Supplier financing is a payment solution that help small suppliers and buyers (of all sizes) float. The unique value proposition in this model is that suppliers are reimbursed as soon as they raise invoices for the sale of their receivables (e.g. approved invoices).
While suppliers get their money back before the due dates, it benefits buyers as well. Buyers’ reputation in the market grows up as responsible organizations to do business with. Also, reverse factoring extends the terms of their accounts payable, while allowing them to fulfill their financial obligations to their suppliers. In other words, they make the payment but not with their own money. So whose money is it then?
Many large buying companies are focused on improving their cash position and one of the mechanisms to achieve this is to build working capital by working with suppliers to extend payment terms, resulting naturally in a longer Days Payable Outstanding — DPO. Of course, the buyers’ benefit comes at a cost to the suppliers, so corporates are putting in place mechanisms to ensure that suppliers have the option to get paid earlier.
Other goals in engaging a supplier finance program might be to reduce the cost of goods sold and/or improve the strength of their supply chain by giving them access to funding. All of these initiatives require the implementation of some type programs to address the requirements.
How does supplier financing work
Typically how it works is that the buyers pay the suppliers, with money that they get from her company’s financial institution (e.g. Banks, NBFCs, or Financial Institutions). This is because buyers have sufficiently good credit/collateral to be eligible for a short-term loan of this kind. Often the interest rates are much higher than typical loans (APR% may vary between 15% to 30% or more).
In return for timely payment of dues, the suppliers are charged fees for being eligible to get paid early. These fees then go to company’s bank offsetting the Interest obligations of buyers to their banks. So the benefits of this solution and their distribution are as follows:
Benefit 1: Sellers get paid early, well within the stipulated 30-day payment period, without having to worry about securing credit.
Benefit 2: Buyers can keep the liquidity with themselves, which gives them a breather to manage their cash flow positive.
Benefit 3: Financial institutions that are putting these funds makes some money off these transactions as well.
Alternatives to banking institutions
There are various services that pose alternatives to the one-on-one arrangement between buyers and their financiers. Some of them function as facilitators. Services that offer suppliers financing provide buyers with a variety of options:
- To apply to a network of financial institutions accessible to the facilitator.
- To use their own funds.
- To combine multiple financial sources: including the buyers, banks, and capital markets.
Supplier financing has proven to be a very popular financial arrangement, particularly among SMBs (for obvious reasons). Small and medium enterprises, both buyers and sellers, would do well to consider adopting this approach in their business dealings.