Why is Supply Chain Finance Under the Spotlight?

invoice finance

Concerns about supply chain finance have flared up at different points and times across the world. This practice is due to come under scrutiny closer to home, with the Australian Small Business and Family Enterprise Ombudsman (ASBFEO) announcing a review of the financing mechanism and how it is affecting small to medium-sized enterprises (SMEs).

Supply chain financing, also called reverse factoring, is a short-term finance arrangement in which both the supplier and the customer get a credit against an invoice. It allows the buyer, usually a larger business, to extend the payment of the invoice beyond the usual 30 days up to anything from 120 to 180 days. The supplier, meanwhile, gets full and immediate access to the payment at a small cost.

The financing arrangement works for all parties, the bank, the supplier and the buyer, because the bank makes money out of the transactions, while the supplier and buyer improve their working capital as a result of the supplier getting its money earlier and the buyer having to pay later.

However, in the UK, the bankruptcy of the most prominent construction firm, Carillion, highlighted the potential problems with the short-term funding practice. The non-disclosure of how much it was relying on supply chain finance to beef up its balance sheet was at the centre of the company’s financial misfortunes.

In Australia, the ASBFEO is more focused on finding out why more large businesses are increasingly offering supply chain finance for small enterprises. In a statement announcing the setup of the review, Ombudsman Kate Carnell said they would also be looking into “whether big businesses are using supply chain financing arrangements as a replacement for reasonable payment terms being offered, 30 days or less from invoice.”

The review was prompted by SMEs approaching the Ombudsman with issues they had been experiencing with supply chain financing. Carnell says the investigation will assess whether big business is using supply chain finance to stretch out formal payment terms and to manipulate its financial reports to benefit working capital and cash reserves.

The ASBEO says it accepts that supply chain financing is a “legitimate and effective tool to free-up cash flow.” However,  in its statement, it adds, “it is totally unacceptable for big businesses to use supply chain financing arrangements as a replacement for reasonable payment terms being offered, 30 days or less from invoice.”

The Australian Ombudsman is not alone in having concerns about supply chain financing. Moody’s suggesting that regulators should provide more clarity on the disclosure of supply chain finance arrangements to prevent misuse to the extent that became apparent after the collapse of Carillion in 2018.

The rating agency would like to see the financing of supply chain invoices disclosed so that it can assess liquidity management objectively relative to peers.

What is Supply Chain Finance?

Supply chain finance is a finance arrangement between three parties: the bank, the supplier and the buyer. In it, the supplier gets immediate access to the invoiced amount owed by the buyer at a small cost. The buyer approves the invoice for payment but only has to pay later.

The arrangement is entered into to improve the working capital status of both the supplier and the buyer because the supplier has early access to the funds it is owed. Thus, the state of its accounts receivables book improves. The buyers working capital situation also improves without adversely affecting its balance sheet.

How Does it Differ From Invoice Finance?

Also known as reverse factoring, supply chain finance differs from invoice finance agreements in that the supplier initiates the invoice factoring. In contrast, in supply chain finance, the buyer does.

In supply chain finance, there are thus three parties involved in the financing agreement. In contrast, in invoice factoring, the supplier hands over its accounts receivables book to the invoice finance company. In return, the invoice finance company funds the early payment of the invoices at a discount, with the outstanding amount, less the fee charged, paid on receipt of full payment from the customer.

Given that the arrangement is put in place at the behest of the buyer, suppliers have less flexibility about how they want to manage their accounts receivables business and whether they would prefer to enter a factoring agreement instead. The Australian government’s review of supply chain financing is welcome in that it is a keen reminder that businesses should only seek financial support if, in doing so, the outlook for the company is improved rather than propping it up unsustainably.

Read More:
Avoiding First-time Small Business Owner Mistakes
Five common misconceptions about invoice financing

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