If you have not heard of supply chain finance, you are not alone. It is still a relatively rare form of financing for Accounts Receivable (AR), but it is gaining popularity in some sectors. In any case, it stands in direct contrast to more traditional methods like trade finance and payroll funding.
Supply chain finance companies engage in a practice known as “reverse factoring.” In doing so, they allow companies to have greater cash flow, even when they have a lot of pending invoice payments.
However, you probably still have a few important questions about supply chain finance. First and foremost, what is supply chain financing? How does it differ from debt factoring? Who initiates supply chain financing and who takes on the associated costs? Finally, how does supply chain finance differ from payroll funding?
In today’s guide, we will answer all of these questions and more, but first, let’s look at the meaning of “supply chain finance.”
Supply chain financing works the same as debt factoring — but in reverse. With supply chain financing, customers or clients of a supplier initiate the process by enlisting the help of an invoice financing firm. Then, the supplier can pick and choose which invoices it would like to have financed. Finally, the supply chain finance company buys the unpaid invoices and pays a portion of the invoice value upfront. Once the finance company has secured payment for an invoice, they pay out the remainder of the invoice value to the supplier — minus the reverse factoring company’s fees.
This method is somewhat unusual, as it must be initiated by a company that has yet to pay the invoices sent from its supplier. Once the process has started, it becomes a collaborative operation between the initiating company, the supplier, and the financier. The initiating company may choose to do this to ensure that their supplier has enough cash flow to continue standard operations, while also delaying the initiator’s need to pay off its debts until a later date.
Supply chain finance is often referred to as reverse factoring because it is just that — debt factoring initiated by the customer, rather than the supplier. Normal vendor financing is initiated by the supplier. In other words, the supplier seeks out an accounts receivable financing company to boost its cash flow while it waits for customer invoices to be paid. This is the standard form of debt factoring.
Supply chain financing follows the same general procedure, but the customer takes a much more active role in the borrowing process. Usually, a customer that has yet to pay its invoices from a supplier would have little or nothing to do with the financing part. In fact, many suppliers seek out debt factoring when their customers take too long to make payments.
For this reason, supply chain finance is a somewhat uncommon method of debt factoring. The customer initiates the process and works with the supplier and financier to find a temporary solution to unpaid invoices. While unorthodox, supply chain financing is a legitimate way to increase short-term cash flow for both suppliers and their customers.
Trade finance, often known as invoice trading, is another way for small businesses to get cash while they wait for invoice payments. Trade finance companies offer trading on credit using unpaid invoices as collateral. This kind of trade loan gives a business access to quick cash, usually a majority portion (around 80%) of the unpaid balance. Then, the trade finance company manages the repayment to ensure that customers pay as soon as possible. Once the invoice has been paid, the trade finance company takes a percentage of the final amount and pays out the remainder to the small business.
In theory, this accomplishes the same thing as supply chain finance. However, with supply chain finance, invoices are not merely used as collateral. As previously mentioned, a supply chain finance company actually buys unpaid invoices and works to chase down payments from customers. This means that supply chain financiers have a greater incentive to ensure payment because they retain ownership of the accounts receivable. In turn, this also takes control away from the borrowing business, as you lose ownership of your invoices in exchange for quick cash.
Supply chain finance and payroll financing are similar in their end goals; both methods aim to provide businesses with extra cash while they wait for customers and clients to make payments. While both methods are forms of AR financing, they work in very different ways. They also incur different costs.
Supply chain finance is a reverse form of debt factoring initiated by a supplier’s customer. This means that it comes with all of the same high costs and pitfalls of traditional debt factoring. This can apply separately to each invoice or as a whole to an entire batch of invoices. Either way, the costs can rack up quickly.
Alternatively, payroll funding works the same as small business loans. You apply for a certain amount based on your business’ payroll needs and the payroll financing company agrees to pay you that amount upfront. You then pay back the loan as you receive payments from your customers and clients. You are only required to pay interest on the funds for as long as you keep the loan. Additionally, the faster you pay back the loan, the less you have to pay in interest.
It’s also important to note that payroll funding companies do not buy invoices. You are not required to pay a percentage based on the volume or invoice amounts you have pending. Instead, you simply pay a percentage based on the amount you borrow. The payroll financing company does not have a direct stake in your invoices, and therefore does not manage the payments from your clients. This means you have more control over the entire process.
Payroll funding also differs from supply chain financing because, with payroll funding, a small business’s customers or clients have no involvement with the procurement or management of borrowed funds. Your business borrows funds from a payroll funding firm while waiting on invoices to be paid. Once they are paid, you can pay the loan back. However, the customers who pay you are not actually involved in the loan process.
Finally, supply chain finance and payroll funding differ in the way the funds must be used. With supply chain finance, the borrowed funds can be used to pay for any part of your business. On the other hand, payroll funding can only be used to pay for payroll expenses. Thus, payroll funding is one of the fastest and most effective ways of paying employees on time, even when you are waiting on pending invoice payments.
We hope you found this guide on supply chain finance vs. payroll funding useful! If you’re interested in learning more about the advantages of payroll funding, feel free to reach out to Payro Finance today!
Morris Reichman is the founder and CEO of Payro Finance. Former Vice President at Infinity Capital Funding an alternative finance company, Morris possesses a versatile background in the finance industry. Having spent 7+ years working across global macro operations and start up corporate finance Morris's expertise is in business accounting, risk management and investment analysis. Morris founded Payro Finance to support business owners and ensure their business continuity.