Continuous Improvement -- New Programs Help Manufacturers Free Up Cash Without Straining Suppliers
Editor's Note: This is Part 1 of two parts. The second installment can be viewed here. It includes information on GAAP compliance and a case study.
It's an age-old question: How quickly should you pay your suppliers? Wait too long, and you chance poisoning the relationship -- after all, vendors need money to pay their own bills. In addition, if extending payments leaves your suppliers scrambling for cash, they may need to obtain financing elsewhere and are apt to build that cost into their future prices.
On the other hand, most companies don't want to tie up their own funds by paying for goods before they're actually using them.
This dilemma becomes even more pronounced when sourcing materials and components from around the world, as the goods are likely to spend more time in transit. If you pay your vendors as soon as the order leaves their plants, your money can be tied up for a week or two before the goods even arrive in your country.
To address this problem, some financial firms (in some cases, the firms may be subsidiaries of financial firms) have become intermediaries in trade payables transactions. They pay the suppliers on behalf of the buyers; often the funds change hands within hours of the goods leaving the supplier's plant. At a later date, the ultimate buyer reimburses the financial institution for the goods and also pays a financing charge.
While the methods used to finance trade payables come in several flavors, they have one common thread: They're designed to put inventory in the hands of the company with the lowest cost of capital. Financial institutions and their subsidiaries typically have a lower cost of capital than asset-intensive manufacturing companies.
At this point, these programs are just catching on. "It's a product that's fairly new, but growing fairly rapidly," says Uday Mahtani, a New York-based vice president of business development for commercial trade finance with Siemens Financial Services Inc., which offers a trade payable financing program.
One caveat: the U.S. Securities and Exchange Commission has raised some questions about the method of properly accounting for these transactions. It's critical that companies take the time to structure these transactions so that they conform to GAAP (generally accepted accounting principles) requirements, and also provide a viable and cost-effective way of financing trade payables.
Several factors are driving the demand for these financial tools. Historically, suppliers used letters of credit to obtain financing from a bank or other financial institution before shipping goods. However, these tend to be expensive, with costs often running about 2% of the value of the shipment, says Patrick Tunison, chief international lending officer with the Small Business Administration, Washington, D.C.
In addition, many companies are moving to purchases done on open account, says Dan Scanlan, San Francisco-based senior vice president for global trade finance with Bank of America. (Open account orders are those in which the buyer is billed and submits payment after the order is shipped.) A vendor may find that obtaining financing on open account orders can be difficult, as it is more or less at the mercy of the buyer.
A number of financial institutions have stepped into the gap with programs and products that go by such names as trade payable financing, supplier early payment and other titles. While the programs vary, they tend to work something like this: A financing firm acts as a paying agent for the buyer, and advances the funds owed by buyer to the seller. This usually occurs as soon as the buyer approves the invoices for payment.
The financial firm doesn't take ownership in the supplier's receivable. Instead, it reaches an agreement in which the buyer promises to repay the financial firm. The terms typically are those originally established between the buyer and supplier.
Buyers identify suppliers that they think will want to be part of the program, and the financial firm works to enroll them. Vendors typically bear the cost of these programs. That raises the question: What's in it for them? The biggest benefit: suppliers receive their payments earlier -- at times, up to several months earlier -- than they otherwise would, says Don Morrison, managing director of the supplier early payment program with General Motors Acceptance Corporation Commercial Finance (GMAC CF) in Southfield, Mich.
In addition, the financial firms typically base their fees on the credit-worthiness of the buyers, which tend to be larger and financially stronger than the vendors supplying them. "We're basically using the financial strength and creditworthiness of a large buyer to providing financing to suppliers," says GMAC's Morrison. As a result, vendors can obtain better financing terms than they probably would be able to obtain on their own.
Not surprisingly, the charge to the vendor usually decreases as the credit quality of the buyer increases, says Mahtani of Siemens.
Bank of America, which also offers a trade financing program, will adjust its rate based on the relationship between the buyer and the seller, Scanlan says. If the two firms have done business together for five years, and the buyer has always paid on time, the supplier will tend to get a better rate than if the two firms just started working together.
Most trade program financing rates are tied to LIBOR, or the London Interbank Offered Rate. LIBOR usually is a couple of percentage points lower than the prime rate, which is the rate on which many consumer loans are based. At mid-September, for instance, the prime rate stood at 6.5%, while the one-year LIBOR was at 4.15%, according to Bankrate.com, an online financial site. The financial firms sometimes charge fees for administering the programs.
Karen M. Kroll is a writer specializing in financial issues.
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