Why CFOs Should Adopt SCF to Meet Cash Requirements
CFOs today depend on the strategic function of treasurers than in previous years. One reason why treasurers’ role has become more aligned to the CFO’s agenda is a direct result of the treasurer’s ability to unlock value within the organization at a low cost, and drive strategic objectives of the CFO, such as offering a more comprehensive view of cash and payments, acquisition strategies and capital allocation strategies.
In fact, securing low-cost financing is arguably the corporate treasurer’s primary objective. Among their many responsibilities, ensuring adequate access to liquidity at the appropriate level of risk and cost is imperative for the success of their role. Luckily for treasurers, there is no shortage of banks eager to discuss various funding arrangements, again based on the probable risk and cost of the FI (financial investment). These funding arrangements will most certainly come at a cost to the treasurer, and drawing down to access the needed liquidity will likely be treated as debt on the balance sheet.
Consider SCF (supply chain finance) as a dynamic solution to remedy the issue. While not a new strategy, SCF has yet to fully penetrate the corporate market. Therein lies a tremendous opportunity for treasurers and CFOs to gain a strategic market advantage by adopting this proven, liquidity solution.
What is a SCF program?
At its core, SCF, or more specifically reverse factoring, is an arrangement where the corporation (buyer) enlists with banks to make payments on their behalf to suppliers. Reverse factoring provides suppliers with early payment of approved invoices, but instead introduces a third party to deliver invoice financing. Reverse factoring offers an attractive alternative to factoring programs for sellers, by offering a lower discount and more flexible terms than they would achieve on their own. For the buyer, reverse factoring offers an opportunity to extend DPO (Days Payable Outstanding), improving working capital while not hurting the liquidity of key suppliers.
As an alternative to reverse factoring, dynamic discounting programs are best suited for corporates that have excess cash and liquidity. This type of program is designed for organizations looking for an alternative to low yielding short-term investments as these programs typically yield in excess of 10 percent APR. With dynamic discounting, buyers pay their suppliers early using their own funds. The early payment discount is calculated based on a pre-agreed financing rate and the number of days remaining until payment was originally due. The earlier the payment is made, the greater the discount realized for the buyer.
So how does a SCF program help drive a broader capital allocation strategy?
SCF programs, especially those housed within treasury technology that also leverage cash management workflows, can greatly improve free cash flow – interest free – via a term extension where reverse factoring is introduced to soften the impact to relevant suppliers. Treasurers are better positioned to satisfy committed share buyback, dividend, acquisition or related milestone payments, or debt buyback targets given the influx of cash flow following reverse factoring program deployment.
Thus, as the CFO pushes out DPO, the liquidity position improves at no financial cost and without additional debt on the balance sheet. This brings us to an important point: SCF alone is not the strategy, but rather the strategy of the corporation is to improve liquidity, and SCF is the tool to execute against this strategy.
Why SCF programs work
It is key to understand that the buyer will have a superior credit rating than their suppliers. A survey conducted by JPMorgan found that 65 percent of corporate suppliers are sub-investment grade. In addition, many suppliers face uncertainty as to when they will be paid from their customers, which puts a tremendous strain on these smaller companies and their ability to manage operations. Given these financial and operational factors, suppliers are eager to obtain low cost, predictable financing, and therefore we have a SCF market.
The flows of a traditional reverse factoring transaction are quite simple. Let’s consider the following example: the corporation extends payment terms on the supplier from 45 days to 65 days, picking up 20 days of liquidity. As a way of softening the impact of this extension and to ensure the critical supplier relationship remains strong, the corporate introduces SCF to the supplier. Through a web-based portal, all future AP invoices between the buyer and supplier are visible. The supplier can simply select the invoice(s) and tell the corporate to ‘pay me now’ on any day ahead of Day 65 (let’s say Day 10 in this example). Then, a financial institution of the buyer’s choosing pays the supplier on behalf of the buyer on Day 10 at a reasonable discount. On Day 65, the buyer pays the full amount of the invoice to the bank. Given the bank’s liability is to the buyer, they are able to offer a discount rate of the prepaid invoice that is lower than the cost of funds for the supplier. So there we have it, a win-win-win for all parties.
Where to start?
It’s important to recall that SCF is not a strategy in itself, but a tool at the CFO’s disposal to execute the strategy. To begin a SCF program, it is important to first recognize the strategic financial goals of the organization. This will often be found in understanding the corporate’s free cash flow targets, and capital allocation strategy (share buyback, shareholder dividends, M&A activity, etc.). In order to execute these strategies, sufficient cash flow generation is required, and SCF delivers cash flow, as previously outlined in this article. This point is critical to gain internal buy-in: SCF will help achieve the finance targets set by the board of directors. The adoption of SCF is not simply a treasury initiative, but rather will need the collaboration of accounts payable, procurement and corporate accounting. Given the various priorities of these groups, SCF at its surface can appear to disrupt supplier relations and the status quo. Thus, it’s critical for treasury to champion the value of SCF cross-functionally, and the strategic value it delivers in way of specific capital allocation commitments, EBITDA guidance, or free cash flow targets previously committed by the CFO.
Supply chain finance is a decades old, and proven finance solution that helps CFOs drive P&L improvements and economic value to their respective organizations. Today’s modern treasurer can benefit from implementing SCF programs in their organization to help improve free cash flow and working capital. Recent enhancements from leading technology companies, including services for supplier prioritization and supplier on-boarding, help ensure that CFOs achieve maximum adoption within the SCF program in a secure, yet comprehensive online workflow. In doing so, the treasurer is securing an influx of cash flow to satisfy capital allocation commitments, and/or offer an alternative form of supplier financing that can lower margins and improve EBITDA for the organization.
To learn more about supply chain finance and other working capital solutions, visit www.kyriba.com.