How Does Supply Chain Financing Work?

Supply chain financing is a general term used to describe a number of financial tools that can be used to improve payments between companies and their suppliers. Supply chain finance solutions can be implemented in various ways.

For example, a supplier that is anticipating large orders and wants to build inventory can use “supplier financing.” This solution allows them to purchase the raw materials (or finished goods) required to meet their purchase orders and growth objectives.

Alternatively, a large company that modifies its payment terms from 30 days to 70 days can risk affecting its supply chain. Suppliers would have to deal with the cash flow impact of slower payments. The large company could implement a “reverse factoring plan” to help its supply chain. This plan provides suppliers with an affordable way to finance their slower-paying invoices.

Note that reverse factoring is a type of post-delivery financing. Supplier financing, on the other hand, is a form of pre-delivery financing. Let’s review both options in more detail.

Option 1: Supplier financing

Supplier financing is a form of supply chain financing that allows manufacturers and distributors to buy raw materials (or finished goods) in order to build inventory or fulfill large orders. It works by partnering with a supply chain finance company that extends you trade credit, and it acts as an intermediary between your company and your suppliers.

Whenever you need to buy raw materials (or finished goods), you place a purchase order to the supply finance company rather than with your suppliers. The finance company, in turn, places an order with your supplier. They also handle the necessary payments.

Once your supplier gets the purchase order, they produce and deliver the goods to you. The finance company pays your supplier and issues an invoice to you. The invoice from the supply chain finance company is payable on net credit terms (usually 30 to 60 days). You can get more details here.

a) Advantages of supplier financing

Supplier financing has several advantages over other solutions. The most important one is that it is a pre-delivery financing tool. It can be used to build inventory and grow your company. Additionally, it does not interfere with your existing financing. The supply chain finance company does not need to file a lien on your assets.

Lastly, unlike other solutions, your clients do not need to do anything on your behalf. It’s available to any small and midsize manufacturing company or product supplier that meets the qualification requirements. Companies with revenues as low as $2 million dollars a year can qualify.

b) Limitations of supplier financing

The solution has some limitations and is not for everyone. It works only for companies that can be credit insured. If your company cannot be credit insured, you won’t qualify. Also, this solution helps you only with the cost of raw materials and finished goods. It does not provide assistance to cover other expenses.

Option 2: Reverse factoring

The most common deployment of a supply chain financing solution involves using a product called “reverse factoring.” In a conventional factoring arrangement, a company seeks to improve its financial position by selling its accounts receivable to a factoring company. This arrangement is quite simple and is available to many companies.

A reverse factoring solution works somewhat differently from the way a conventional factoring arrangement works. A large company (e.g., Company A) enters a reverse factoring agreement with a supply chain finance company. The supply chain finance company then intermediates the accounts receivable process for this company.

Conventional reverse factoring solutions allow suppliers of the large company (Company A) to get an early payment on their net-30 to net-60 invoices. The supplier pays a small fee for this service. The reverse factoring company then collects the invoice from the large company (Company A) once it matures.

a) Advantages of reverse factoring

From a supplier perspective, reverse factoring has a couple of advantages. It allows the supplier to get early payments for invoices due from their customer. Obviously, early payments can improve their cash flow.

Additionally, the fee the supplier pays to get the early payment is competitively priced because the cost is largely determined by the commercial creditworthiness of the large client. This point is very important, as the large client is likely to have good credit, thus allowing its suppliers to pay a lower fee for the early payments.

b) Limitations of reverse factoring

Reverse factoring has a number of significant limitations. First, it is driven by the customer (Company A, in the explanation). The customer must get the reverse factoring program and must offer it to its suppliers – as a benefit to them (suppliers) for working with the client. This program helps only those suppliers with payments from that customer (Company A). It does not help suppliers with payments from other customers, unless they have their own reverse factoring program.

Perhaps the greatest limitation of reverse factoring is that, much like factoring, it can be used only as a form of post-delivery financing. You can get funding only after the product has been delivered and the invoice has been approved.

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