Supply Chain Finance has evolved over a period of time. To start with, we have what we call phase 1, where an anchor company is buying from a supplier, who will be paid in 90 days’ time. Typically, the supplier needs the money sooner than that, because of which, he/she goes to the bank requesting for the money 30 days earlier. The bank agrees, but instead of the full INR. 100, the bank only pays INR. 99. Effectively it is then costing the supplier 1% to get the money one month earlier. We can call it a 12% annualized cost of funding.
Phase 2 is when the supplier and the anchor entity decide not to give the 1% to the bank. Rather, they decide to share that value between themselves. The bank in this case gets disintermediated and the supplier ends up getting a benefit beyond what he/she was getting in phase 1.
Finally, we have Phase 3 which is platforms like trades, where the supplier, the anchor entity and a group of finance companies all come and exchange data with each other. Various financing companies find that the amount of funding that’s needed, the period of time that its needed for, and the start and end time of the financing window, matches well with surplus funds that they may have. Hence, it ends up being an even better value for all parties concerned.
Comparing the relative costs, we see that the Phase 1 cost is between 12% to 15% annualized, whereas Phase 3 cost can drop to as low as 8%. It’s almost a 50% drop from the highest end of Phase 1 to Phase 3. Therefore, the more evolved Supply Chain Finance gets, the better it is for all parties.
So how does India compare with the other countries? One way to look at an inter-country comparison is by starting with a country’s GDP. The Western European countries including the UK, Italy, France, Germany, and Spain tend to be very good at penetrating the GDP with Supply Chain Financing. In the UK, for every 100 dollars of GDP, 12 dollars are addressed by Supply Chain Financing, which is incredible when compared to all the other countries. India, unfortunately is at the bottom of the pile in terms of the percentage of GDP that is addressed by Supply Chain Financing, as well as the absolute amount of Supply Chain Financing.
Let us now take a look at the cause of this problem and how we can resolve it. Ultimately, it comes down to a version of the prisoner’s dilemma. The US Small Business Administration came out with a research where there are two large companies. One of them facilitates Supply Chain Financing while the other company withholds the payments to its suppliers. What is seen in such a case is that it will be detrimental to the company that is doing the right thing by implementing SCF. Due to this, both companies withhold payments to their suppliers as they fear that the other large company will steal a march on them. However, if both the companies unlock the value that comes out of Supply Chain Financing, the overall liquidity in the system will benefit the entire economy as well as themselves. The main reason for Supply Chain Financing not getting unlocked is the fear that not all companies will do the right thing.
Now, let us look at why this harms the rest of the economy. Firstly, if we don’t allow more liquidity in the system, the disproportionate impact tends to be on the smaller companies, who then have significantly higher costs of financing. Our research shows that the typical median interest rate for large companies tends to be around 8%. On the other hand, for a micro company, it tends to be approximately 15% in terms of the formal cost of financing. To top this, they have to get more financing through informal sources, driving the total cost up to 25%. Hence we see, what tends to be 8% for a large company is 25% for a micro company. Furthermore, a much higher percentage of cost for the micro enterprises tends to be fixed costs like labour costs and rental costs. Not only does it cost them more, it also hits them harder.
The flip side is also true. If we unlock the liquidity in the system, the disproportionate benefit comes to the micro enterprises. We looked at the speed with which the growth in net sales changes as the number of payment days comes down. We found that in case of large companies, the growth tends to be modest, from 10% to around 18%. For small companies however, it grows from 5% to about 14%, which is nearly a three-fold increase. Therefore, liquidity in the system benefits everyone, especially the micro enterprises.
So what do the large companies need to do to unlock the liquidity in the system and facilitate Supply Chain Financing? It boils down to three things. Firstly, people need to have a mindset that suppliers and vendors are actually partners. Secondly, the processes need to be more automated and the speed between procurement and payment needs to be as fast as possible. Finally, the systems need to be automatic and without human intervention issues, like the exchanges, where people can see the best value and then bid for it.
To conclude, there is a huge value in Supply Chain Financing, which could result in a massive 50% drop in the cost of working capital. The initiators of it have to be the large companies and it helps in the growth of net sales. Implementing Supply Chain Financing also disproportionately benefits the smaller companies. However, if the large companies don’t do it, it raises the cost of financing so much, that it cripples the entire system.