Many people running their own business will be overwhelmingly familiar with the whiplash sensation of having to slam the brakes on while awaiting the payment of an invoice. Increasingly long payment terms are putting pressure on smaller businesses that are trying to make ends meet. And whilst solutions like factoring can help address the shortfall, they can also eat up a lot of time in the process. Fortunately, there is a solution.
The conflict between a small supplier’s need for capital and a larger buyer’s desire for longer payment terms was originally born out of necessity. “It originally started because large companies have a much bigger administrative burden than a smaller company,” explains Christian Lanng, CEO of Tradeshift, the global supply chain platform. In the days of paper-based processes, the sheer time it took to receive and enter paper invoices into an accounts payable system necessitated longer periods to turn around payment.
However, as these costs have lessened, the length of payment terms has actually increased. “Due to the tightening up of credit and companies wanting to make their balance sheet look a little bit healthier, we’re seeing an increased trend of larger companies pushing out their payment terms,” says Nigel Taylor, director of European business development at Taulia, the e-payments, e-invoicing and supplier finance provider. Whilst 30- and 45-day terms were once standard, most enterprises are also familiar now with terms that can range from 60 to 90, something that causes a far more noticeable gap in their balance sheets.
It’s not hard to see how this has a negative impact on SMEs trading with larger partners. “They’re basically giving a loan to the large companies,” says Lanng. “That means they then need to go and cover that hole in their cashflow by going to the bank or factoring.”
But this also has a knock-on effect for the large suppliers, one that may be overlooked when trying to present a robust picture of working capital to their shareholders. Lanng says: “Where it’s hurting the large company is that all of the cost incurred for that small supplier will eventually only go to one place: the bill to the large company.”
For any SME dealing with a hole in their books, there are a few solutions. A supplier can resort to traditional lending, but these are themselves rather hard to come by in the current climate.
One option is obviously factoring, in which a company borrows against its outstanding invoices. “Essentially they sell their whole receivables book to a third party,” explains Taylor. The factor will pay a price based upon the combined credit rating of the supplier and of the buyer, allowing the supplier to fill the hole in their balance sheet and recouping from the buyer once the payment terms are up. “But the rate will be affected by the fact that party is taking on a whole set of risks,” he says. “For example: ‘Will the goods be okay? Will there be any disputes? And will it be paid on time?’”
Another solution, which mitigates some of this risk, is reverse factoring. The key difference between this and traditional factoring is who initiates the process. “The factor is working directly with the buyer,” Taylor says.
On delivery of a product, a buyer interested in reverse factoring will hand pick certain suppliers that they want to offer up to a factor. “The invoice has been approved, meaning it matches to the purchase order and the goods have been delivered in good order,” Taylor comments. Because of this, the factor can offer suppliers a rate based on the larger buyer’s credit rating alone, presenting them a much better rate. This means the supplier closes the hole in their balance sheet, buyers can spin out their payment terms to a point that suits them and the factor gets a safer return.
Obviously this is good news all round and gives everyone what they want. “It’s actually possible for the large company to extend the payment base and the small company to get access to cheap finance,” says Lanng. “You can solve both problems.” Unfortunately, this means that there needs to be certain mechanisms in place to smooth the passage of transactions. He continues: “It requires that both sides collaborate.”
And this is, in part, why reverse factoring hasn’t had as much traction as its bigger brother. Whilst reverse factoring is a $275bn industry around the globe, traditional factoring is worth a staggering $2.8tn. The reason its growth has been limited thus far is largely logistical. “If you look at the past, all transactions were more or less paper based and all of the data was locked into these pieces of paper,” Lanng comments. “This made it very hard for anybody to get any transparency or figure out what’s going on.” If those in the SME space are to feel the benefit, increasing the accessibility of data and the speed at which it travels is essential, particularly in light of the number of know your customer checks banks are required to conduct when lending these sorts of sums. Taylor says: “If you want to get across the whole of the supply chain and let’s face it get liquidity to the suppliers who really need it – not just the big ones but those mediums and smalls – then you have to have a degree of automation in place.”
Fortunately, if there’s anything that we’ve gotten good at in recent years it’s data. Using modern platforms, it’s far easier to serve up required information to third parties and automate the process. This means that supply chain financing has become much more streamlined for all involved. As Taylor explains: “Anybody who wants to step in and finance a purchase order can actually examine all of the crucial supply chain data and make a very detailed analysis as to what risk is involved.”
And it’s where these things cross over with other elements such as e-invoicing and cloud accounting that things become really interesting. “The thing that supply chain financing does and that e-invoicing does is they both build up a very detailed audit trail over a period of time,” says Taylor. The data picture this creates can be used to power applications that handle this sort of processing in real time, meaning that, long- term, ensuring liquidity in the supply chain may be a much more hands-off process. “It’s the perfect opportunity to automate the entire supply chain.”
The ramifications of this are, potentially, huge, saving founders and execs massive amounts of time and revenue. “In the long run, we can hopefully make some or all of this stuff go on much more in the background,” Lanng says. And this means if less time has to be spent on chasing payments and patching cashflow shortfalls, entrepreneurs can concentrate on securing growth. “We can focus on the things that matter for our business,” he concludes. “But the inner mechanisms of that business should actually be trivial.”