Supply Chain FinanceAs private equity has expanded over the last 20 years, being able to make a profit from companies has become more difficult. Gone are the days when a good purchase price, a touch of financial engineering and finding a bigger buyer were all it took to make a profit. Private equity groups are being forced to start making their profits by diving into operations in order to make firms more profitable and efficient.

However, there may still be a few places where financial optimization and smart negotiation can boost the operating profits of companies. One place that has started to get more attention recently is supply chain finance. While most firms focus on internal optimizations, different types of financing throughout a supply chain can have significant effects on every firm involved in the production and sale of a given product.

Supply chains are typically affected by two major financial issues. The first is double marginalization, where everyone in the supply chain thinks of themselves as an independent entity and tries to protect their own profits by pushing up prices. As the price rises each step, the total profits for the entire supply chain are lowered and the end product becomes less competitive in the retail market – especially when compared against vertically integrated producers.

The second problem is the instability and risk that comes from suppliers failing to deliver necessary components in a supply chain. By forcing the brunt of the financing burden down to suppliers, manufacturers or retailers can end up making their critical components producers less reliable. In fact, according to the paper The Effects of Supply Chain Glitches on Shareholder Wealth, the stock market returns for publicly-traded firms suffering from supply disruptions are roughly 40% lower than their competitors.

The trick is to start looking at the supply chain for any company you operate as a part of the business itself. Suppliers are critical to ensuring your operation runs smoothly or, if you’re a supplier, upstream buyers can be used to help finance your business. Depending on which side of the coin you find yourself on – the party with more cash or less cash – you can help influence the supply chain in different ways.

According to recent research, supply chain finance is best used in 3 situations:

As a manufacturer with low marginal cost and high demand

According to a recent paper, Finance Sourcing in a Supply Chain, models of financing show that it’s best for manufacturers to extend trade credit or supply chain financing to suppliers when the manufacturer has low marginal production costs relative to the market and high demand for their products. In this case, it’s in the interest of the manufacturer to bear some of the retailer’s default risk in exchange for a bit of additional profit. This eliminates some of the effects of double marginalization. Otherwise, if the demand for the product is lower, it’s actually better for a retailer to find bank financing.

Trade credit, in the right situations, can effectively mitigate double marginalization by creating higher total profit in the supply chain than bank credit would create, but not always.

In highly concentrated industries

When an industry has few competitors, manufacturers can occasionally compete based on their availability and predictability. By managing the financing of a single supplier or set of suppliers, a manufacturer can differentiate themselves because their suppliers are more predictable. In industries with significant concentration around a few competing firms, providing supply chain finance can become an advantage that allows a firm to grow market share at times when their competitors have supply chain or supplier problems.

In more diverse industries, however, it can be in the interest of manufacturers to cross-subsidize the same set of suppliers. That allows the supplier to receive more financing than they would from a single upstream supporter while requiring less from each manufacturer. This creates significant increases in reliability but removes any ability to compete based on supplier predictability in the marketplace.

When working in emerging markets or across borders

The most common type of financing for cross border deals has traditionally been trade credits and factoring. However, it’s often in the best interest of larger buyers to do reverse factoring, a three party contract where a supplier is paid by a bank immediately and the bank is paid by the buyer after 30-90 days. This allows the bank to use the credit of the larger, more established firm while still providing capital to the emerging market firms. There is risk in the deal for the larger firm, but it can help smooth out working capital issues for everyone in the supply chain. In many cases, buyers using reverse factoring experienced a 13% increase in their working capital.

Another way to help mitigate risks across borders is through currency risk agreements, where the supplier and buyer share any currency movements. That reduces the pressure on both parties, leading to a more stable supply chain.

While not every supply chain can be optimized, spending the time to think through how the supply chain currently functions can open up the possibility for significant reduction of risk or increases in profit. For more insight into supply chain financing, we’ve written a short description of each of the six types of supply chain financing.