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Assignment I
Group members:
BADREDDINE EL RHARBI
DIMITRIS SOUMPASIS
Table of Content
1-Introduction
1.1 Background
1.2 Research questions
2 Methodology
3 Underlying Theories
3.1 transaction cost
3.2 Information asymmetry
7- Conclusion
1 Introduction
After the financial crisis, the effects resulted to the reductions of loans granted by the
financial institutions. In such times, firms with strong bargaining power were giving out
trade credit from the supplier as a source of financing, as a result making it worst on
upstream supply chain. Such dilemma demanded the need for a solution. Amongst
other, came in the introduction of one of the most talked about topic, the Supply Chain
Finance (SCF). SCF can be described as the integration of financial flows into the
physical supply chain, and it is integrated part of the supply chain management
(Stemmler, 2002). Hofmann (2005) defines SCF as the connection of the logistics,
supply chain management and finance, he describes it as a approach with two or more
firms in the supply chain, mutually working toward the creation of value through
planning, routing and controlling the financial flows on a inter organizational level. SCF
objective is to align the financial flows through solutions operated by the financial
institutions or nowadays technical providers. The main goal is to align the financial flows
with product and information flow within the supply chain, improving the cash flow
management from a supplier perspective (Wuttke et al, 2013). Gelsomino et al, (2016)
describes the benefits of SCF relies on the corporations of the members of the supply
chain, order to create a win-win situation of all members.
Even though there is general understanding of the topic, literature and academic look in
at in two different perspectives. The first one focuses of the financial perspective, where
financial instruments are considered for firms in the supply chain. It focuses solely on
the reverse factoring (RF). It is an agreement where financial institutions buys an
account receivable from transparent, high quality buyers with a credit risk that is higher
than the ones of the suppliers thus enabling the supplier to have access of lower cost.
RF is also referred to as SCF in literature. (Wuttke et al, 2013) The financial perspective
is more of a short term and narrow in the sense that it is only rely on RF as a solution to
financial problem in the supply chain. The second one is the supply chain oriented, the
optimization of inventories between the supplier and buyer in the supply chain. In order
to reduce working capital, therefore the need to shift working capital to the member with
more availability of cash and lowering cost. In simple terms, the optimization of financial
flow with the supply chain, adopting several solutions (Pfohl and Gomm, 2009). This
perspective goes beyond the financial solutions to explore inventories, supply chain
processes and collaborating solutions. While SCF has been seen as a new financial
solution for banks the fundamental are still unclear. The objective of the paper is to run
through recent literatures and identify possible benefits of SCF, and furthermore to
showcase existing solutions that have been adopted by companies.
The paper aims to review at the recent reviewed literature on the subject on SCF. The
paper is organized as follows: section two highlights the methodology, followed by the
underlying theories within SCF. It then goes on to response the two questions this paper
tries to answer, the existing solution that exist and the benefits of SCF. The paper ends
with a conclusion, to whom the paper would be beneficial and propose areas in need of
further research.
2 Methodology
This paper review literature with focus on the concept of SCF and other solutions of
SCF. Within this paper, we aim to focus on two particular themes in order to answer the
following questions; What are the benefits of SCF?What are the other solution of SCF?
The starting point of the paper was the smorgasbord of topic. Four papers were cited by
the lecturers as as starting point,we did not use all the articles recommended on the
smorgasbord. We decided to read the literature available, from there we went on to
increase the sample size to 13. The selection of the literature under review were chosen
first by using the search string “Supply Chain Finance” and went on to narrow it down
focusing on the two themes as mentioned before. In the Solution theme, we carried out
other search string such as “Factoring”, “trade credit”, “Dynamic Discounting”, “Line of
Credit”, Reverse Factoring” and other more since they all fall under solutions of the
SCF.. As SCF is a broad topic, we decided to concentrate on our chosen area, to avoid
derailing from objective of the paper. The chosen literature are all based on recent
publications, mainly within the past 15 years.
We used two comprehensive review papers, (Gelsomino et al 2016) and (chen et al
2018). Gelsomino et al (2016) concentrated on the concepts and solutions of SCF,
while chen et al (2018) extended Gelsomino study by containing all aspects of SCF and
examined a longer period.
3 Underlying Theories
Literature within the topic has given insight to a number of theories that can be related
to SCF. The theories of Information Asymmetry and Transaction Cost are mostly used
by academia to base their theoretical background on research in the field in SCF.
3.1 Transaction Cost
Transaction cost is crucial in understanding and explaining SCF. Transaction cost
supports the core concept of opportunism that aids the financing in the supply chain and
lower the cost in supply chain Wutkle et at (2013). The application of transaction cost in
the supply chain reduces the cost, optimizes inventory level and cash level.
3.2 Information Asymmetry
Information Asymmetry focuses on the decision of transaction cost, where one party
has more information than the other party. It creates inequality of power in transactions
which can lead to an unfair transaction for example adverse selection and moral hazard.
Schmidt-Eisenlohr (2013) noted that exporters tend to adjust prices based on the
vagueness of available information. Asymmetry information and the financing fees
charged by financial institutions are interconnected, the higher level of information
available results to a lower financing fee from the financial institutions.
Being aware of the above theories can be beneficial for members of the SCF. For
example; availability of information is seen as positive input for the financial institutions
who might have to bear the risk and have problems in accessing the required and
necessary information needed to mitigate their risk and price the cost of financing
accordingly. These theories will further assist the coordination of SCF within the supply
chain. Hence, they can also act the barrier toward a successful implementation of the
SCF.
4.1 Factoring
In factoring, the accounts receivable plays the role as the underlying asset. Factoring is
a financial solution that converts bills into cash. The factor, usually a financial institution
or a bank buys a supplier’s invoice at a discounted price. The balance is settled with the
seller when the buyer has paid the accounts receivable to the factor, less interest and
service fee (Klapper, 2006) . This can either be on a recourse or non-recourse basis.
On the recourse basis, the factor has a claim on the supplier in case of default on the
buyer whereas in non-recourse, the factor bears most of the risk. When factoring, the
supplier sells accounts receivable to receive fast cash. An important aspect of factoring
is that the factor advancing less than face value of underlying assets even though it
takes ownership of the assets (Klapper,2006). Information Asymmetry can be
problematic in this case for the factor, the lack of information on payment performance
which are mostly collect by the factor themselves can be reduce the reliance on
factoring (Klapper,2006). He further went to say that RF maybe possible to mitigate the
informational issue if only accounts receivable from a high rating buyer is factored.
4.2 Reverse Factoring
The academia has followed the uprising of the SCF topic, as there are several papers
contributing toward the subject RF.(wuktte et al 2013) did a case study for adoption of a
framework for RF.RF common referred to as SCF is a financial solution where the buyer
initiates the process by agreeing with the financial institution to buy their supplier’s
invoices at a discount during a payment time period based on their credit rating of the
focal company which in this case is the buyer (wuktte et al 2013). The main objective of
RF is that the supplier can its invoices as true sales, in this case it is recorded at off
balance sheet financing. The buyer consequently pays the invoice to the financial
institution at a agreed specific date. The RF is cheaper compared to traditional
factoring, as it does not factor recourse. (wuktte et al 2013). This solution is from a
‘buyer driven perspective’ where the buyer is driver of the arrangement. RF gives the
buyer an extension of payment terms without having an effect on the other’s party
liquidity because the SFC provides the required funds for the supplier.
In the traditional way of financing inventories, the logistics service provider deals only
with the physical processing of the transactions within the supply chain and does not
intervene in the financing the inventory (Selviaridis and Spring, 2007). The capital and
settlement facilities are provided by a financial service provider.
In fact, the funds required to financing the inventory can be provided through a short-
term loan like bank credit arrangements (e.g. single payment loans, letters of credit)
(Buzacott and Zhang, 2004). In this case, firm’s current assets are used as security or
as collateral which can create a problem of Marketability. This means that inventory has
to be sold to turn in to cash. In other words, the easier the inventory to turn to cash the
easier it is for the financial institution to sell it, and therefore it makes it a high value
collateral inventory (Lasher, 1997). The financing can also be provided by spontaneous
financing related to the cash conversion cycle, which is a working capital provided by
vendors in the normal course of a firm's operations. The availability of spontaneous
financing, however, is tied directly to the credit terms offered by supplier to their
customers (Richard et al., 1980). The figure above shows the different flow of goods,
cash and securities between different actors of the from a traditional supply chain
finance perspective.
Inventory related conflicts of interested between actors in the supply chain
Within the traditional perspective of inventory financing and from a suppliers’
perspective, inventory financing depends on determining the optimal level of inventory
through a balance between setup costs and holding costs (Wilson, 1991). In the other
hand the shipper has to offer a high level of delivery service. This can be achieved
through holding high level of inventory or a fast and flexible means of transportation.
Both solutions come with a cost of tied up capital. Knowing that strong credit collection
procedure or selling good cash on delivery is difficult. (Mian & Smith, 1992). This
situation can be very hard for the supplier (shipper) sustain giving the fact that, in the
other hand, the recipient (buyer) aims to determine not only the time but also the
quantity of a delivery following his actual needs and therefore assumes ownership of the
product at his demand. This situation creates a conflicts of interest since the supplier
himself is pursuing the same objective to attain a short or even negative a Cash-to-
Cash Cycle (CCC)(Farris and Hutchinson, 2002,) by ordering products according to
their needs and ideally make the customer pay cash on order on the delivery (Hoffman
et al.,2009).
The CCC cycle is a key performance indicator for the management of the entire supply
chain (Farris and Hutchison, 2002). It can be defined as “the average days required to
turn a dollar invested in raw materials into a dollar collected from a customer” (Stewart,
1995). The Cash Conversion Cycle (CCC) is a metric that shows the amount of time, in
days, it takes a company to convert its investments in inventory to cash.
Days Sales Outstanding (DSO) is the number of days, on average, it takes a company
to collect its receivables. Therefore, DSO measures the average number of days for a
company to collect payment after a sale.
The cash conversion cycle formula is aimed at assessing how efficiently a company is
managing its working capital. As with other cash flow calculations, the shorter the cash
conversion cycle, the better the company is at selling inventories and recovering cash
from these sales while paying suppliers (Farris and Hutchison, 2002).
Potential conflicts of interest are found between the financial service provider and the
producer. The conflicts arise during the assessment of creditworthiness, when the bank
(as a lender) wants to ensure that the risk does not deteriorate beyond priced
expectations. The risk-adjusted interest rate is done by the calculation of the expected
loss (EL) (Hoffman et al.,2009).
The Expected Loss (EL) depends on two indicator: probability of default (PD) and loss
given default (LGD) describing the loss severity (Altman et al., 2005).
• PDs is provided when the financial institution applies its own rating process to
assess the creditworthiness of a counterparty and derives a probability for default
event to occur within a one-year (Hoffman et al.,2009).
• LGD is mainly influenced by the amount of collateral attributed (physical
securities, personal securities and additional agreements) (Hoffman et al.,2009).
In one hand the calculation of expected loss requires all the available information about
the company and the financed goods (type, amount, duration). In the other hand the
supplier or its buyer, do not want to provide more information than necessary. This
situation of asymmetry information create a transaction costs (e.g. information costs,
negotiation costs, monitoring costs) in the financing service as well as higher financing
costs due to lack of transparency (Hofman et al.,2009).
Buying inventory from the supplier and selling it to the buyer does not make the LSP
merchant. “ The term “merchant” commonly refers to a company which buys goods at a
(lower) wholesale price and sells them with a margin at a (higher) retail price”. In
contrast to a merchant business model, the LSP neglects retail-pricing opportunities.
The inventory held by LSP is not linked to pricing decisions (Boyaci and Gallego, 2002).
Instead, the LSP profits from the compensation of carrying the inventory and from the
offering of additional logistics services (e.g. order picking, packing and labeling)
(Hoffman et al.,2009).
In the above figure we can try to have a first view the effect of using SCF solutions to
extend payment terms but also care about the partners well being. Before 1995 Apple
paid its suppliers before receiving payment from customers and had a very high positive
conversion cycle. After 1998 Apple first received payments from the customers and then
payed its suppliers creating a negative cash conversion cycle.
By analyzing table 1 we can see in detail a switch in the way they did business
(strategy). The days sales outstanding (accounts receivable) dropped from 63.7 days in
1995 to 40.5 days in 1999 , days payable outstanding (accounts payable) increased
from 52 days in 1995 to 68 days in 1999 also inventory holdings dropped from 80 days
in 1995 to 1.6 days in 1999. So in relation of those three factors Apple financial
performance and its partners has been steadily increasing.
Source: Huff, 2015
Klapper (2006) with empirical methods note that reverse factoring in the developing
countries is a very important finance source. It is worth not that as there is not enough
or available information out in the public in developing countries, access to this
information to assess the credit rating of the firms can be an issue. The paper pointed
out that SCF reduces the Net operating Working Capital through a decline in accounts
receivable/increase in accounts payable, as in the case of RF and similar model
(Klapper 2006). Polak et al, (2012) states that with the use of DD, the solution can
benefit from an increasing in profit. Where there is a reduction of financial cost through
the reduction of cost of goods sold. Instead Huff (2015);Shang (2009);Elliot and
Lindbolm (2018) concludes that SCF is synergistic relationship between a firm and its
local partners, the change in inventory carried has long term benefit in firms
performance in the future (not immediate) instead cash flow management is not enough
to improve performance. Wuttke et al (2016) delves even deeper and derives two
reasons for the successful adoption of SCF in the supply chain, firstly clarification of the
purpose and the processes related to SCF to the partners secondly the upstream
dissemination of the suppliers motives which are based on prices and payments terms.
In contrary Dello Iacono et al. (2015) suggest based on a simulation that if the
implementation costs are high then SCF is not a win-win situation.
We go in more detail differentiating the benefit from the supplier and the buyer
perspective. The benefits to a supplier are they will not be hampered by their credit
ratings as the buyer dictates the term, resulting low interest rates (Wuttke,2016). Early
payment as a means of raising working capital, for smaller companies can be very
attractive as this finance practice is not on base of their financial standing but on the
strength of the buyer’s creditworthiness (Elliot and Lindbolm, 2018). Effective
management of the cash flow as the invoice will be paid on time (Demiroglou and
James, 2010) .
From the buyers side the benefits of SCF are receiving extension of their payment
terms in order to obtain further trade credit to improve the working capital (Wuttke et al
2016);(Elliot and Lindbolm, 2018);(Seifert, 2011). Additionally, achieving better trade
terms and without impacting the relationship with the supplier ensuring their financial
survivability.
7 Conclusion
In this paper, we analyzed 13 papers. We chose the papers based on their relations to
the benefits and the solutions in the area of SCF in order to answer our research
questions. The main objective of our paper is to introduce the topic of SCF which has
gathered the attention of theory and practice. SCF it has been recognized as an
important research area in supply chain management, as evidently seen by the
increasing number of publications.
SCF aims to optimize the financial flows on an inter organizational level through the use
of several financial solution. Literature has dwelled on this area from a financial
perspective view and a supply chain perspective. Within the financial perspective we
have explore financial solution such as RF and Factoring, on the other perspective we
shed the light on other solution such as traditional inventory financing and LSP. We
agree with Huff (2015) and Hoffman (2016) that SCF is broader than the practices of
factoring and reverse factoring. There is more SCF solutions out there but the paper
focused on the solutions mentioned.
After reviewing the benefit of SCF, we recommend that this paper would be useful for
managers and CFO who are in the verge of implementing SCF within the company.
From a manager’s perspective, the paper allows managers to get an insight of the
existing financial solutions and their benefits. It may not be a solution for all liquidity
problems, but it can serve as a sustainable solution to reduce working capital in the long
run.
Further research can be carried out in terms of development of a guideline for which
financial solution is applicable for specific objectives and firms. Another area which lack
focus is the theory of SCF. SCF has been discussed in several literature but it still
requires more concentration in exploring the foundation and concepts within the field of
SCF.
The limitation of this paper can be seen by the number so solutions covered. As there
are a lot more SCF solutions, we decided to concentrate on the few that were
mentioned because of time limitation and word count. Since SCF is a very broad area,
covering all aspect of the area requires a lot more time to carry out an assessment.
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