Working capital—the cash a business requires to fund its day-to-day operations—has become a hot topic within many companies, peppering conversations from the finance department to the factory floor. The traditional view is that by collecting receivables more quickly and paying suppliers more slowly, a company can reduce its need for cash. However, a more holistic approach to working capital—one that ultimately gives a company more opportunities to improve its finances—should include inventory and the supply chain in the scope of the analysis. It also requires developing a coherent, integrated strategy for improving management of payables, receivables, and inventory.
For that to happen, supply chain managers need to take a broader view of finance. Their connection to working capital management typically has been through their control of inventory, working to keep inventory levels low (which helps to minimize the amount of cash tied up in the warehouse) and to move merchandise quickly to market to assure a speedy conversion of goods to cash.
![[Figure 1] Scenario 1: Letter of credit (l/c)](/media-library/scq200801trade-fig1.jpg?id=53612484)
![[Figure 2] Scenario 2: Open account + 60-day terms](/media-library/scq200801trade-fig2.jpg?id=53612485)
![[Figure 3] Value of extending payment terms](/media-library/scq200801trade-fig3.jpg?id=53612486)
As supply chains have become more efficient, however, further improvements through standard means (accelerating inventory or cutting transportation costs, for instance) have become progressively more difficult to achieve. New tools such as supply chain finance programs and electronic payment platforms can offer buyers another way to improve how they manage their supply chains' cash flow, often with excellent results. Understanding these tools and how they fit into the supply chain is a critical first step toward harnessing their power.
Where the physical and financial meet
Supply chain managers typically are preoccupied with physical inventory. But the physical supply chain isn't the only one they should be concerned with—they also need to consider the financial supply chain.
If the physical supply chain is the network through which parts and products flow, the financial supply chain is the parallel path that related payments follow. The physical and financial supply chains, then, are closely connected. By applying the lens of financial analysis to a company's supply chain activities, managers can discover a powerful way to influence a company's performance. Moreover, new financial and technological tools are giving supply chain managers greater ability to automate their finance-related processes, capture the related data, and quantify and make use of the results. To understand how, it may be helpful to start with the basics:
In every sales transaction there is a buyer and a seller; money changes hands in exchange for goods or services. For the buyer this money is a payable; for the seller that same money is a receivable. For the sake of simplicity, this article will discuss the payables process from the perspective of the buyer.
The overall goal for most companies is to sell a product or service to a customer at a profit, and different players within the supply chain employ the tools at their disposal to advance that goal. Purchasing managers and buyers try to source goods or inputs at a lower cost. Supply chain managers work to control inventory and speed goods to market. Marketing managers aim to sell products at a profit. Members of the treasury staff hope to collect cash as quickly as possible and are inclined to hold on to that cash by extending their own payment terms with suppliers. Finance managers seek to fund the company's cash needs at the most advantageous rate.
Each of these players is doing his or her best to improve the company's working capital picture, and individually they have the potential to succeed within a limited sphere. Operating as independent entities, they will at best fall short of their full potential and at worst create conflicts through competing agendas. For example, a treasury manager who extends payment terms could inadvertently damage an important supplier relationship. Or a procurement manager who decides against buying with a letter of credit (L/C) may actually drive up a supplier's financing costs. (For a brief explanation of letters of credit and other terms used in this article, see the sidebar.) In order to optimize its results, then, a company must adopt a broader view of working capital, set cooperative goals that are synchronized with the overall corporate finance strategy, and ensure that its operational entities are working in harmony.
Financial managers optimize payables and receivables streams, and it is natural to view these flows of cash through the lens of financial analysis. But the supply chain—with its inventory, transportation costs, and customs duties—also represents a major pool of working capital, and as such is fertile ground for improvement not just of physical inventory management but also of financial performance.
As the supply chain has gained importance as a competitive tool, managers have become adept at wringing out unnecessary costs. Improving the efficiency of an inland transportation network, better utilizing a distribution center, or obtaining lower ocean freight rates all yield measurable benefits. By reducing transportation costs, companies can improve profit margins and reduce the cash required for operating the company's infrastructure. The more tightly supply chains are managed, however, the harder it becomes to find new savings.
The cost of cash
Operating expenses—the cost of goods, freight bills, salaries, warehouse storage, and so forth—require working capital, the lifeblood of cash needed to fuel the corporate machine. It is important to note that the cash used to fund a company's operations must come from somewhere; it may be generated from operations, sourced from public markets, or borrowed from a bank—and it all comes at a cost.
Because the cash used to pay for operations might instead have been invested in some other way, the cost of that cash can be defined as the cost to the company of a missed investment opportunity. That cost is expressed as a percentage (similar to an interest rate) and is called the cost of capital.
Cutting back on the need for working capital reduces the company's financing expenses and either lessens its dependence on outside credit facilities or else frees internal cash for alternative uses, such as investing in a new plant, developing a new product, or returning a dividend to shareholders.
If your cost of capital is 12 percent, for example, reducing freight expenses by $100 saves your company not just that $100 but also the cost of using that $100—in this case an additional $12. Thus, the benefit of any cost reduction is magnified. Transportation expenses, however, represent only one area where working capital may be trapped within the supply chain. The negotiation and payment process offers another example.
Traditionally purchasing—especially for international procurement—has been carried out using a letter of credit. The letter of credit serves several purposes. It guarantees payment (for a fee), creates an agreed-upon transactional process, and reduces the risk of default by one of the counterparties. A seller may also use a letter of credit to prove the legitimacy of a purchase order to its local lender. In return, that lender would provide more competitive pre-sale financing.
Over the last decade, many buyers have moved toward open-account purchasing, which involves making a direct payment to a supplier without using an underlying credit instrument. The open-account approach facilitates the payment process, but it does not protect counterparties from payment and performance risks. It also reduces the seller's access to financing. Meanwhile, as buyers work to improve margins, open-account terms are lengthening from payment "at sight" to 30, 60, or more days.
Cost is the most widely cited reason for changing from letters of credit to open-account payment terms. Moving away from L/Cs, however, has ramifications that extend far beyond a simple question of cost, and buyers would be wise to compare the various payment methods. The common payment methods can be arranged along a spectrum, beginning with letters of credit and ending with a straight, unencumbered wire payment or check. The L/C end of this continuum represents lower risk and higher third-party transactional costs, while the open-account end typically bears higher risks and lower third-party transactional costs.
This conventional analysis, however, overlooks important underlying aspects of the transaction. Leaving risk mitigation aside, an L/C generally allows the supplier better access to lower-cost financing and a greater amount of pre-sale financing from its local lender—in other words, working capital that may not be available under an open-account transaction.
The L/C is typically marked against the supplier's credit line with the issuing bank. The bank assigns a certain amount of credit or risk-related cost to usage of this credit line that is commensurate with the risk of providing an independent guarantee of payment. The cost, which varies depending upon the creditworthiness of the applicant, may be borne by the importer or by the exporter. With the L/C in place, the supplier's local bank knows that as long as the supplier performs (that is, it meets the terms set out in the L/C), the supplier will get paid.
For that local lender, payment risk is virtually eliminated; that's because under a letter of credit, the buyer also is guaranteed by a creditworthy bank. Only the supplier's performance risk remains. The local lender is thus willing to provide working capital to the supplier at a lower rate than would have been possible without the guarantee provided by an L/C. Without it, the local lender would have only a purchase order (PO) to rely upon, and to that lender the PO might not be worth much more than the paper upon which it is written. In such a case, financing under an open-account scenario would be calculated solely on the basis of the supplier's stand-alone credit rating.
Higher financing costs generally translate into a higher cost of goods. Figure 1 shows a supply chain flow, beginning with the time when the buyer first orders the goods from the supplier, and continuing along as the goods are produced, shipped, clear customs, delivered into available inventory, and finally purchased by an end customer. In this example, the goods are being purchased under a letter of credit. The supplier receives the L/C about 90 days before the goods are shipped, allowing it to receive financing from that point until it eventually receives payment.
At the bottom of Figure 1 are a number of different interest rates, which are not true market rates but instead are representative of the relative borrowing costs for different types of financing for working capital. The buyer's cost (shown here as 1 percent) is the lowest; the seller's rate, shown as 4 percent, is the highest; and the L/C-based financing and supply chain finance rates fall in between. In this example, if we look at the 140 days between the start of the production process until the goods are converted to cash, 110 days are financed at the 3-percent L/C-based rate, and 30 days are financed at the buyer's 1-percent rate.
Now examine Figure 2. It shows the same supply chain flow, but in this case the buyer is using an openaccount payment process. In addition, the buyer has negotiated 60-day payment terms—a move that is commonly associated with open-account payment. Now, the entire 150-day flow is financed at the seller's 4-percent rate. In fact, the seller is still carrying this burden for 10 days after the buyer has converted the goods to cash.
In the first scenario, the goods are financed for 140 days at a combination of 3 percent and 1 percent, and in the second scenario, they are financed for 150 days at 4 percent. Clearly costs have been added to the overall supply chain, and logically the supplier will endeavor to recover those costs elsewhere—for example, through the cost of goods.
It is critical for companies to recognize that the supply chain is a linked system in which a change that benefits one party is likely to extract a price from another participant. Therefore all involved should consider how the procurement process would best support their overall financial strategy.
Supply chain finance programs
As buyers work to better manage their working capital and improve key financial ratios, the drive to reduce cash requirements provides an incentive for them to aggressively extend payment terms. Suppliers, of course, have the opposite motivation: They want to collect receivables quickly in order to improve their own working-capital situation. Although each party's goals seem to be separated by an unbridgeable chasm, a well-structured supply chain finance (SCF) program can close that gap.
The point of an SCF program is simple: The seller has the opportunity to be paid before the maturity date of the invoice but at less than the full amount. Let's examine such a program by using the example of a buyer that until recently had been paying its supplier 15 days from the date of the invoice.
In this example, the buyer has ordered $100 worth of goods under 60- day payment terms. The supplier ships the goods, and on day 1 it presents the invoice to the buyer. The buyer validates the invoice and by day 5, has approved it for payment. Then the supplier receives an offer: Receive $98 on day 10, or wait until day 60 to receive the full $100.
Note that $2 off of a $100 invoice is a 2-percent discount, which the seller would be granting in exchange for receiving payment 45 days sooner. There are approximately eight 45-day periods in a year; multiplying 2 percent times 8 results in an annualized value of 16 percent. If the seller's financing costs are relatively high—in this case, close to or above 16 percent—the benefit of receiving the reduced payment earlier will outweigh the $2 it has "given up."
In general, the supplier is likely to accept a discounted early payment if it views collecting less cash sooner as being more valuable than collecting more cash later. If the supplier is well capitalized—that is, it has access to plentiful financing at a low cost—then its supply of cash will be greater and the extended payment terms may not be a burden; it will generally wait to receive the full invoice amount. If the supplier's financing costs are high or its cash is limited, it will generally accept the early-payment offer. In this example, if the supplier's cost of capital is 16 percent or close to it, it should be inclined to accept the offer.
The buyer has decisions to make as well. Capturing a 2-percent discount is an appealing proposition, but this approach requires internal funds and thus increases the need for working capital. When a company is cash-rich or has access to plentiful low-cost financing, paying early to secure a discount can be particularly advantageous.
The buyer, however, could engage a third-party partner, such as a bank, to offer the accelerated payment. In that case, the buyer would hold off paying the bank until the invoice matures. By doing so, it would benefit from a reduced need for cash, but it would still provide suppliers with the option of receiving early payment, which helps to manage the supplier's financing costs. This approach would be appropriate for a company that is focused on extending its payables and reducing its need for working capital.
In general, supply chain finance programs such as the one in this example are established by a buyer that has a large network of suppliers with diverse financing needs. Some buyers have aggressively extended terms without such a program, often leaving sellers in need of cash and exposing them to unacceptable levels of risk. Such moves create tension and leave suppliers without the flexibility they need to respond to such situations as sales growth, seasonal peaks, and supply chain shocks.
Order-to-pay solutions
One requirement for a successful payables-management program is for buyers to be able to receive invoices and process them for payment quickly enough to make an accelerated payment worthwhile. Generally, this requires automation: an orderly, systematic process for receiving and validating invoices paired with a technology infrastructure that is capable of managing the necessary interfaces as well as a high volume of data.
Automation can greatly improve the order-to-pay process (sometimes referred to as "O2P"). The O2P process begins when a buyer issues a purchase order to a supplier, continues as the supplier invoices the buyer, and culminates when the buyer settles that invoice. Platforms that manage the order-to-pay process can facilitate electronic invoices, document matching (for example, the comparison of the invoice to the purchase order), and the payment process while providing simplified access points for suppliers. They also can act as portals that integrate buyers and sellers into an electronic network, creating electronic documentation, managing workflow, and highlighting exceptions.
Such a platform also brings clarity and reliability to what may be a bottlenecked, paper-filled system. Suppliers will appreciate the ready availability of information and will benefit from an orderly process and predictable payments; this will give them the ability to better manage their own cash flows and will generate valuable goodwill. What is more, an automated O2P platform provides managers with visibility to the events of the order-to-pay process, highlights exceptions, clearly defines areas for improvement, creates an audit trail with clear accountability, and provides the ability to measure efficiency.
Another requirement for implementing a successful payables management program is to involve all of the concerned constituents in the planning and implementation processes. These stakeholders are likely to include a company's finance, treasury, accounts payable, procurement, and information technology groups.
This level of coordination may appear to be complex, and it may prompt the question of whether or not such an effort would bear suitably large fruit for it to be worthwhile. To gain a better appreciation of the potential value of this approach, let's consider the example of a company with $1 billion in sales and the same 12-percent cost of capital we used earlier. Let's also hypothesize that its cost of goods is $500 million. The company's average days payable outstanding (DPO) is 30 days, but by employing order-to-pay and supply chain finance tools, it extends payables to 45 days. This one change alone would unlock more than $20 million in working capital. In addition, it would save another $2 million in interest costs. By most measures, that is worth a significant investment of time and resources. As shown in Figure 3, extending DPO by just a single day would be worth approximately $1.5 million to the company's cash flow.
Strategic linchpin
Supply chain managers who understand the financial dynamics of the supply chain can employ tools, such as supply chain finance and order-to-pay solutions, as powerful levers to help companies meet their objectives for working capital. By viewing the supply chain through a financial lens and cooperating with internal partners, supply chain managers not only make their companies more competitive, they also become the linchpin of a successful working-capital strategy.
