For any business to thrive or even survive, one of the most critical elements – even more critical than the organisation’s bottom line – is its Working Capital. A well-thought-out Working Capital Optimisation strategy is more often than not the differentiator that enables some firms to grow exponentially. This is especially true for the Micro, Small, and Medium Enterprises (MSMEs), who generally lack access to capital and therefore have to put a lot more thought into their Working Capital Requirements.
And in a country like India, where MSMEs account for upwards of 29% of the country’s GDP and roughly half of its exports, access to capital is limited, to say the least, and it becomes imperative to look at what are the various working capital financing solutions available for Indian MSMEs, and what value do they represent.
During our interactions with a number of Chief Financial Officers (CFOs) of organisations who have registered themselves on our platform, it was brought to our knowledge that even though the aforementioned CFOs are trying to support their MSME suppliers and other stakeholders, through dynamic discounting, factoring or even helping them secure loans from financial institutions, their knowledge on the same is surprisingly inadequate: they are unacquainted to the numerous supplier financing solutions in the market today, which have the potential to help them overcome their working capital challenges.
In this Blog Post, we would be covering the various Supplier Financing Options available to MSMEs in India today.
Traditional Supplier Financing Solutions
1. Bank Financing & Financing from NBFCs:
Perhaps the most prevalent method of financing, Banks have played a key role in Supplier Financing for a long time. For the longest time, Banks have been catering to the financial needs of all the parties in the supply chain. However, the huge arbitrage that is created in this setup makes Bank Financing somewhat uneconomical for MSMEs in the current times, not to mention the time and effort it takes to secure the same.
Bank Financing usually includes Loans, Overdraft/Cash Credit Limit, wherein the aforementioned can withdraw/overdraw cash as per their requirement, at a predetermined rate of interest. However, the interest that is charged seems astronomical when compared to other sources of Supplier Financing, and setting up bank financing is a daunting task in itself.
Thus, it’s safe to say that commercial banks have been living off of the arbitrage for too long, without making an impactful difference in solving suppliers’ liquidity woes.
Financing from NBFCs, on the other hand, is a relatively faster option when compared to bank financing. However, it comes at a relatively higher cost (usually 18-24% p.a. and upwards with additional processing fees). This can further create cash flow issues at the time of repayment and is the first one to be stopped when the economic tide takes a turn for the worse.
2. Vendor Financing Programs:
A large number of commercial banks, Non-Banking Financial Corporations (abbreviated NBFCs), FinTechs and other financial entities have started what they call ‘Vendor Financing Programs,’ wherein they extend Credit Facilities to the Suppliers of large corporations using instruments such as invoice discounting, loans and advances, as well as other working capital facilities.
3. Invoice Financing:
Whenever a Supplier borrows money from a lender against an unpaid bill or invoice, it is referred to as Invoice Financing. The Modern concept of Discounting has stemmed recently from this practice. Under the traditional method, Invoice Financing was an inflexible option that did not live up to its full potential. This is why the industry reinvented itself with Dynamic Discounting (more on that later).
If this bill is offered to the lender as ‘collateral’ in exchange, with the loan amount to be returned as and when the supplier’s account is credited with the amount stated in the invoice, the transaction is classified as Invoice Discounting.
If, however, the invoice is ‘sold’ to the lender (also known as the factor), wherein the lender is now responsible for the collection of payment from the buyer, it would be classified as (Invoice) Factoring.
Simply put, Factoring refers to the practice of selling one’s accounts receivables to a financier/lender at a discount, at a date before the instrument in question matures, so as to meet their immediate cash requirements.
Factoring has the potential to add significant amounts of liquidity for both the parties involved in the transaction since the time between the date the invoice was sent and the due date can extend from a few weeks to a few months.
Modern Supply Chain Finance Solutions
With fiercer competition, unpredictable sales cycles, unprecedented supply chain disruptions, and greater overall uncertainty, it was clear the traditional methods of Supply Chain Finance were severely under-equipped for the onslaught of what was to come. The COVID-19 induced global pandemic and the lockdowns/shutdowns that followed highlighted how fragile the financial system actually is.
This is why the industry had to redefine itself to give greater access to working capital to all members of the supply chain, to maximise supply chain efficiencies, return on investment, and boost the overall ease of doing business.
This is where the importance of modern solutions to the time-tested problems of supply chain finance was highlighted. Here are some of the most important ones:
1. Reverse Factoring:
As with Factoring, Reverse Factoring also has the potential to add significant amounts of liquidity for the buyers as well as suppliers. Under Reverse Factoring, the transaction is initiated by the buyer, where the interest rate charged by the bank/financial institution is based on the credit rating of the buyer in question, leading to a significant reduction in the overall cost of funding.
2. Dynamic Discounting:
The concept of discounting bills/invoices is not new: it has been part and parcel of the Supply Chain Finance Industry for a long time now- its applications had been severely limited. This was because supplier-led sporadic discounting systems of old were plagued by a number of limitations. Under this system, one major problem that needed to be addressed was the leakage of margin from the Buyer-Seller Ecosystem, wherein the borrowers (suppliers) would borrow at 18-24%, and the buyers would earn somewhere between 5-6% on their deposits. This is where the arbitrage lies, and also where a number of FinTechs operate, to provide Dynamic Discounting (sometimes referred to as Invoice Discounting) facilities to their customers. These FinTechs enable their customers to earn the margin as cash discounts.
The aforementioned FinTechs, like ourselves, have invested in the adoption of e-invoicing, integration with ERPs and digital upgradation, and offer technology-driven, cutting edge dynamic discounting platforms.
The aforementioned platforms calculate discounts on a sliding scale, providing a flexible solution for both buyers and suppliers, that is efficient enough for buyers to pay their suppliers for a lower price for all purchases and convenient enough for suppliers to take early payment before the due date in exchange for a small discount, with the guiding principle: the greater the number of days, the larger the discount. Figure 1 gives a brief introduction to this concept.
3. Algorithm-Based Discounting:
A handful of FinTech Startups in this domain offer another innovative Supplier Financing solution known as Algorithm-Based Auction. It is a unique price discovery tool wherein an auction based on weighted parameters is held to discover the market price by the buyer(s) in collaboration with their supplier(s).
Algorithm-based discounting, sometimes referred as algo-based auction, allows buyers to achieve their strategic treasury objectives- something other solutions do not; while allowing suppliers to bid/rebid on the discount they are willing to offer, with suppliers raising the bids and an algorithm dispatched to select the bids to achieve the organisational goals of the buyers.