Supply chain financing: a smart solution for fast working capital

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The key theme of this article series is that startup financing comes in many different forms. And crucially, it can come at many different times in a company’s growth and lifecycle.

We can get so fixated on seed or series funding because these represent major milestones for startups. But what about the smaller cash injections that keep you running at full speed?

There are, of course, financing options that can help you get to the end of the month in the black. Or perhaps they let you balance the books and have a positive quarterly report, even when times are tough.

Most importantly, they can give you the short-term working capital you need now.

Supply chain financing is a perfect example. As I’ll explain, it gets you paid sooner for outstanding receivables, to give you the cash you need before your runway runs out.

In this article, we’ll explore why you might want to consider this option, the kinds of companies it suits best, and what to watch out for along the way. But first, let me explain how I became so interested in all this.

About me and the GFL

After studying, I began my career seriously at Euler Hermes - a credit insurance agency. Credit insurance is used for trading companies who want to ensure their receivables. As we’ll see, these companies deal with lots of outstanding invoices and often long payment terms, so insuring them can be very important.

After that, I went to the big broker company AON and did the same there, but as a broker. I had the chance to pick solutions from a range of insurance companies, and to see credit finance from many different perspectives.

And in 2014, I switched from AON to the GFL, where I'm working now.

The GFL is a small insurance and financing broker. We’ve been in business for more than 10 years, with two main areas of focus. The first is the normal credit insurance business, as I explained above. But over time, clients started asking us to help them with financing on top of this. So eventually, we added that service.

Our financing business is very focused on working capital. Many of our clients already have other funding in place, but they’re growing or restructuring and need money they can work with now. But the rate they can get from the banks isn’t going to work. And we have a range of options we can help them attain, including supply chain financing.

Which is what this article is all about. Let’s see how everyday businesses - including growing startups and scaleups - can free up working capital via their supply chains.

What is supply chain financing?

As the name suggests, supply chain financing lets you use the value of your supply chain to secure cash in the short term. You essentially trade what you’ll eventually get paid for capital right now.

Let’s use an example. When you need cash right away, the first option is often a bank loan. But when you apply for one, the first question will be about the security you can offer.

Most startups and small businesses don’t have a positive balance sheet because they’re focused on growth. So you don’t have a great “credit score” as a company, and you likely won’t have any assets either.

You may have to give a private guarantee from the CEO, or you could offer your private house. These are both very risky, and it’s always best to keep business dealings separate from your personal life.

So what can you offer?

The one thing that some businesses do have is receivables - outstanding invoices waiting to be paid by customers. In many cases, these invoices are pretty certain to be paid - they’re with good companies with a strong track record.

But a promise to pay doesn’t improve your working capital today.

Supply chain financing - or factoring - lets you sell these outstanding debts to a third party (an agency). The “factor” usually buys 90-100% of your receivables upfront, at a discount of course. So you have the cash you need immediately, even if the total amount received will be lower in the long run.

Here’s another example. We have a client who’s in restructuring - near insolvency. They need money now, but no bank will give them a loan in these circumstances. But they actually have good deals in place with Siemens.

Siemens is a very reliable debtor - they’re going to pay.

But the payment terms are between 90-120 days. And smart companies like Siemens are very unlikely to pay early, as this impacts their own working capital. So factoring makes a lot of sense for both parties - our client and the factor.

This is a good example of how the main focus for a supply chain financing agency is going to be different from a bank. A bank would look at this company and see a struggling balance sheet. But the focus here is on the receivables and the products themselves.

If the agency sees a high likelihood that they’ll get their money in the longer term, that’s all that matters.

Factoring vs equity

As I wrote above, many startup founders are fixated on venture capital - giving up equity in return for substantial sums of money. And in reality, you can still do this and use factoring to your advantage.

Supply chain financing uses debt, and doesn’t dilute your share in the company. You might see lower margins in the short term, but you still own as much of your company as you did before the funds came in.

This is why debt is always cheaper than equity.

Here in Germany, I deal with a lot of second, third, and fourth generation companies. They’re not looking for new owners - they’re family businesses and want to keep it that way. And so culturally, raising equity is not a real option for them. It’s seen as something for new companies to investigate, but not traditional ones.

And it shouldn’t really be any different for young startups. Yes, you’ll probably want seed or series funding to grow quickly, but you may also need shorter-term working capital at times too.

And you absolutely don’t want to give away equity in the company if you can avoid it.

Benefits of supply chain financing

The big benefit of all this, of course, is that you have access to funds without offering up any security. The mere fact that this is available is a benefit for businesses that need it. It can be a financing source for businesses without many other choices.

But we also have successful, stable companies that simply need more working capital. For example, many businesses in the trading industry deal with small margins and long payments periods. They can be moving huge amounts of goods - doing great business - but they won’t see the fruits of their labor until months later.

So they’ll use factoring periodically to keep the business running smoothly.

And then there’s also the very positive impact on your balance sheet. Plenty of companies want to hit December 31 with healthy financials. So they’ll call in their debts - so to speak - by factoring receivables and getting money into their accounts before the end of the financial year.

The advantage of this is that the receivables are sold to a factor on the balance sheet date, and therefore removed from the balance sheet. This reduces the balance sheet amount and can have a positive effect on your equity ratio.

What to watch out for

Of course there are potential downsides to supply chain financing, too. Business is business, and there are certainly areas to be wary of if you’re entering into a factoring deal.

For starters, many agencies want to have all your receivables. My example above was just an illustration, but normally we wouldn’t only be looking at Siemens as a debtor. There may be more uncertain third parties in there, and this can affect the price.

In fact, the price is determined by the number of debtors, but also by the total volume of receivables. And of course we also look at the creditworthiness of the debtors. So if there are many good debtors included, then it is cheaper than if there are debtors whose credit is debatable.

One more practical note: the credit insurer usually checks the debtors and fixes a limit for them. The customer either does this with their own policy, or the factor who might have a policy in the background. So if the insurer reduces or removes limits - which can happen due to the Corona crisis, for example - then this is also a problem for the factor, who can no longer finance the debtors.

You might also not want to include all of your receivables. You’ll know which are more valuable than the others, and it’d be great to keep them in hand. But usually, this isn’t an option.

Which also means that you can’t use these same receivables as security for a bank loan, or include them in other factoring deals. They’re already tied up. And vice versa - if your receivables are already tied up in another loan, you can’t use them for factoring.

And naturally, cash with no security is going to be more expensive. You might, in some circumstances, find a bank willing to give a loan using your receivables as security - often at a cheaper rate.

Which brings us to the fees involved. As we said, the factoring agency buys your receivables at a discount. But you also have the factoring fee, based on turnover and paid to the agency. You might pay, for example, 0.5% from the turnover.

And then you have normal interest paid to the bank. Which can of course be significant. But the trade-off is having money when you need it. As the saying goes, “a bird in the hand is worth two in the bush.” Money is typically worth more now.

Typical factoring costs

We just mentioned interest, so it’s worth setting out the kinds of costs you can expect in this process. You’ll typically have a factoring fee as written above (e.g. 0.5%), and interest. And the interest is calculated on the amount of credit line used, as is usual for banks.

The customer also gets a contract in which a funding line is arranged. If the customer now sells their receivables (€500,000, for example) to the factor and this amount is charged to the line for 45 days, the customer pays interest for this period (in addition to the factoring fee).

The interest rates are usually between 2-4%, so at first view they are very cheap. But companies should always pay attention to the fact that there are 2 costs in factoring, and these must be calculated correctly if you want to compare them with the costs of a bank loan.

Simply comparing the interest rates is wrong.

Who should consider supply chain financing?

You should by now at least be considering supply chain financing as a short-term funding option. So what kinds of companies does this instrument suit?

For starters, you obviously have to have outstanding receivables. Not all companies actually have many unpaid invoices that look attractive to factoring agencies. So you do actually need to be part of a busy supply chain.

Perhaps the best example is companies in the trading business - it doesn’t even really matter what they trade. They normally have very low margins, and long payment terms - 30, 60, 90 days. Which is a long time to wait for that money.

Factoring becomes a very good option to get liquidity directly, so you’re not waiting all that time.

Another very famous example here in Germany is the automotive industry, for the same reasons. For companies like BMW or Audi, payment terms can be as long as 150 days! And if you’re a small supplier to one of these companies, you don’t have a lot of power to negotiate faster payments. So you’re probably going to have to live with it, and again factoring can be your answer.

On the other hand, one example that doesn’t usually work for factoring is construction. That’s because payments are typically in several steps, with all sorts of different payment periods involved. This makes it much more complicated to set up factoring contracts.

Then just as a general principle, factoring is best for companies needing working capital, with no clear assets they can use as collateral. So that can mean young startups or restructuring companies who really need the money now.

And finally, there’s one class of companies that you wouldn’t expect: some companies with great credit scores and assets still do use factoring, even if the banks would gladly give them a loan. And it comes down to the balance sheet at the end of the financial year.

Because once someone buys your receivables, you have that cash up front. So many larger companies will take that deal as a way to improve their ledgers at the end of the financial year, and then worry about next year later.

The alternative is to wait for those receivables to come in months later, which is no good if your reporting is due now.

Factoring gives you future revenue now

As is hopefully clear, factoring provides a smart way for companies to increase working capital immediately, by making future earnings available to buyers. While it certainly comes with strings attached - including interest and fees - this can be just what fast-growing companies need.

Whether it’s to make much-needed timely investments, or just clean up the balance sheet, supply chain finance may be right for your business. So if you have a stack of receivables - especially with lengthy payment terms - consider cashing those in for flexibility today.

Those fees will almost certainly be cheaper in the long run than giving away more precious assets like equity.

Read more on startup financing

• Beyond equity: the full range of startup financing instruments

• How asset-based financing works for growing businesses

• What is venture debt? A complementary alternative to venture capital

• How revenue-based financing supports sustainable startup growth

• Inventory financing for startups: how to grow with debt funding

• How startup business loans compare with venture capital

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Fabian Sarafin is Branch Manager at the GFL, a small insurance and financing broker in Germany. Prior to this, he worked in credit and credit insurance for brokers including Euler Hermes and AON.