers and seers, but SCF has substantia potentia to enhance cash fow and DPO for buyers and improve cash fow and finance costs for suppiers. In situations where buyers are heaviy reiant on key suppiers, SCF is an attractive financia too to create an incentive for partnership. Furthermore, there is an even greater need for coaboration in ow-margin sectors. SCF creates the opportunity for arge corporate buyers to extend their payment terms or seek better pricing, but without detriment to their suppiers. Suppiers wecome the additiona credit as it generay does not compromise the credit which may aso be avaiabe from their existing banks. Lengthening payment terms is often considered desirabe by buyers, but it can be damaging to suppier reationships and jeopardises suppiers financia stabiity. Average payment terms differ between countries and are generay onger for southern European countries than in Northern Europe. In Spain, a version of SCF, known as confirming, has been avaiabe since the eary 1990 s, which enabes suppiers to receive eary payment whie buyers can continue to benefit from ong payment terms, often more than 180 days. SCF is now more widey avaiabe, athough it is not currenty used by the majority of companies. Those that take the opportunity to impement SCF are in a position to gain competitive advantage through more secure suppy chains, better reationships with business partners and stronger baance sheets. Fig 4 provides an iustration of a potentia SCF soution in practice. SCF in Practice Costs of SCF SCF is generay set up without cost to the buyer, so ong as the voumes are sufficient. Instead, costs are paid by suppiers, which coud incude: Set-up fees and structuring costs Reguatory costs e.g. stamp duty and/or withhoding taxes where appicabe TMI ING Guide to Financia Suppy Chain Optimisation 33

6 TMI171 ING info pat :Info pat.qxt 19/12/ :02 Page 34 Risk premium for credit risk Operationa fees (potentia discount offered to buyer) Management time However, as the iustration shows, these costs are generay more than offset by improved financing terms, making an SCF arrangement highy beneficia for suppiers. Lega and Accounting Issues There are various issues to be taken into account when setting up an SCF programme and companies shoud seek expert advice from the beginning. Many SCF soutions, which have been operationa for some time, shoud be reviewed in ine with IFRS and US GAAP requirements to avoid possibe negative accounting issues. For suppiers, in order that the receivabes are derecognised as assets, it needs to be cear that the credit risk has transferred to the financia institution. If the financing is non-recourse i.e. the bank has no recourse to the suppier in case of non-payment by a customer, the asset is derecognised and therefore constitutes off-baance sheet funding. However, companies may have to report under different accounting principes where the requirements may vary. As a genera principe, the position of the financia institution in the SCF arrangement cannot differ from the rights of the origina creditors i.e. the suppiers. Any additiona improvement, such as: corporate guarantees; unti further notice causes; A direct contract of the buyer with the bank, indicating a commitment (i.e. buyer is not at arms-ength) or committed faciities is ikey to resut in recassification from off-baance sheet financing to bank debt. Recassification ceary has an adverse impact on debt ratios and coud trigger critica covenants in existing oan docu- Fig 4: SCF Iustration Key Data: Spend Amount 50m Suppier s Cost of Funds 9.03% (S&P BB-) SCF Rate 6.16% (based on buyer s rating) Origina Payment Terms 60 days net Extended Payment Terms 80 days net Buyer s resuts Better/(worse) Suppier s resuts Better/(worse) Cash fow Cash fow DPO Cash fow Finance fees Option 1 Option 2 Option 3 SCF? For buyers, the primary cash fow benefit resuts from extending the term from 60 to 80 days, resuting in an improvement of 2.7m (options 2 and 3). However, for suppiers, the primary benefit is in the SCF programme itsef (options 1 and 3). Extending the payment term without the SCF means that the suppier carries the fu cost from which the buyer has benefited i.e. 2.7m Consequenty, from a cash fow perspective, the win win is achieved by extending the term in conjunction with the SCF programme (option 3). Finance fees The worst scenario for the suppier is option two, with the term extension but without the effects of the SCF. Fees paid by the suppier are 20 days x 9.03% (20/365 x 9.03% x 50m) = 247m. However, under a SCF arrangement, and eary payment to the suppier on day 5 (option 1 above) the finance fee improves for the suppier for the remaining 55 day period, as the suppier benefits from finance costs of 6.16% rather than 9.03%. Therefore, the benefit is 55/365 x 2.87% = 216k. Under option 3, the vaue of eary receipt of cash fow under an SCF arrangement with an extended term means that the finance fee is more than offset, resuting in a potentia profit for the suppier of 47k m 216k Term ext? SCF? 2.7m 20 ( 2.7m) (247k) Term ext? SCF? days days 2.7m m 47k There are various issues to be taken into account when setting up an SCF programme and companies shoud seek expert advice from the outset. Term ext? Source: ING 34 TMI ING Guide to Financia Suppy Chain Optimisation

7 TMI171 ING info pat :Info pat.qxt 19/12/ :02 Page 35 mentation. Companies need to review restrictive covenants in pace with their existing banks end ensure that they have the right to enter into SCF arrangements. Bank Issues Financia institutions providing SCF services are ceary most concerned with buyer-reated risk. For exampe, the jurisdiction in which the buyer is ocated needs to be stabe, such as an OECD country. Some of the specific risks a bank wi consider incude: How to enforce buyer obigations to pay irrevocaby the payments processed through the SCF structure; In case of the buyer s insovency, the bank needs to be recognized as a creditor. In the event of fraud and in certain jurisdictions, there is a cawback risk. For exampe, matured receivabes paid by the buyer may be reversed by a receiver in the case of bankruptcy during the suspect and caw back period in case of fraud. Inter-departmenta Reationships SCF reies on significant interaction between departments, particuary procurement and finance. In many organizations it is that individua departments have evoved more-or-ess independenty, so there is often too itte integration of information fows. Whie processes within a department are frequenty highy efficient, there has been ess focus on the automation or timeiness of data transfer between departments. Deaing with this issue requires significant management attention and potentiay investment in technoogy and business processes. Technoogy Most patforms today are web-based, providing an easy-to-use, ow cost interface for both buyer and suppiers in an SCF programme with itte additiona hardware or software requirement. When first starting to use such a patform, it can take a short time for users to become famiiar with it, and initiay, the number of exceptions may be reativey high, but this is ikey to be resoved over time. In some cases, the patform wi be configured according to the specific nature of the SCF programme. For exampe: Currenty, SCF is based on approved invoices. ING expects an evoution towards a common standard for patform technoogy. Once widespread impementation has been reaised, additiona suppy chain activities can take pace such as routing of invoices and e-invoice presentment. SCF can then evove towards earier stages of the post-shipment phase and even the pre-shipment phase of the goods manufacturing and goods payment cyce. Ad van der Poe, Head of E-Business, Payments & Cash Management Option to make some currencies ineigibe; Abiity to net credit notes against unfunded invoices, reducing operationa risk and reconciiation time; Abiity to operate as a purchase edger system, taking a of a buyer s invoices rather than just the suppiers participating; Integration of sourcing and procurement i.e physica suppy chain appications; Digitising paper documents. When setting up an SCF programme, the technoogy patform as we as financing arrangement is important to encourage suppiers to make use of the technoogy. In Part Three... In the fina section of this Guide, pubished in the next edition of TMI, we ook at some of the considerations when designing a successfu strategy for financia suppy chain optimisation. We ook at issues such as seecting a banking partner, deveoping a business case and some of the issues, which wi affect the way, in which optimisation programs are set up, such as SEPA and connectivity issues. Concusion Suppy Chain Finance has sti not yet been everaged to its greatest potentia by many organisations; however with traditiona debt forms of financing becoming more expensive and ess accessibe, SCF provides significant opportunities for both buyers and suppiers. Technoogy wi pay an increasingy important roe in the deivery of effective SCF soutions, both to automate the exchange of information between buyers, seers and financia institutions, but aso to integrate the financia and physica suppy chains. In this way, not ony can financia counterparties share a common view of information and import/export data easiy to/from their systems, but events in the physica suppy of goods can trigger financing events. This eads to more efficient, timey financing, specificay adapted to the needs of each organisation. Currenty, SCF offerings are based on invoices approved by buyers. In the future, we anticipate that such soutions wi be made avaiabe earier in the financia suppy chain, towards the time of the purchase order. n If you have any queries, pease contact: Michie Steeman Head of Internationa Business Commercia Finance ING Whoesae Banking michie.steeman@ingcomfin.com TMI ING Guide to Financia Suppy Chain Optimisation 35