Benefits and Risks of Supply Chain Finance for CFOs

Supply chain finance offers benefits to large organizations and cash-strapped suppliers, but supply chain finance models create regulatory and other risks that CFOs must consider.

Supply chain finance looks increasingly attractive to large businesses and their liquidity-constrained suppliers as a way to optimize working capital. An estimated 23% of organizations in a Gartner 2020 poll relied on supply chain finance to increase available cash flow to the business in the face of pandemic-driven economic headwinds.

However, before pursuing supply chain finance as a permanent strategy, CFOs need to ask which supply chain finance models support their broader cost strategies and should be aware of regulatory and other risks.

It’s critical for CFOs to be discriminating in the type of supply chain finance they adopt and the way they disclose and report it

Several factors are driving the popularity of supply chain finance, from the emergence of highly sophisticated fintech solutions that allow for dynamic discounting to a push for both suppliers and buyers to optimize working capital and legislation that intends to tighten payment windows for small suppliers.

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CFOs must, nevertheless, weigh potential costs as well as benefits. “Different types of supply chain finance have different cost, benefit and risk profiles,” says Miguel Cossio, Director Analyst, Gartner. “The CFO must select the type that supports broader financial strategy and discuss disclosure requirements with external auditors to avoid regulatory and reputational risks.”

What is supply chain finance?

Supply chain finance refers to agreements between buyers and sellers that restructure the financing of supplies in ways that generate working capital benefits for both. Supply chain financing is effected through a financial counterparty, usually a bank or a fintech partner.

The term “supply chain finance” is often used synonymously with the term reverse factoring, but the latter describes one of two primary types of supply chain finance, the other being dynamic discounting. There are many additional naming conventions, including trade finance, confirming, supplier financing and accounts payable discounting.

It’s critical for CFOs to be discriminating in the type of supply chain finance they adopt and the way they disclose and report it.

Read more: Make a Compelling Case for Your Digital Supply Chain Transformation

In reverse factoring, buyers set up the supply chain financing instead of the supplier. Because large corporate buyers typically have a higher credit rating, the financing is cheaper than it would have been for the supplier. The parties share the benefits: The buyer achieves extended payables terms, while the supplier lowers the cost of financing by leveraging the buyer’s lower cost of borrowing.

In dynamic discounting, the buyer funds the program, enabling suppliers to access early payments on invoices in exchange for a discount.

How does reverse factoring work?

Reverse factoring takes place in four stages:

  • The seller transfers purchased goods and the associated invoice to the buyer.
  • The buyer approves the invoice and shares the approval with the financial counterparty.
  •  The supplier can either request from the financial institution an earlier payment for a larger discount or choose to defer payment for little or no discount. The flexibility of the arrangement is part of its attractiveness to suppliers.
  • The buyer settles the account with the payables payment on a predetermined schedule.

The supply chain finance core reverse factoring model

How does dynamic discounting work?

Dynamic discounting is a financial service provided by a fintech company where the supplier receives a faster payment from the buyer in return for a product discount. The stages are as follows:

  • As with reverse factoring, the seller transfers purchased goods and the associated invoice to the buyer.
  • The buyer and the supplier can then negotiate different payment discounts and timing using the technology platform.
  • Buyer issues payment.

Risks of supply chain finance for CFOs

“The naming ambiguity exposes all companies that use supply chain finance to the reputation and regulatory risks associated with the worst liquidity risk management examples in common use,” says Cossio.

Why? Because it’s not clear to regulators and investors which kinds of supply chain finance involve just operating cash-flow adjustments — industry-standard payables and receivables adjustments — and which involve financing activity where a material extension of payables durations is the financial risk equivalent of short-term debt.

Mainstream financial analysts refer to longer-than-normal receivables terms for the supplier as bad reverse factoring

Despite consensus on the reverse-factoring model, for example, some variations of supply chain finance push buyer payables beyond industry averages — extending 90- or 120-day payment obligations to 365-day terms. These variations create confusion regarding whether the intent is to maintain working capital or to “hide debt.” Mainstream financial analysts refer to longer-than-normal receivables terms for the supplier as “bad reverse factoring,” and to extended payables terms for the buyer as “confirming.”

Dynamic discounting is also birthing variations that take the arrangement onto potentially shakier grounds. Hybrid discounting models are where suppliers and buyers can use the same technology to arrange discounting directly with the buyer and through reverse factoring using bank financing.

A firm’s ability to switch seamlessly between direct payment or financing will further obscure the operating or financing cash-flow dynamic, which can raise concerns for regulators and equity analysts.

Read more: Top Emerging Risks for Business Leaders

Prepare for regulatory scrutiny of supply chain finance

Problems with transparency related to supply chain financing have been acknowledged by the four largest auditing firms, which have highlighted the wide range of supply chain finance models and related challenges to classifying supply chain finance payables as operating or financing cash flow.

Critics of supply chain finance point to two areas where the practices can lead to trouble: Poor disclosures hiding financial distress and an invitation for U.S. Securities and Exchange Commission (SEC) scrutiny.

When a struggling company utilizes supply chain finance models, it can potentially transform traditional payables owed to a bank and thereby create something closer to traditional debt. The supply chain finance arrangement with the bank can technically be unwound at any time, creating a massive short-term repayment due for the company in question.

Additionally, the SEC has sent at least two comment letters to companies regarding their supply chain finance arrangements, inviting negative publicity that can also entice hostile activist investors.

CFOs should weigh these risks with the many potential benefits of a healthy supply chain finance arrangement.

Read more: Diversifying Global Supply Chains for Resilience

Recommended resource for Gartner clients*: The Benefits and Risks of Supply Chain Finance.


*Note: Some documents may not be available to all Gartner clients.

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