FD Report: The weakest link - improving cash flow when credit is so hard to come by

Despite talk of the famous green shoots, credit is still very much under the crunch. The banks, having put the ‘Closed’ sign up on business lending (despite protestations to the contrary), are in no position to offer straight-up debt. Overdrafts are coming under review across the board, while the capital markets are convalescing too slowly from the seismic shocks of the autumn to offer much encouragement.

Which leaves many businesses squeezed. Credit is more expensive, while demand continues to lag. Indeed, it’s leaving many finance directors scratching their heads as to how best to secure funding. The number one headache? “Businesses are not paying on time,” says Philip King, chief executive of the Institute of Credit Management. “And there is a temptation to create cash flow by delaying payment, which is a problem for smaller businesses.”

Hence, the growth in alternative financing. The Asset Based Finance Association reported a 9% increase in their members’ revenues in the final quarter of 2008, proving that while banks are more cautious and selective when it comes to lending, businesses are busy looking elsewhere (or at least to the bankers’ specialist finance arms) to find the cash to keep the business going. “We’re seeing a greater hunger for alternative finance,” says King. “The banks would argue that they are lending, but we all know it’s less available.”

Breaking the link
The result is that bankruptcies will continue to rise as more smaller businesses go to the wall every week, increasing the risk of key links in the supply chain breaking.

Indeed, for many industries, the issue of single sourcing ­ relying on a small number of strategic suppliers for a particular piece of technology, say ­ is becoming a serious business risk.

“At the moment everyone’s talking about cash management and working capital,” says John Morris, Ernst & Young’s working capital partner. “And everyone’s looking at improving cash flow but they can’t get finance. Alongside that, consumer and business demand has fallen, so people are looking to defend their balance sheet and hit covenants.

Externally, businesses are looking to demonstrate cash flow even though earnings are falling.”

Alongside the usual alternative financing options such as factoring and invoice discounting ­ which gain in popularity when credit is squeezed ­ is the financial supply chain (FSC) model. Well established in a number of forms across Europe, put simply, FSC is designed to unlock working capital from the supply chain by inserting a bank between buyer and supplier.

Here’s how it works. A supplier submits an invoice, the buyer approves it and instructs the bank to pay the supplier within three-to-five days at a slightly discounted rate.

Meanwhile, the buyer is able to push back their terms to 60, 80 or even 90 days when it settles with the bank.

Unlike normal invoice discounting, the funding is secured on the creditworthiness of, say, a large supermarket rather than a multitude of smaller suppliers. In theory, therefore, it’s a win-win situation. “The buyer gets two things,” says Avarina Miller of FSC specialists Demica. “They can get longer terms from their suppliers by virtue of knowing that the suppliers’ cost of capital is made cheaper. So the buyer can ask for 60 days instead of 30 days, or longer in some cases, since it won’t cost the supplier any more because you’re going to have cheaper funding available to you. Second, the buyer will foster good relationships with their suppliers.”

The benefits for suppliers are clear. “Cash up front, within five days,” says Miller. “And that’s an effective cost of money that in most cases is going to be less than what they normally pay. And even if it’s the same as they’re paying now, the value of having cash in five days is enormous.”

But this is not just a bottom line issue. The government has made no secret of its desire to see larger corporates supporting their smaller suppliers. And while there might not be legislation in place to enforce fairer treatment of suppliers, the reputational risk for large public companies being exposed as pushing terms too far is still great.

“There’s a huge CSR angle to this,” says E&Y’s Morris, who believes some large corporates are lagging behind in terms of understanding their suppliers’ needs. He says big buying companies should be talking to their suppliers about how best to help.

“The message from corporates should be, ‘We’re going to extend terms for these reasons, but we realise that might be difficult for some of you so we’ve arranged for a finance facility through a third-party bank which will help’.” It’s catching on in some places. So far this year, Morris has advised a large telecoms company on setting up a FSC facility and so far feedback from suppliers has been great.

It should be an easy sell. Unlock your own working capital and get better terms and happier suppliers? The risk management benefits aren’t small either. Big buyers should be looking to protect suppliers, “because if there’s any vulnerability in their supply chain, then there is sourcing risk and that makes the buyer vulnerable,” says Demica’s Miller.

“Large businesses need to maximise the credit rating across the supply chain rather than each little party trying to maximise their creditworthiness.

However, Morris is at pains to point out that buyers need to take FSC seriously and understand exactly why they should do it. “A lot of people do this wrong,” he says, “partly because they think it will help suppliers get interest arbitrage and the buyer will get better prices. That’s the wrong approach. You have to do this alongside an extension of terms. It makes no sense without it.”

Given that the whole idea is to improve both the buyer’s and supplier’s cash flow, hoping to shave a few extra pence off suppliers’ prices misses the point. As Morris says, “What you’re trying to achieve is giving something to your suppliers while taking something for yourself.”

Wake-up call
The banks are waking up to the fact that they need to play an active role in driving take up. Typically, a buyer will approach a bank to set up a financial supply chain system.

That’s the easy bit. The hard part is to communicate the benefits to suppliers and sign them up.

The major decision points should be: what’s the quality of the technology platform to be used and how does it work with your system; and what are the banks prepared to offer you in the area of supplier onboarding?” says E&Y’s Morris. “At the end of this process you want your suppliers to be appreciative. You want them to say, ‘thanks, that really helped us’,” he says.

“A common way is for us to do workshops with the buyer to get the buy-in of suppliers, but it’s a lengthy process,” says Russell Brown, head of trade finance sales for the UK & Ireland at Deutsche Bank. “Some buyers may not realise the resources required for onboarding. If you’re looking at a client with 1,000 suppliers and you’re looking to onboard even 30%, then it’s still a lot.” Any FD considering implementing an FSC system needs to know how much support the bank will offer to get suppliers on board.

Despite the obvious benefits, so far the FSC model has had limited take-up. But as the credit crunch continues, we should expect to see more large companies rolling this out.

The banks are certainly getting more enthusiastic. “The landscape is becoming more competitive,” says Ian Armstrong, head of supply chain finance at Abbey UK Corporate Banking.

“I think there’s been an internal battle at the main UK clearing banks around the fact that all of them have very strong commercial finance divisions offering invoice finance and factoring,” he says. “Some of them might have seen FSC as a loss of revenue for them through undercutting their own margins. So there might have been a reluctance to move into this, but now there’s a recognition that this is the way it’s going to move in the next couple of years, so it’s a space they want to be in.”

In practice
Olivier Bayzelon is managing director of Volvo Supplier Financial Solutions in France. He implemented a financial supply chain system at the carmaker three years ago.

“The reason we did it was fairly obvious: we wanted to lengthen the payment terms with our suppliers. Our suppliers often complained that they weren’t bankers, so we introduced a tool so they couldn’t use the excuse that they couldn’t finance the extended terms.

“Basically, we offered the same conditions to all suppliers – and said if they could get better elsewhere then great – we were not forcing them to use it. To those who were interested, we said, ‘If you want to sell your receivables then you can do that at an extremely attractive rate.’ So now they get paid somewhere between five and ten days depending on the approval process.

“But the basic principle applies. Regardless of whether they take up the offer, we now insist on 90 days, apart from in territories where there are obstacles in the law.

“We’ve seen a massive improvement in our cash position. That has allowed us the opportunity to expand capacity a lot. Though maybe we’re now regretting that.

“It’s been well accepted by and large. We have just under 100 suppliers in the programme and they all seem to be satisfied and I don’t’ hear any complaints. I think that’s partly because they have transparency of the payments. They can look at the system and decide which invoice they want to sell, so it becomes a kind of revolving facility for them.

“Although the initial purpose was to improve payment terms, more recently, the financial supply chain system has been used in a more proactive manner to help suppliers avoid bankruptcy. With some of the suppliers, we are married for a long time. So we are protecting our suppliers because it’s in our own self interest.”

Going nuclear
Given that more companies are waiting longer for their invoices to be settled, it is not surprising that those firms owed money are looking to the courts to speed up the payment process. What is surprising is the aggression of such proceedings. More and more aggrieved creditors want to use the nuclear option – threatening to force the winding up of a debtor company – but lawyers warn against abusing that procedure.

Tim Pope, senior associate in the commercial litigation team at law firm Burges Salmon, says companies can issue a statutory demand against individuals or companies that owe them money if three conditions are met: that they are owed more than £750; the debt is not disputed; and the creditor believes the company cannot afford to pay.

The demand can be followed up 21 days later with a bankruptcy petition for an individual or a winding up petition for a company. The UK Insolvency Helpline, a network of lawyers and accountants specialising in insolvency issues, says that in 99% of cases the debtor pays up before a bankruptcy petition is ever issued.

Creditors can issue a statutory demand without going through the normal procedure of issuing reminders after the invoice was due to be settled, demanding payment through a 14-day notice letter and, if payment is still not made, pursuing the matter through the county courts, whereby interest, legal and court fees can be added to the money already owed.

No guarantees
However, Pope warns that this could be self-defeating for the creditor. “Just because a company that is owed money takes the initiative to force the debtor into liquidation, it does not mean it will be the first in line to receive funds. Nor does it mean that the creditor will recover its funds in full, or that its legal fees will be paid. The move could result in the debtor company closing down without anyone being paid.”

Pope also warns that companies that are owed money should not automatically issue a statutory demand instead of trying the usual methods of chasing payment first.

“Creditors should always act in good faith and should make an attempt to have their invoices settled by sending out reminder letters and 14-day letters first. It is not really in the ‘spirit of the law’ to seek liquidation as a first resort and courts may look down on this.”

The costs of bringing the action can also put creditors under strain, says Pope. “Court costs can vary widely and, if barristers are involved in the process, the action can be very expensive.”