Category Archives: Supply Chain

The Great Divide: Working Capital Efficiency in Consumer Industries

 

With the new year upon us, we here at Flowcast have one resolution: help companies bridge the ever increasing gap in their cash conversion cycles. Based on a study we conducted of over 300 companies from the S&P 500, we found that nearly 55% of those companies have consistently increased their Days Payable Outstanding (DPO) over the past five years. This trend is especially pronounced in the consumer industries where over 70% of companies have increased their DPO by an average of 11 days. Not exactly the best news for their suppliers going into the new year.
Take a look at Flowcast’s latest infographic to find out more:

 

 

Brewers lead the pack by a wide margin in DPO increases with 140 days. Although these increases in DPO are good news for Consumer Staples giants, it can cause issues for their smaller suppliers, who will need to find ways to make up the gap in their own cash conversion cycles. Here, we believe tech innovations in supply chain finance will help bridge the gap for both buyers and suppliers.

Follow us on Twitter @flowcastlab to stay up to date on the latest supply chain news, trends and analysis.

Addressing the Debt Reclassification Issue In Buyer-Led SCF Programs

 

Cash flow is the lifeblood of most businesses. As operations grow increasingly global, today’s organizations face the increasing challenge of working capital needs. The complexity is exacerbated in cross border transactions in which trade receivables are subject to separate legal jurisdiction and payment terms tend to be longer. In this context, supply chain finance (SCF) programs could be a powerful tool to drive working capital efficiency in the supply chain, helping suppliers get cost-effective financing while allowing buyers to maintain a stable supplier base by capturing value from their payables. Indeed, SCF is now a $275bn industry, growing 30% a year . However, despite years of implementation, a growing number of buyers see SCF programs as potentially negative to their overall company debt rating. There is a growing concern that rating agencies may treat SCF programs as debt rather than trade payables. What can tilt the balance are changes in the terms of trade between the buyer and the supplier. In a report last December, Moody’s voiced its concerns about overly complex SCF programs and encouraged less enclosure when communicating engagements in SCF programs.

While SCF offers tremendous potential to dramatically improve operational and financial efficiency for organizations, debt reclassification could be the Achilles heel. It has become the top concern for CFO’s and Treasurers as they evaluate adoption of SCF within their organizations. Consider a company with $300M trade payables outstanding. A sudden reclassification of these payables would severely impact their leverage, access to additional credit and existing debt covenants. Take for example the case of the Spanish energy group Abengoa, which recently filed for bankruptcy for one of its subsidiaries. Although their large scale SCF program did not cause their decline by itself, it certainly had debt-like features and was a large contributor to their decline.

Unfortunately, the IRS has not yet addressed this issue in a satisfying manner, and existing guidelines are vague at best. IFRS rules do not fare that much better. IFRS suggests reclassification of trade payables into debt only if there is a substantial difference in the terms of the existing financial liability and the new liability. The ambiguity and subjectivity make the reclassification issue a major headache for treasury organizations considering the deployment of SCF programs, causing companies to be more conservative, slowing down the programs and making the set-up costs more expensive. [1]

All worries aside, we did a bit of digging and learned that there are ways to navigate the choppy waters of buyer led SCF programs. Programs that successfully have been put in place tend to have a set of recurring characteristics to comply with auditors so that transactions are kept as trade payables. First and foremost, a thorough understanding of the trade terms is required. The key question to ask: Are there any significant changes in the payables to make it look like a debt-like obligation? Trade Financing Matters provided some useful insights regarding this issue and offered the following key points:

  • You should avoid a tri-party agreement between the buyer, seller and the funder. Extended payment terms for the buyer and discounted early payment for the seller should be treated as two separate events. Therefore, if the seller for some reason wants to opt out of the program, the buyer still gets his extended payment terms. The higher level of influence the buyer has in the negotiation process, the harder it becomes to convince regulators that the company is not borrowing money from a bank to pay its vendor. [2]
  • The bank should in no way be involved in the discussions between the buyer and the supplier regarding the terms of trade. [2]
  • The discount rate offered to the supplier should be offered by the bank and not the buyer. [2]
  • The buyer should not guarantee payment to the bank. This point is important and in many ways the crux of the issue: If the buyer is confirming to the financial institution that it will pay on maturity regardless of any disputes or other rights of offsets it may have against the supplier, then it is giving a higher level of commitment to the bank than it gives to the supplier. As a result, the economic substance may have changed significantly as this could be constructed as a form of financing on the firm’s books. [2]
  • The bank should not share any interest revenue from the discount with the buyer. The presence of interest is not customary in a trade payable arrangement and would suggest that the obligation is more akin to debt. [3]
  • Peer-to-peer comparison may motivate DPO extension beyond the industry standard: Although an extension of payment terms(DPO) to better align with its peer group may not significantly change the economic substance of the arrangement, the payment terms should be consistent with other peer companies in the company’s industry. If your payment terms have extended beyond the industry standard, it may indicate that the presence of a SCF program have resulted in an obligation that is inconsistent with the customary trade payable terms and thus that the economic substance have changed. [3]
  • Discounts are typically negotiated between the seller and buyer, and if there are disputes, the buyer normally has the ability to withhold payment. If, for any reason, the arrangement does not allow for such negotiations and abilities, the economic substance of the arrangement may have changed. This becomes relevant in cases where the vendor delivers a product defect. If the buyer is still obligated to pay the bank in full, despite the defect, then this may imply that the company no longer retains its right to negotiate terms for that specific payable. [3]
  • Buyers should have no say in determining which party that should finance the program. [2]

Some buyers look towards non-bank platform providers in order to lessen the likelihood of debt reclassification. Although many successful SCF programs are orchestrated by banks, non-bank providers, (eg., PrimeRevenue), separates the buyer from the bank and do not utilize the contract between the bank and the buyer. This reduces some of the aforementioned risk, such as the tri-party agreement.

The emerging field of supply chain data science is transforming supply chains from reactive- to predictive operating models. The implications extend far beyond traditional supply chain operations. Ultimately, they will help the next generation global company – the insight driven enterprise – getting ahead of competition.

Written by August Riise, Flowcast.

*Full disclaimer: We are not auditors or accounting professionals. These are strictly based on our own research and opinion

[1] Is Supply Chain Finance Constricted by Accounting Rules? David Gustin, Trade Financing Matters

[2] Supply Chain Finance Payable Reclassification issue – dead or alive? David Gustin, Trade Financing Matters

[3] Dataline: A look at current financial reporting issues , No.2013-28, PwC

Five reasons why Obama’s SupplierPay isn’t working

 

While the roster of companies signing up for SupplierPay initiative has certainly grown, Obama’s program has limited substantial results to show for itself.

In 2008, multinational beer giant InBev acquired one of the largest American brewers, Anheuser-Busch, to create the world’s largest beer company. InBev is an affiliate of 3G Capital, a conglomerate that also owns food and beverage staples like Heinz and Kraft Foods.

In the wake of the Anheuser-Busch and InBev merger, 3G Capital began requesting that its suppliers give it up to 120 days to make payments, rather than the standard 30. Not in a position to refuse, the much smaller farmers and manufacturers that supply 3G Capital companies reluctantly complied.

The extended payment arrangements marked a paradigm shift in supply chain economics. The practice soon caught on almost everywhere, giving big companies breathing room in the aftermath of the 2008 financial crisis. But it led to cashflow problems for the small, captive suppliers with little financial cushion, and the tactic still affects them today. Irked at being treated like lenders instead of suppliers, the UK’s Marketing Agencies Association encouraged advertising agencies to strike against Anheuser-Busch InBev.

In response to the increasingly unfair terms imposed by companies, the Obama administration launched the SupplierPay initiative in 2011. The primary function of the initiative is that companies pledge to pay their suppliers earlier, unclogging capital flows and helping small businesses.

While the roster of companies signing up for SupplierPay has certainly lengthened since launched (growing from 26 in 2014 to 47 in 2015), the program has limited results to show for itself. We examined the days payable outstanding (DPO) of 17 of the first 26 pledged companies, we found that more than half of those companies have actually extended their overall payment days, to a median of +1.9 days.

Here are five reasons why Obama’s SupplierPay initiative is not the answer:

  1. No enforcement

Perhaps the single biggest flaw with SupplierPay is the fact that there is no enforcement for companies that have pledged to pay suppliers faster. David Gustin, the founder of Trade Financing Matters, writes, “the White House has no teeth in their proposal.”

“Getting companies to volunteer and pledge without mandating change via regulations (like Brazil or Mexico have mandated electronic initiatives around trade flows) is just a tough road to travel,” Gustin explains in a blog post.

As a result, the average payment time for pledged companies has actually increased, not decreased.

  1. The Prisoner’s Dilemma Paradox

A report from the US Department of Commerce explains a fundamental disincentive for companies to pledge. The Prisoner’s Dilemma is a hypothetical scenario that explains why two rational entities might not cooperate even if it is in both their best interests to do so.

If two firms pay their suppliers quickly, they receive the same adequate compensation. However, if Firm A decides to delay payment in order to invest the savings or finance short-term projects, it can benefit from higher compensation. Firm B is put at a competitive disadvantage and might even have to absorb the costs of Firm A’s delay. Firm B now wants the same benefits as Firm A, so it decides to delay payment as well. Now the supplier is being squeezed by both firms, resulting in shoddy goods, unstable output, and/or higher prices. In effect, everybody loses.

Even if SupplierPay means well, it accomplishes little unless everyone participates and pays earlier, not just pledged companies.

  1. Cost is passed back to suppliers

Because most of the pledged companies are large corporates, they can leverage their huge buying power to force the added costs resulting from earlier payments back onto suppliers. In addition, those with extended payment terms are typically non-strategic suppliers and therefore, are are not the suppliers that are high up on a large buyer’s priority list. A farmer might only sell his or her barley product to a single brewer, for instance, so that brewer can dictate the terms. If a corporation can no longer gain an edge from extended payments, then it can force captive suppliers into discounting their products instead.

  1. Ineffective without Supply Chain Finance

Supply Chain Finance (SCF) needs to be more widely available to both the suppliers and the buyers. Dynamic discounting solutions, virtual cards, and working capital platforms can all help suppliers get paid faster. Innovative SCF solutions can help companies extend their payment terms in a way that’s fair to both parties. However, SupplierPay does little to encourage more supply chain finance solutions. In fact, it fails to acknowledge the economics for large buyers to offer such options without tying their availability to an extension of payment terms.

  1. Paper checks are slow

In addition to more supply chain finance options, experts agree that upgrading to more efficient payment methods can also reduce the strain on suppliers. Simply switching to electronic payments instead of sending checks and invoices through the mail could go a long way toward alleviating unnecessarily long payment periods.

Despite the significant cost savings of moving from paper checks to e-payment, a recent report suggests B2B checks will not go away. Some 70 percent of organizations it surveyed are struggling to convert to electronic payments, and most companies cite customer/supplier hesitance to adopt and IT barriers as the top obstacles.

Yes, we are in an election year. So the question is: is SupplierPay 2.0 in the cards? Given the lackluster results thus far and notwithstanding who wins the White House later this year, my money is on a radical change in the current initiative. If the new administration does double down to have any impact, it will require direct intervention such as regulations, tax incentives, and repatriation credit. I am much more optimistic about the technology innovation happening in SCF to help small businesses. Such innovations from digitization of invoices to cloud solutions to new ways to optimize working capital to new alternative forms of B2B financing, collectively will have a far more substantive impact to the entire supply chain ecosystem.