Tag Archives: SCF

Reverse Factoring, the Next Financial Bubble?

Some months ago, I read a piece praising Procter&Gamble for having finally adopted the “new standard” of paying suppliers in 90-100 days rather than the “old” 45 days [1]. This new standard comes from using “Reverse Factoring”, a financing approach that became popular in Spain in the 80’s and 90’s (oddly enough, the “Spanish” name for reverse factoring is “confirming”, a registered name by Banco Santander). The scheme has spread since 2008, to many other countries, especially in Northern Europe.

How reverse factoring (RF) works

Consider a strong buyer (say with rating AA) that buys on account from its weak suppliers (say with rating BBB), and pays them in 40 days. Suppliers in need of liquidity sell some of the buyer’s receivables to a financial institution at a high cost, say 15%. The cost is high because 1) the bank protects himself against the risk of the buyer not paying the supplier and 2) the supplier is weak so he may not be able to repay the bank if the buyer doesn’t pay him.

Now the buyer, in conjunction with her bank, proposes the supplier the following: “Whenever you need liquidity, you can sell my receivables to the new bank, which will charge you a mere 6% rather than 15%. In return, I will pay you in 80 days rather than 40.” The bank is willing to charge only 6% because it has the commitment from the buyer that she will pay at due date–recall the buyer is financially strong. The supplier is better off because, even if he is paid later, the lower cost of the factoring contract more than makes up for it. The buyer is better off as well because she pays 40 days later to the supplier, freeing up a nice pile of cash. Therefore, reverse factoring (the scheme just described) seems to be a win-win-win solution. That may be the reason why some European governments, such as Mr. Cameron’s in the UK last year, have seen in this scheme a potential solution for the liquidity problems of many private SME companies, thus they are encouraging firms and financial institutions to adopt RF programs. Others, as the Dutch government, might follow suit.

Where the problem stems from
The scheme works beautifully as long as the buyer pays on time, which is expected, since it is a relatively financially strong player. However, what if the buyer cannot duly pay for her invoices? Banks may immediately opt out of the corresponding RF program, which may well drag weak suppliers into bankruptcy. This may affect an entire industry, and even a major portion of an economy. In fact, if these RF practices generalize, they may well become the seed of the next financial crisis.

You may be right to think that odds are not high that a strong player cannot pay her suppliers on time. But it does not mean that it is impossible. For instance, Moody’s, Standard & Poor’s, and Fitch Ratings of Lehman Brothers was A or above when the latter went bankrupt in Sep 2008. Similarly, 75% of the analysts covering Parmalat had a buy or neutral rating on the stock a quarter before it collapsed in 2003. OF course these two corporations went bankrupt because of a financial scandal, but it is a fact that financial scandals do occur.

How to prevent RF from growing exponentially
Although RF programs may be beneficial under some circumstances, its generalised use may lead to serious situations. One way to prevent these programs from growing too much would be for factors (the financial institutions that provide liquidity) to put a risk premium on buyers, so as to compensate the negative outcome if they collapse. Additionally, suppliers should be aware of the risks of joining these RF programs before it is too late.

[1] http://www.scdigest.com/ONTARGET/13-05-02-1.PHP?cid=7006


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Counting the Cost of Liquidity in the Euro Zone

Finance and Supply Chain execs need to collaborate on ways to release cash locked into supply chains

Alejandro Serrano – Feb 6, 2012 – CFO.com | US

The liquidity crisis in Europe has cast a spotlight on the need to bridge the divide between finance and supply chain management (SCM). More than ever, executives in these two key disciplines need to collaborate on ways to release some of the cash that is locked into supply chains.

Reducing inventory is probably the most obvious strategy for liberating these financial resources, particularly for companies that maintain high stock levels. In addition to tying up large sums of money in the products stored, inventory adds cost in others forms, such as insurance premiums, investments in storage facilities and related transportation budgets, and obsolescence costs.

Large companies in Europe have become very concerned about this cash-equivalent mountain, as it has become more difficult to meet their working capital requirements (WCR). But addressing the problem requires a concerted effort to understand the financial implications of SCM decisions.

When firms resolve to outsource production to low-cost manufacturing centers in countries such as China, for example, the move may enhance their profit and loss (P&L) statements. But the overall impact on the balance sheet could be much less favorable. The longer pipeline and corresponding increase in uncertainty require higher inventory volumes, which eats up precious cash reserves.

Transferring production to remote suppliers also is likely to involve larger lot sizes. These vendors often need to sell big batches of product to make the business profitable. Again, this consumes the buyer’s WCR when it purchases 1,000 units even though the enterprise only needs, say, 30 units. Sourcing domestically might be a better option because it is easier to work with local producers to reduce lot sizes.

Stock-keeping unit (SKU) proliferation is another supply chain issue that can have far-reaching financial implications, and a number of multinational companies are striving to rationalize their product assortments. In positive economic times, the inventory holding and ordering costs associated with multiple SKUs tend to be underestimated.

In April 2012, sports apparel company Adidas announced plans to cut its 46,897 SKUs by 25%. Other successful companies have followed a similar path. Apple’s iPhone offers only 10 SKUs worldwide for the product’s color and memory variants, for example. Compare this to Nokia, which sells 37 different models in Germany alone. Spanish supermarket chain Mercadona boasted a net profit of more than 19% at its 1,500 supermarkets in 2011. The retailer has about 4,000 SKUs per store compared to a typical U.S. supermarket, which sells around 40,000 SKUs.

Assorted Products
The product-assortment issue is a good illustration of how the lack of a holistic view of the supply chain can rob a company of working capital. Often, the marketing department believes that introducing more SKUs delivers more buying opportunities and hence boosts sales. But the marketers may fail to consider how the wider product selection both decentralizes and increases inventory, and has an adverse effect on the company’s balance sheet. Many senior executives also suffer from this myopic view of operations.

Extending payment periods or shifting inventory to suppliers are tactics that many financial departments adopt in a tight economy. Again, understanding how such actions ripple through the supply chain – working capital is more expensive for small suppliers so their performance declines, for instance – may not be a high priority.

SCM leaders are just as culpable. They might take an outsourcing decision without giving much thought to how such a move constrains WCR. Basic financial concepts, such as “WCR equals cash plus receivables plus inventories minus payables,” need to be an integral part of the SCM decision-making process. Supply chain professionals should appreciate that inventory levels directly affect financial risk.

Firms that understand the impact of SCM decisions on their financial statements can capture huge competitive advantage. That holds true in any commercial environment, but especially in one where there is a scarcity of working capital.

Alejandro Serrano (aserrano@zlc.edu.es) is a professor of supply chain management at the Zaragoza Logistics Center, Zaragoza, Spain. He teaches “Finance for Supply Chain Management” as part of ZLC’s masters and executive education programs. This article will be published in the MIT Supply Chain and Logistics Excellence Network newsletter, “Supply Chain Frontiers.”

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How CFOs, COOs Can Bury the Hatchet

Discovering the ways their metrics match up can help finance chiefs and supply-chain executives align their companies’ spending choices.

Alejandro Serrano – CFO.com | US

Supply chain and finance are usually seen as separate and conflicting disciplines.

In a retailing or manufacturing company, key performance indicators are typically set by the chief operating officer to maintain high customer-service levels by keeping inventories high. At the same time, the CFO pushes the company’s supply-chain management to reduce inventory as much as possible to avoid the financial burden imposed by high working capital requirements. As a result, supply-chain and financial incentives become misaligned, and efforts to arrive at a compromise can be extremely frustrating for both disciplines. However, it is possible to bridge this divide.

There are many examples of how the interests of supply chain and finance can diverge in companies. In turbulent times, for instance, finance may have stronger reasons and incentives to free up cash by reducing inventories. But in prosperous times, supply chain may advocate the need for on-time deliveries even though such a strategy elevates inventory volumes.

In recent years, many companies have tried to become more efficient by operating on a global rather than a local level and developing a more-holistic view of their operations. But even if a consensus is reached on what the efficiency goals should be, a crucial question often remains: What’s the best method for assessing the appropriateness of an investment?

That question brings supply chain and finance into conflict again. Finance, for instance, may firmly believe that supply chain’s evaluations of investments are incomplete because they miss a portion of the picture. Supply chain may feel equally that finance’s analysis is missing an essential piece of the puzzle.

Still, finance and supply chain can find common ground even here. During a recent consulting project at a multinational company, for example, I learned how the two sides can come together.

Three people from different departments in the company proposed distinct approaches to solving a manufacturing problem: defining the production batch size. The finance people offered the approach of choosing the batch size that maximized the discounted economic value added (EVA), as was customarily done in the company. (EVA is the economic profit earned by a company minus its cost of capital.)

For their part, the supply-chain folks proposed using the economic order quantity (EOQ) formula, commonly used in business to calculate order quantities at the best possible cost. (Companies use EOQ to find out the correct number of units to order to minimize the total cost of buying, delivering, and storing the product.) At the same time, project management wanted to calculate the batch size so as to maximize the net present value (NPV) of the resulting incremental cash flows.

These approaches led to three different solutions, and it was impossible for the three departments to reach a consensus on which batch size to choose. I was asked to find the right method to use and to outline what assumptions, if any, would invalidate the other approaches.

Our first assumption was that the EOQ formula could not give the right solution to maximize value, because it does not discount cash flows; instead, it merely minimizes a cost function. However, working through the calculations produced a surprising result: all three approaches yielded exactly the same solution.

How could this be possible, given the differences between minimizing cost and maximizing value in the different approaches? It stems from the fact that the EOQ formula does, indeed, discount cash flows. In broad terms, the formula contains the inventory holding cost, a part of which is a financial cost, which coincides with the discount rate in any NPV approach.

The result immediately removed the misalignment between supply chain and finance. Although this is just one example, it sheds light on how barriers between departments can be removed by delving into the reasons for these divisions. The project should encourage managers to take a holistic view of their firm when making decisions and encourage researchers to keep working on ways to align the interests of finance and supply chain.

Alejandro Serrano (aserrano@zlc.edu.es) is professor of supply chain management at the Zaragoza International Logistics Program of the Massachusetts Institute of Technology, Zaragoza, Spain.  www.zlc.edu.es

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