In my previous post i wrote about how company can improve their key figures and shareholder value by entering in to Receivable Purchase Agreement (RPA) with a bank or financier. The Cash Conversion Cycle (CCC) could then be improved by reducing Days Sale Outstanding (DSO) from eg 45 to 5 days.
The process where the bank is purchasing the receivables can also be done in “reverse” where the bank instead is buying the company’s Account Payables from its suppliers. The process and agreement is commonly known as Supply Chain Finance (SCF), and gives the opportunity to enhance CCC by increasing Days Payable Outstanding (DPO). Before we go into details about how the operation goes through and why (how)? it can improve DPO, it is important to say that the SCF in its true meaning embrace a much wider concept of operations than just payables financing. Letter of credits and other Trade finance credits that Magdalena wrote about in her post “How to pay your Chinese supplier” in October, are all means to finance the supply chain. In this post though, we are going to focus on SCF by selling Account Payables and for the sake of simplicity, from now we are just going to refer to it as SCF.
Setting up a SCF agreement demands a close dialog with the customers suppliers to agree on scope (should the supplier be able to choose which invoice to sell or is the agreement applicable for all invoices?), new payment terms and potential early payment discounts. We also encourage reviewing payment routines for maximum effect on Working Capital Optimization.
Depending on the extent and configuration, the solution could either be setup by the banks itself, or in combination with a platform provider. Hence the variation of providers and the tailoring of solutions there is no standard answer of how it will look like, but many providers will set up portal where the supplier will have the opportunity to choose which invoices that s/he will sell. Such SCF solution suppliers will also benefit from new tools of Working Capital Management. The solution can be outlined as seen in picture1 and described as follows:
A supplier/s will on agreement send goods and invoice/s to the buyer (1). Buyer will on the platform register approved invoice (2), who the supplier can choose to sell (3). The platform (external) will then notify the financier, typical a bank and send payment instructions (4) to pay the supplier/s the discounted invoice (5). The buyer will then according to new agreement settle the bill to the bank on due date (6). The transaction of the early payment of the invoice is finance on the low credit rate of the buyer and is usually forwarded to the supplier either directly, or indirect through agreed early payment discounts. The transaction is usually done as, and accepted by accountants, as a true sale. This means that it will not just improve the liquidity of the supplier it can also be booked as cash in the balance sheet, and improve the suppliers key figures such ROCE or NIBD/EBITDA.
For this to be an interesting source of finance for the suppliers, the terms must be more favorable than they could achieve on their own (either through improved key figures or by attending low financial cost). Customers of this type of solution is usual lager corporates that have lower credit risk than their suppliers and therefor can receive better credit terms. Because of the effort that is put into the agreement the relationship is almost every time improved between the buyer and supplier. The reasons for entering in to an SCF can be many and a short summary is set up in the table below.
So there are a handful of advantages both on the supplier side and the buyers side but the most important and common reason for entering in to an SCF agreement is as mention in the beginning, working capital optimization. By increasing DPO either financed through early payment discount or by simply providing more reasonable financing to the suppliers, the CCC can be considerably improve and reduce weighted cost of capital by increase non-interest bearing debt. In a publication from PWC in july 2017, they inform that 42% of the respondents choose SFC because of the Working capital optimization effects. On shared second place is supplier liquidity needs (18%) and supplier relationship improvement (18%). According to PWC:s Working Capital Study Unlocking enterprise value through working capital management (2017/18), Nordic companies lag European and North American counterparts on working capital performance, and only 7 out of 17 sectors managed to improve working capital since 2012. That said, we hope that you find this post interesting!
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A Receivable Purchase Agreement ("RPA") is a financial arrangement between a bank or financial institution and a company, where the bank provides liquidity to the company by purchasing its undue account receivables. The agreement regulates the purchasing process, terms and conditions and how the cash flow will work. The bank is buying the creditors rights in the Account Receivables (“AR”) from the company (seller), against the buyer (debtor), under the current applicable commercial conditions.
Figure 1 below illustrates how the agreement works in practice. In step 1 the seller issues invoices assigned to the bank. When the bank has received the AR report containing the receivables, it will pay the seller the face value of the receivables minus the discount fee, and sends a purchase report back to the seller (step 2-3). In many cases the bank will also demand that the receivables are insured by a credit insurance company. The buyer (debtors) will thereafter on due date pay face value to the new collection account, set up by the bank (step 4). For accounting and collection purposes, the seller will get reading access to the new collection account. Figure 1 -RPA work flow
Effects and benefits There are many incentives for setting up an RPA. Bellow are the most important to bear in mind when managing working capital.
Risk management By setting up a RPA the seller will reduce the credit risk on the buyer and possible currency risk, through receiving settlement much earlier. The bank will also take over the late payment risk on the buyer.
Improvement of Cash Conversion Cycle, key figures and shareholder value. Most companies have a substantial proportion of its assets tied up in its working capital. A common way to illustrate the working capital is with Cash Conversion Cycle ("CCC"). The formula express how many days it will take to convert the resources tied up in assets in to cash flow. By selling its inventory, collect receivables and the length of time it has to pay its bill and obligations, before it will result in penalties. It is calculated by adding Days Inventory Outstanding ("DIO") and Days Sales Outstanding ("DSO") subtracted with Days Payable Outstanding ("DPO"). Depending on the sellers current average DSO, a RPA can have a significant effect on the Cash Conversion Cycle. The example below is a 2 billion company with an EBITDA MNOK 0,11 EBIT of MNOK 0,95 who is estimating to reduce its DSO with thirty days.
Example - Simulated effects in the balance sheet.
The free cash flow can for example be reinvested into new productive projects, that can enhance revenue. It can also be used to paying down short term debt and improve key figures such as NIBD/EBITDA or ROCE.
Free cash flow has also a positive effect on shareholders wealth. In the study Working Capital Management and shareholder Wealth by Robert Kieschnick, Mark laPlate and Rabin Moussawi (2012), the author finds clear evidence that a dollar in cash is valued almost twice than a dollar invested in net working capital. This conclusion is also supported by the results in the French study Working capital and Firm Value by Autukaite and E.Molay.
The study of Kieschnick et al can be read at the Social Science Research Network ("SSRN") at the following link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1431165 - enjoy :)
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