What is Supply Chain Finance – Types, Benefits & its working

In an economic framework that incentivises specialisation, each business is dependent upon the other for one or the other activity. Given the interdependence in either domestic supply chain or global supply chain, Supply Chain Finance comes to the fore as an efficient mechanism to provide working capital to enterprises and optimise their cash flow.

But what is Supply Chain Finance?

We comprehensively describe the meaning of Supply Chain Finance, its various types, how Supply Chain Finance works, the process, its benefits, and how it is different from Trade Finance.

What Is Supply Chain Finance (SCF)?

Supply Chain Finance or SCF is a mechanism to provide a cash advance to businesses against their accounts receivable, thus unlocking their working capital trapped in bills of exchange or unpaid invoices.

Supply Chain Financing includes Bill Discounting, Invoice Discounting, or an Overdraft Facility and helps bridge the cash flow gap of MSMEs by providing supplier finance to businesses for their working capital requirements. Supply Chain Finance could either be against purchase invoices or sales invoices.

The parties involved in Supply Chain Finance are buyers (usually large companies), suppliers (small or medium-sized businesses), and financial institutions (Banks or NBFCs).

Types of Supply Chain Finance

The types of Supply Chain Finance are-

1. Purchase Order Financing or PO Financing

In Purchase Order Financing, a buyer approaches a financial institution to finance a purchase order raised against a transaction.

The finance provider then provides an advance to the firm’s supplier against the purchase order.

The buyer then makes the payment into the supplier’s finance account to settle the outstanding amount to the financer.

The need for Purchase Order Financing arises since the suppliers may not get immediate payment from their clients yet require working capital for order fulfilment.

Suggested Read: Pros and Cons of Purchase order financing

2. Sales Invoice Discounting

In Sales Invoice Discounting, the supplier approaches a financial institution to get finance against a sales invoice. The Finance provider then authenticates the validity of the invoice, checks the credit rating of the supplier and the buyer, and provides finance to the supplier in an escrow account.

Upon order fulfilment, the buyer makes the payment into the escrow account to settle the outstanding amount in the escrow account.

How does supply chain finance work?

Supply Chain Finance works in the following 2 ways-

1. Anchor-led Model (Spoke and Anchor Model)

In an Anchor-led Model, there is a Large Corporate which is considered an Anchor, and its several trading partners are considered spokes.

In this model, the Supply Chain Financing could either be Buyer-Centric, or Seller-Centric.

In buyer-centric supply chain finance programs, the Buyer is the Anchor and the Sellers are the spokes. A financial institution, or Finance Provider uses the buyer’s credit rating (Anchor) to finance the supplier’s invoices. This reduces the risk for the lenders while reducing the financing costs for the supplier.

In a seller-centric supply chain finance program, the Seller is the Anchor and the Buyers are the spokes. A Bank or NBFC provides financing to the buyers against their purchase orders.

In an Anchor-led model based Supply chain financing, the credit provided by the financial provider is based on the anchor’s financials and its credit rating, and thus may provide lower cost funding to the spokes to the anchor.

2. Marketplace Model (TReDS)

In the marketplace model, only MSMEs or Micro, Small and medium-sized Enterprises are allowed to participate as vendors by uploading their unpaid invoices on a supply chain financing platform.

Once the invoice is uploaded on the platform, it is accepted by a potential buyer of that invoice- an anchor or other businesses.

Once the buyer approves the discounting rate, the finance is processed by a financier.

In this model, the KYC and due diligence is conducted by the platform itself, which helps reduce risk for the lender.

However, an anchor cannot discount the invoices of MSMEs on TReDS.

Supply chain finance process

Supply Chain Finance works in the following way-

• A buyer or a seller makes a transaction of goods on extended payment terms.
• The buyer or seller then goes to a financial institution to get an unpaid invoice of the transaction discounted for an early payment so as to unlock working capital locked up in invoices.
• The Financier (or the lender) then provides a cash advance against the approved invoices at specified financing rates or a small fee.
• The buyer or seller then makes the payment into the financing account to settle the outstanding finance provided by the financial institution.

Suggested Read: What is Invoice Discounting

Benefits of Supply chain finance

Supply Chain Finance has the following benefits-

1. Unsecured financing solution- Supply Chain Financing does not require any collateral and is primarily provided against the proof of trade invoices.

2. Short tenure- Supply Chain Finance has a short-tenure for repayment, usually ranging from 90 to 120 days. The payment terms also allow for repayment as soon as the buyer pays.

3. Accessible alternative to business loans- Supply Chain Finance is a win-win situation for both the buyer and the supplier since it provides more working capital to businesses without having to take a business loan.

4. Allows for flexible payment terms- Supply chain finance is useful in situations where early payment is required but the enterprise may not have immediate cash to pay.

5. Lower financing costs for small suppliers- The credibility of the Anchor allows small suppliers to get supply chain finance at lower costs.

6. Optimises Working Capital- Supply chain finance helps both suppliers and buyers to optimise their working capital.

7. Stronger relationship between a buyer and supplier- The requisites of supply chain finance lead to deeper relationship between buyers and suppliers. Both the buyer and the supplier are dependent on each other for the smooth functioning of their own operations.

Suggested Read: What are Different Types of Working Capital?

How is Supply Chain Finance different from Trade Finance?

While both Supply Chain Finance and Trade Finance help sellers and buyers optimize working capital, the difference between the two lies in the nature of funding or the debt instrument used to provide credit to a buyer/supplier.

In Supply Chain Finance, primarily invoices are discounted to provide credit to buyers and suppliers. On the other hand, a bank guarantee or letter of credit (LC) is the debt mechanism used in Trade finance to provide credit.

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