Innovative forms of purchase and inventory financing

Arno Schneider Executive Director WCF Finetrading GmbH, Munich 10 Arno Schneider WCF Finetrading GmbH Innovative forms of purchase and inventory financing Banks lending has become more restrictive, which is a problem for small and medium-size firms (SMEs) wanting to grow. But there are ways beyond the classical and ever more difficult financing via banks. For suppliers who must tie up a lot of capital in their customers inventory, there is a new option that extends working capital management: Stock trading. This innovative form of inventory and sales financing optimises current assets and balance sheets. As unexpected as the recovery following the financial and economic crisis may have been, German SMEs are today facing a new problem. They frequently don t know how to generate liquidity in the recovery. And it is important to take advantage of the economic upswing which could soon come to an end again. For entrepreneurs there are usually only two alternatives: Either they postpone R&D, expansion and acquisitions or they try the classical way of turning to the banks. 92 Banks are continuing their restrictive lending stance and are likely to remain restrictive especially if the Basel Banking Commission should tighten the equity and liquidity rules as a reflex to the turbulences in the financial sector. Under the header Basel III the new rules will have direct effects on the financing possibilities of SMEs. Credit terms will tighten because the demands on collateral as well as transparency obligations will rise and expand the risk margins. If the plans of the Basel Banking Commission are implemented, credit supply of the savings banks alone will decline by more than 200 billion euros, according to a position paper of the German Savings Banks Association. Especially affected would be the SMEs. Although in the view of the government, the stricter rules for financial institutions are only consistent, for the SMEs with their chronic low equity ratio it averages only 11 to 15 percent this course is risky. Already the problems are threatening the existence of many small firms. On the one hand,

Folker Weise Executive Director WCF Finetrading GmbH, Munich Folker Weise WCF Finetrading GmbH they must provide advance financing of orders given that inventories have been depleted during the crisis. On the other hand, their customers payment morale is deteriorating. This is the finding of the EOS Study 2010 European Payment Behaviour. Ever more important: Working capital management Alternative ways of financing offer a solution, although not every instrument may serve every firm and not every tool can do justice to every economic situation. Leasing bears the risk that balance-sheet effects may be cancelled from 2013 if firms must reveal their leasing costs. This would raise their liabilities. Mezzanine financing carries high interest rates and is inflexible, given durations of seven to ten years. Asset-backed securities are frequently structured in a complex way and are cost intensive. In contrast, new financial products are reacting to the changed demands of high-growth SMEs. These instruments include the purchase finance tool of finetrading and the inventory finance tool of stocktrading. Both are instruments to deal with current assets and actively support working capital management (WCM). There are liquidity potentials here of up to 30 percent. At first glance this potential may be surprising. But it can be explained by firms wide-spread obsession with optimised investments in plant, machinery and financial assets. In contrast, firms pay little attention to net current assets. WCM aims especially at tying up a minimum of working capital primarily inventory, claims and liabilities. The aim is to accelerate capital inflows and to slow down capital outflows. The key levers of WCM are: Stock management with supply chain, logistics and inventory control (Supply Chain Management) Claims management (Process Order-to-Cash) Liability management (Process Purchase-to-Pay) 93

Arno Schneider Folker Weise WCF Finetrading GmbH Whereas the supplier would like to see his bills paid immediately, the buyer tries to get the longest possible pay periods. The efficiency of the entire supply chain may suffer from these diametrically opposed interests, especially if the supply chains are complex with many individual components like in the electronics or automobile industries. The way firms contractually manage their purchase and sales modalities quickly becomes a decisive competitive advantage. In addition, firms are usually both, purchasers and suppliers. This forces them to improve both sides of the balance sheet. Optimisation of the financial supply chain becomes correspondingly relevant. Financing alternatives like finetrading and stocktrading help to procure short-term liquidity and make for a relaxed supplier-customer relationship at the settlement level. Simple and effective: Finetrading In purchase financing finetrading the so-called finetrader acts as an intermediary between buyer and supplier: He pays his customer s supplier on time for the needed merchandise, for which he receives a cash discount as well as a fee. Raw materials and other inputs are then resold to the customer by granting him an extended payment period. As before, the buyer negotiates quality, quantity and price directly with his supplier. The finetrader does not pay the bill until the merchandise has arrived at the ordering party without any complaint. 94 The buyer achieves some breathing space by paying for the merchandise after one, two, three or four months at the maximum. As a rule, this does not cost anything in the first month; the finetrader only earning from the cash discount. For an extended and flexible payment period a fixed deferral fee has to be paid for each month that has to be settled exactly per day. The fees depend on the customer s credit standing, the size of the finetrading line as well as the size of the negotiated cash discount: They vary from 0 to 1.75 percent per month. The length of the customer s payment period depends on his credit standing and the order volume and on whether he wants to save fees by paying quickly. It is his decision.

Innovative forms of purchase and inventory financing Schematic presentation of FINETRADING Fig. 1 Customer Merchandise delivery Finetrading Repayment after at most 120 days Supplier On-time payment Finetrader In the ideal case, finetrading funds already flow within three to four working days. Additional advantages: the supplier shortens his balance sheet and improves his credit standing and his rating. The buyer strengthens his position as a reliable payer and thus improves his negotiating position as a solid customer. Both parties benefit: The customer increases his financing scope by getting a longer payment period and the supplier improves his cash flow by getting a steady, reliable payment inflow. Finetrading is a solution for firms that have difficulties in financing growth in the conventional way. This instrument also benefits other firms that have already exploited all granted credit lines, can now optimise their capital structure and want to improve their rating. Financing lines from 100 thousand euros to 15 million euros can be made available. But there are limits: For firms that cannot receive credit insurance or that are facing insolvency this financing variety is not an option. That is why internal company and credit worthiness analyses are done before any deal. In addition, the credits are reinsured, precluding risky deals. 95

Arno Schneider Folker Weise WCF Finetrading GmbH Consignment warehousing: Shackle or gold mine? In order to produce flexibly and without loss, companies of the automobile, packing, textile and raw materials industries have adopted so-called consignment warehousing. These supplier warehouses are located directly at the site of the buyer. The special aspect: the supplier remains legal owner of the stored merchandise until it is withdrawn by the buyer who does not pay until that time. At times, millions of euros worth of merchandise are in storage without the supplier being able to ask for payment. Frequently he must provide for advance bank financing for the entire stock. This can be difficult as banks don t like to finance inventories because of the risks involved like improper withdrawals. The advantages of the inventory strategy lie asymmetrically with the buyer: High supply flexibility, high availability, high supply guarantee Short routes, fast access to the merchandise Lower processing costs Optimised processing and setup times Lower transportation, administration and inventory costs Lower operating risk Less capital tie-up 96 The supplier generates close customer ties, is able to plan long-term, can optimise lot sizes, saves transport and packing costs by stocking his warehouse at greater intervals, and minimises the risk of looming contract penalties for failure to deliver. But his capital is tied up. His legal responsibility for the merchandise remains. His balance sheet is lengthened although the merchandise that is produced and made available to the customer is in principle a claims item. Not infrequently do suppliers therefore consider consignment warehousing to be a shackle. Although such negative effects may be cushioned by smart contract design, the ideal case is rare in which the payment times for the supplier are agreed in such a way that consignment deliveries equal normal deliveries. Another option in contract design is the fixing of clear payment periods or factoring within short intervals. But hardly a buyer will accept this. A potential disagreement is the question of how the merchandise is insured and protected.

Innovative forms of purchase and inventory financing Stocktrading provides liquidity and improves the supplier-buyer relationship A solution of this conflict of interest is stocktrading. In this form of off-balance sheet financing the stocktrader receives merchandise or materials from the supplier. These are stored in the buyer s consignment warehouse who continues to manage it and can quickly access the merchandise. Formally there is no change to the process. But financially a lot changes: The supplier grants the stocktrader a payment period of 120 days. But the supplier receives his money for the invoice right away, as the intermediary includes a factoring partner in the triangle relationship of stock-trader, supplier and buyer. The excellent creditworthiness of the stocktrader granted by the credit sale insurer guarantees the supplier a high degree of security. Payment delays or even defaults are impossible liquidity can be planned and is available short-term. The buyer continues to be obligated by contract to withdraw the merchandise from the warehouse within four months and to pay the stocktrader after this maximum period. As supply contracts as a rule determine purchase within one to four months, the fixed withdrawal period corresponds to past business practice. The advantages of this form of refinancing consignment warehousing are: Increase of liquidity Expansion of the financing volume Positive balance sheet effects by a shortening of the balance sheet Conservation of existing collateral Improvement of business ratios Improvement of the rating and thus improved credit terms Transfer of the collection risk to the service provider Unchanged full disposition of the inventory Increase of purchase volume, exploitation of economies of scale Improvement of supplier-buyer relationship, etc. The double role of the stocktrader as trader and provider of credit standing creates true value added for both parties, the supplier and the buyer. Stocktrading is attractive for all firms from nearly any industry that have an effective consignment warehousing contract, for which made to order production is dominant and quick turnover articles are of strategic importance. 97

Arno Schneider Folker Weise WCF Finetrading GmbH STOCKTRADING Advance financing in the consignment warehouse Fig. 2 Buyer Unchanged warehouse usage Payment to a special account Supplier 100% on-time liquidity Stocktrader Strategic value added at market conditions 98 The costs of the optimised working capital are comparable to those of a bank overdraft: the stocktrader factors a handling fee that currently amounts to three percent. No factorig fee is normally charged. The supplier pays market factoring rates that are tied to the 3-month Euribor and currently amount to about 4.5 percent. For granting a normal market discount the supplier can get advance financing for his consignment warehouse at favourable interest rates. The financing lines in stocktrading are bigger than in finetrading: They start at 500 thousand euros and may reach mid-size two-digit million euro amounts.

Innovative forms of purchase and inventory financing Smaller volumes are hardly attractive, because economies of scale cannot be exploited in warehousing. This also means that the tool can only be offered seriously in the market by financially strong suppliers. Experienced service providers like WCF have the necessary know-how to provide an ideal financing instrument to suppliers by way of stocktrading. Past attempts of other service providers to open this route to suppliers failed due to processing problems, lacking infrastructure, lacking expertise in managing merchandise stocks or lacking know-how regarding turnover tax or customs questions. The stocktrader, in contrast, as a trading company, manages the entire merchandise imports and exports without generating costs for the suppliers. In addition, banks abhor the risk of carrying merchandise stocks on their own balance sheets. The reason: Uncertain sales growth and the uncertain economic situation of the buyer might lower their own rating. WCF, for example, does not do refinancing in the open market, but refinances itself or via a strong capital company in the background. The refinanced stocktrader is thus involved in sustained WCM and at the same time shoulders the default risk. Therein lies the charm of this solution: Full risk coverage at full capital strength and reliability. The triangular relationship means a marginally higher cost of the contract design. Two contracts are signed: A framework agreement between the service provider and the supplier as well as one regarding the set-up and processing of the consignment warehouse between service provider, supplier and buyer. An additional factoring agreement is necessary between supplier and co-finance provider. Furthermore, the stocktrader takes out credit sales insurance that insures against inventory shrinkage and default risk for both parties to the contract. Subsequently, the IT of the electronic merchandise trading system must be adjusted at the participating parties, as an additional agent will be included. These one-off investments are offset by short-term liquidity effects and long-term positive balance-sheet and customer retention effects. 99

Arno Schneider Folker Weise WCF Finetrading GmbH Outlook It is hard to imagine that the poor payment morale of businessmen will change in the future. The terms for suppliers will tighten because of increasingly international and stronger competition. The result: SMEs will be faced by serious liquidity bottlenecks. At the same time, the banks lending behaviour will become more restrictive in the incipient era of Basel III. One way out of this situation is provided by intelligent and individually adaptable financing alternatives beginning with net current assets. The more difficult it will be to get a bank loan as a classic refinancing source, the more alternative financing products will be needed in the market. The ground has already been broken with Finetrading and Stocktrading. schneider@wcf-finetrading.de weise@wcf-finetrading.de 100