Buyer supplier relationships crucial to SCF solutions

Supply Chain Finance (SCF) solutions for the region’s small and medium enterprises (SMEs) are in their infancy when compared to the developed markets. These are offered by few banks and among them, fewer Islamic banks. SCF solutions are about unlocking the potential cash flows and liquidity in businesses based on the existing buyer-supplier relationships.

In this column we look at how businesses can build on this relationship with banks offering such financial solutions. In other words, what can and, importantly, what should the customers of banks (the SMEs, the emerging corporates and the large ones) do to utilise such solutions and what best practices to follow to ensure these work in their favour.

Managing relationships with banks

One of the working capital solutions which a business can utilise is born out of its ability to leverage the financial strength of a larger buyer. The financing institution is able to look at the buyer’s credentials, especially his ability to pay the seller’s bills on time and utilise this for favourable credit risk assessment. This essentially allows the SME supplier to access working capital finance to grow the business which may not have been available on its own credit standing.

For those businesses for which SCF solutions have worked well, it is not necessary for them to have a deep understanding of all such products and solutions. However, one of the most critical things for them is to be able to explain to their banker how effectively they are managing their business — how it works, what’s the process flow, what’s the business cycle, and what is the extent of the working capital gap that needs to be bridged.

Based on this, banks can offer readily available products and customise bespoke solutions to fit the client’s needs. The important thing, therefore, is to present the business case to the banker in its entirety rather than just request a fixed financing amount to grow the business, without any underlying rationale and justification.

Pricing considerations

In any SCF transaction risk assessment of the credit worthiness of the client is core to the proposition. The ability to repay is central to any financing that a bank does. SCF structures offer solutions which are attractive not just for customers but also for the banks. For the customer, a receivable financing solution (factoring) can be off-balance sheet, whereby funding is extended against accepted invoices.

For the bank, a favourable invoice payment history between the buyer and supplier can provide comfort to mitigate risks associated with non-performance and default. Additional risk mitigation factors could be credit insurance policies that can be assigned to the bank. At the end of the day, customers must recognise the extent to which the risk factors in any financing transaction are covered and has a bearing on the risk premium banks consider for establishing the pricing level. Typically there is a higher premium associated if the size of the entity looking for financing is small.

Best practices

Some of the best practices SMEs should keep in mind while utilising factoring solutions are highlighted below.

First, meet your banker as often as you can. Keep him informed and keep him aware of what’s going on in your business. If you need more funds, it should not come as a surprise. Regular communication with the bank is indispensable.

Second, the business should keep a good track of invoices generated and receivables from its clients. It’s not a bad idea to do a bit of your own exposure monitoring to make sure that the portfolio remains diversified. Also, have a follow up mechanism to make sure that those bills, or obligations, get paid on time. Business processes within the company should be robust to make sure that the usual follow ups are done on time.

Third, you should be more vigilant than the bank would be. That’s because the processes on the bank side are not designed to send reminders about, or take on responsibility for, what the customer is doing with his client with regard to settlement of invoices.

Finally, take into account the element of unpredictability when dealing with large clients. It is important that when you assess your financing needs, that you build in a degree of flexibility. Sometimes the order amount can vary with a large national or multinational client. For timely processing of the order, it’s a good idea to tell your bank that you could be required to stretch the facility limit, as an exception, during certain periods in the business cycle.

In summary, interaction with your bank, being vigilant with your own clients, and building a margin of flexibility makes the SCF solution work better.

— Ehsaan Ahmed is the Head of GTS and Corporate Strategy at Noor Bank. This article is based on the proceedings of a seminar on “Simplifying Supply Chain Finance”, Contribution of Vijey Kapoor, managing partner of Velocity Ventures, is much appreciated.