Trade finance
by Paul Gosling
The global ‘credit crunch’ has caused the financing of many commercial deals to fall through. Surprisingly, though, there is one financing activity that has not only resisted this trend, but has actually grown significantly – supply chain financing.
Supply chain financing provides a secure basis for a lender to finance transactions. Because the loan is secured on the transaction, it is less vulnerable to the collapse of lending confidence that has afflicted the world’s markets.
According to research just published by Demica – which provides business systems to banks operating supply chain financing (SCF) facilities – more than 90% of major international banks now offer SCF services to corporate clients. That is double the number providing the service last year. The research suggests a 65% increase in the volume of finance provided through SCF compared with 12 months ago. Nor is this likely to be a temporary blip, with most European banks expecting the use of SCF to grow further.
There is nothing particularly new about transaction-based financing. Debt factoring and invoice discounting (see box) have been around for decades. But there are problems with them – they can be very expensive and they are not always appropriate. SCF is growing in popularity because it is a different way of doing things. The modern systems that SCF use are more automated, with more systems analysis of creditworthiness, for example, which can drastically reduce the cost of SCF for the lending banks.
SCF is a particularly important tool for the emerging markets – but not just for sellers. Traditionally, invoice discounting and factoring have been used by companies (often SMEs and micro-businesses) that are short of cash. Today, SCF approaches are particularly appealing to buyers. And by providing the basis for a more reliable trading platform for buyers, they are an important ingredient in the opening-up of emerging markets.
Risk in any trading relationship flows both ways. Just as sellers risk not being paid, buyers risk a supplier becoming insolvent and not fulfilling an order. Placing SCF as the financial link between buyer and seller creates mutual confidence. This, in turn, enables buyers to source more freely, taking advantage of lower prices offered by producers in emerging markets.
Consequently, the initiative for an SCF approach often comes from the buyer in the developed world. And the SCF solutions may only be available for companies operating in the advanced nations, not in the emerging markets.
Abbey – part of the Banco Santander group – has recently launched its ‘Supplier Payments’ system, which the parent company intends to use to build its UK division’s presence in the corporate market, using the group’s IT systems and established international contacts. Abbey works with UK buyers to help improve their supply chain management, providing a guaranteed payment service for suppliers. While Abbey has contracts with the range of suppliers, the primary relationship is with the buyer.
But Abbey admits the system works better in some parts of the world than others – it is strongest where Santander itself has the greatest presence. That makes the system suitable for buying from Europe, Asia and Latin America, but not from Africa. “We know with each of the markets what compliance we have to go through,” says Ian Armstrong, head of financial supply chain solutions at Abbey. That means, for example, that despite the bureaucracy of India, the bank has established and reliable payment channels.
Because of the traditional links between Spain and Latin America, Santander already processes 50,000 invoices every day, for its 275,000 corporate customer base. The service saves those customers about 1% on their procurement bills, by providing greater certainty in the trading relationship and reducing the capital requirements of suppliers. Abbey points out that its system is ‘non-recourse’ (see box), with payment in full by electronic transfer on the day an invoice is issued – compared to the often 90 to 180 days payment period suppliers often have to suffer.
Avarina Miller, senior vice president of Demica, says that the growth of SCF reflects the changes taking place within the banking market itself, which has become more conservative because of the losses on mortgage-backed securities, focusing banks instead on their known and trusted customer relationships. “A lot of banks are withdrawing lines [of credit],” she says. “This is enabling them to use their existing client base [more effectively].” One of the benefits of this is that in place of traditional factoring, with its “fairly rapacious terms”, as Miller puts it, SCF is a more affordable option, because it exposes banks to lower levels of risk.
Although SCF is cheaper than factoring or invoice discounting, Miller says it is not possible to discuss a typical discount rate because it will depend on the credit rating of the companies involved, the nature of the relationships and the level of risk exposure for the bank. The buyers involved are usually large corporates. “Most financial institutions are not interested unless they can create a relationship up to €100m, which might start with €20m,” she says.
But most of the suppliers will be SMEs. Many of these will be companies based in the emerging markets, including some established by Western entrepreneurs. Demica reports that SCF is generally strong in supporting businesses in the Eastern European and Asian regions, including China and Turkey, but less developed in the Middle East. However, companies operating in countries whose currencies are weak or the political environment unstable are likely to be regarded by banks as too high risk to participate.
Typically the initiative for an SCF arrangement will come from the bank approaching the corporate buyer, seeking to extend its banking services. Once that relationship is established, the buyer will introduce that same bank to its range of suppliers. From that, the banks hope to build-up new and strong relationships with all the supply companies, extending their reach of customer relationships.
SCF represents a new chapter in the story of trade finance, but does not mark an end to the traditional operations of factors and invoice discounters. Coface, for instance, continues to specialise in providing invoice discounting services on international transactions and in helping businesses with their credit management functions, including in overseas markets. Its relevant services include credit insurance, debt collection and credit status checks. Each of these services is available for emerging markets.
Pricing varies, according to circumstances. For example, credit insurance costs depend on an assessment of a company’s credit control capability, its previous exposure to bad debt, the territory in which their partner trades and the nature of that trade. But, says Coface’s Trevor Byrne, the cost is “usually well below 1/2% of turnover”. As part of a bank – France’s Natixis – Coface claims that on invoice discounting “we are competitive, because we are owned by a bank – other invoice discounters may not be,” says Byrne. And with a direct presence in 65 countries, Coface argues that it has a global reach that benefits its clients. For internal trades within the UK, the invoice discounting operates under recourse terms, whereas on international trades it is non-recourse – because it is covered by Coface’s credit insurance.
Byrne adds that on credit insurance Coface focuses on the risks associated with a particular deal, rather than the perception of risk in a particular country. “There are good and bad risks in all sorts of countries,” he says.
However, Coface has recently warned that the credit crunch is having a bad impact in some territories. It reports a 45% increase in payment defaults in the first four months of this year in general, while the fierceness of competition between Chinese suppliers and the lack of domestic financing for Chinese companies is leading to specific problems of slow payment and extended payment terms for companies doing business there.
Those pressures on the traditional trade financing options emphasise the value of good supply chain financing. It is a part of the business that can be very important to get right.
Definitions
Supply chain financing is the process of directly linking payment with supplies, eliminating the wait for payment on the normal terms of credit. Traditionally this has been achieved by suppliers borrowing against the security of invoices through invoice discounting, or by factoring. Today, ‘supply chain finance’ is the term used specifically to enable buyers to improve their security of supply and giving them access to the lowest cost buying terms through (usually externally) financed early payment against invoice. Using web-based systems, suppliers have the guarantee of speedy payment of invoices, without the worry or cost of delays as corporations slowly process invoices for payment. By processing payments within a few days of supply instead of waiting perhaps 75 or even 90 days – and perhaps requiring expensive sources of credit, such as factoring or overdrafts – suppliers can bring down costs and prices substantially, benefiting the buyer.
Letter of credit
A letter of credit is issued by a bank to guarantee a payment from a buyer to a seller. The guarantee covers the amount and the date on which it will be paid.
Irrevocable letter of credit
A letter of guarantee that cannot be cancelled. It is particularly appropriate in international transactions.
Factoring
Under a factoring agreement, a trader sells their sales ledger to a third party financier. The financier – often one of the largest banks – pays a discounted price for the total value of the debt. The benefits to the trader are that it does not need to collect debts, it is paid quickly, has fewer bad debts and it has a guaranteed cash flow. Disadvantages include the cost of factoring (which varies between 2% and 12% – expensive for short-term finance), lack of control over debt collection (a factor may be more aggressive in debt collection, damaging customer relations) the possible reputational damage associated with perceptions that factoring is a crisis measure and the likely unwillingness of factoring companies to take on the most high risk debts.
Invoice discounting
With invoice discounting, responsibility for debt collection remains with the trader. This means that the arrangement is confidential, so the potential reputational risk associated with factoring is removed. Invoice discounting also avoids the possible damage caused by an external body that is unsympathetic in its debt collection tactics. The cost will typically be between 0.75% and 2.5% of turnover.
Recourse and non-recourse payments
Bad debts are the bane of trade. But the risk does not normally end when a finance house advances payment against the debt. Where a contract for factoring or invoice discounting is on ‘recourse’ terms, the creditor must repay the advanced payment – plus fees and interest – if the debtor fails to pay up within a specified period. Some factoring and invoice discounting contracts are on ‘non-recourse’ terms – which cost more.
VAT deferment
In the UK, a Duty Deferment Scheme operates to provide security for the full amount of import VAT payable. This is included as part of the Simplified Import VAT Arrangements (SIVA). SIVA aims to ease the impact of VAT on importers by allowing businesses to make deferred VAT payments. More details are available from the VAT booklet, Simplified Import VAT Accounting.