When a buyer and supplier both agree that they need more working capital to keep their businesses running smoothly, they might decide to try supply chain finance (SCF). This type of invoice finance solution allows both parties to keep the supply chain rolling without expending any cash out of pocket. Learn more about SCF and whether this form of trade finance is the right option for improving your cash flow.
What Is Supply Chain Finance?
Supply chain finance, also known as reverse factoring, is a type of financing solution in which financial institutions provide buyers with the funds they need to make purchases and simultaneously provide suppliers with the value of the purchase. In this type of finance, a bank or another financial institution finances every part of the supply chain involved in a transaction, which is why this agreement is called supply chain finance.
Unlike other forms of invoice finance, the buyer initiates supply chain finance by directly reaching out to a finance provider. Whether it is a large company or a small business, the supplier must agree to the payment terms and the other stipulations of an SCF agreement before it can proceed, and the finance provider will examine the credit rating and other metrics of creditworthiness of both parties before offering this type of trade finance.
SCF is a type of short-term finance. The buyer has until a specific due date to make payment in full on the invoice, and the bank will enact its credit control policy if the buyer fails to make payment. This type of trade finance may be preferable to suppliers for a variety of reasons that we’ll cover as we proceed.
How Supply Chain Finance Works
Supply chain finance is relatively complicated. We’ll make things simple to understand by breaking down this type of financing arrangement step by step:
- Step 1: The buyer places an order with the supplier using the usual methods. However, the buyer’s bank already knows that an SCF agreement is in place.
- Step 2: Upon receiving the order, the supplier invoices the buyer. The supplier logs this order in its balance sheet as usual.
- Step 3: As soon as the buyer receives the invoice, he or she confirms the intent to pay the bank the full invoice amount at the specified date. In exchange, the bank takes over payment of the invoice.
- Step 4: The supplier sells the invoice to the bank. In exchange, the bank provides the supplier with the full value of the invoice up front. The bank is fully in control of the credit policy regarding the invoice; if the buyer fails to make payment for the invoice, the supplier will not be on the hook.
- Step 5: Upon maturation, the buyer pays the bank the full amount of the invoice. The SCF agreement is now considered to be complete.
Differences Between SCF and Other Types of Invoice Finance
While SCF is similar to a variety of other forms of invoice finance, supply chain finance solutions are different from other forms of trade finance in several ways. To help you understand whether SCF is right for your business, we’ll compare and contrast this finance solution to other popular options.
SCF vs. Invoice Factoring
The most notable difference between supply chain finance and invoice factoring is that the seller initiates financing in an invoice factoring agreement. In many other ways, SCF and invoice factoring are highly similar.
For instance, the supplier sells the invoice to the bank in both types of financing agreements. In addition, the bank takes over credit control in both SCF and invoice factoring. However, the supplier usually only receives a maximum of 85% of the invoice value upfront in an invoice factoring agreement.
Since banks consider invoice factoring to be a higher-risk type of finance, they usually aren’t willing to provide the full value of the invoice up front. However, financial institutions consider SCF to be lower-risk, which means they can often extend the full value of the invoice.
When the invoice reaches maturation, the buyer pays the bank directly. This is the only involvement that the buyer has with the bank throughout the invoice factoring process, but switching around the payment process without warning can sometimes be disconcerting to buyers. It’s important for suppliers to clarify the basics of the invoice factoring agreement with their buyers ahead of time.
SCF vs. Invoice Discounting
There are significant differences between SCF and invoice discounting. For starters, in an invoice discounting agreement, the supplier initiates the finance process instead of the buyer.
In addition, the supplier retains credit control over the invoice in this type of trade finance. While the supplier technically sells the invoice to the bank to receive a portion of the invoice value in cash, the bank doesn’t have any responsibility to pursue bad debt or engage with the buyer in any way.
Many companies choose invoice discounting for its confidentiality. While an SCF agreement requires the intimate involvement of the buyer and the buyer makes payment directly to the bank in an invoice factoring agreement, the buyer makes payment directly to the supplier as usual in an invoice discounting agreement. The only difference is that the supplier has already received a portion of the invoice value from its bank.
Financial institutions are usually willing to be somewhat more giving when it comes to invoice discounting. For instance, a creditworthy supplier might receive 90-95% of the invoice value up front when it makes an invoice discounting agreement.
Supply Chain Finance in the Real World
To give you a clearer idea of exactly what supply chain finance is and isn’t, imagine that you’re the head buyer of a company. You do your best to cultivate healthy supplier relationships, and you almost always have the funds you need to make the purchases that keep your company afloat.
Sales have been slow this month, however, and your overhead has made cash relatively tight in your company. To keep things running smoothly, you need to make a £3,000 purchase from one of your suppliers. You don’t have enough cash in your business checking account to make the purchase outright, and your supplier doesn’t feel comfortable offering a net-30 or net-60 invoice.
You decide to reach out to your bank to determine which financing options are available in this situation. Your bank suggests that you try supply chain finance, and you reach out to your supplier to float the idea. Your supplier agrees, and you decide to move ahead with SCF keep things rolling.
After ordering the goods you need from your supplier, your supplier sells your invoice to the bank. Your supplier then receives the full £3,000 to cover your invoice.
After about two weeks, your cash flow situation has improved because you were able to make your order, and you decide to make an early payment to show your supplier that you appreciate the convenience.
NOTE: Your bank may add various financing costs, such as interest and administrative fees, to the total amount you’ll need to pay when your invoice reaches maturation.
Benefits of Supply Chain Finance
In the world of receivables finance, many experts consider supply chain finance to be a win-win situation for everyone involved. Your supplier can continue growing with the cash that the bank provides in lieu of your direct payment, and you’re able to grow your business with the supplies that you purchase.
Your supplier also doesn’t have to go out on a limb to offer you financing, which can help keep things simple and stress-free between you and your supplier. On top of it all, your supplier receives 100% of the invoice value up front, which makes this finance option preferable to invoice factoring and invoice discounting for the supplier.
While the supplier benefits heavily from an SCF arrangement, there’s no agreement on the finance market in which the bank doesn’t also get a good deal. The bank will receive significant fees for providing the funds to help you and your supplier prosper when you didn’t have enough working capital to get the job done.
Pros and Cons of Supply Chain Finance
While supply chain finance has impressive positive attributes, there are also some significant detractors to using this type of financial service. Here are some of the most notable pros and cons of SCF:
- Gives buyers the power to make purchases even when they’re low on working capital.
- Allows suppliers to make sales without having to worry about extending credit.
- Suppliers generally receive 100% of the invoice value up front.
- Buyers have longer than the usual invoice window to make payment to the bank.
- Depending on which bank they work with, buyers could end up paying significant administrative fees.
- Getting buyers, sellers, and banks to work together can be complicated.
- Buyers and suppliers often have to go through a rigorous application process to be approved for an SCF agreement.
Supply Chain Finance and CreditDigital
It’s natural to like the idea of supply chain finance. Being able to pay later for goods you receive today is highly useful for buyers, and not having to worry about late payments and lack of working capital in the interim is great for suppliers. What if, however, someone figured out a way to do all those things but better?
Here at CreditDigital, we use one of the most innovative financing technology platforms ever developed to make supplier payment simple and intuitive for everyone involved. Like an SCF agreement, CreditDigital provides extended payment terms to buyers and 100% of the invoice value in cash to suppliers, but unlike supply chain finance, CreditDigital is always straightforward and easy to use.
We approve buyers and suppliers for our platform in mere minutes, and we provide suppliers with the full value of their invoices without any hassle. As soon as your buyer decides on a payment plan, we’ll release the funds you’ll need to keep growing your business.
For buyers, we offer 0% interest plans and up to 12 months of financing. You can pay as you go, and you can rest assured that your supplier has already received the full amount listed on your order total. Since we take care of credit control for our clients, suppliers never have to worry about extending credit when they shouldn’t.
We understand that buyers and suppliers want the finance process to be easy, but banks so often make it so complicated to get the capital you need to keep your business running smoothly. Here at CreditDigital, we cut through all the red tape to offer all the benefits of supply chain finance with none of the logistical hurdles.
As you consider the benefits and risks of supply chain finance, it might help to have a good grasp of the following terms:
Reverse factoring is the same thing as supply chain finance. In normal invoice factoring, the supplier initiates the financing of its invoice or invoices, but in reverse factoring, the buyer initiates the finance agreement.
Invoice finance is any finance agreement in which a supplier sells its invoice or invoices to a bank in exchange for cash. Supply chain finance is a type of invoice finance, and while most kinds of invoice finance only involve a bank and a supplier, the involvement of the supplier, buyer, and the bank makes SCF one of the most complicated versions of this type of agreement.
Asset-based lending is any financial agreement in which an entity offers an item of value in exchange for cash. For instance, a company might sell the ownership rights to its inventory to a bank to improve its working capital, or, as in the case of supply chain finance, a business might sell its invoices to a bank to improve its cash flow.