The subject of working capital reduction has been explored in detail in scientific journals for about a century, while business press articles have heralded its benefits for nearly two decades.
Numerous conferences unite practitioners to discuss best practices every year but, for some companies, the topic has only recently moved to the top of the agenda. With banks less willing to hand out loans, companies are finding it difficult to maneuver.
In the past, suppliers often reacted to long payment delays by factoring (selling receivables to factors for immediate cash). Because the receivables are sold rather than pledged, factoring is different from borrowing - there are no liabilities on the suppliers' balance sheet.
Typically, suppliers sell receivables from more than one buyer, making it necessary for factors to evaluate buyer portfolios before entering an agreement. This has made factoring an expensive source of finance in emerging markets.
Today some buyers are recognizing suppliers' difficulties in accessing finance and instead of taking a "no tolerance" approach, have started to implement a collaborative approach termed Reverse Factoring or Supply Chain Finance (SCF).
Recent survey results show that, on average, companies reduce working capital by 13 percent and suppliers by 14 percent with the introduction of Supply Chain Finance (SCF). An innovative opportunity to reduce working capital, SCF is based on reverse factoring - making the technique buyer - rather than supplier-centric.
Implementing SCF is both difficult and time-consuming and requires top management attention, but promises significant savings. Three factors differentiate successful implementation of SCF: choosing the right banking partner, ensuring CEO sponsorship and involving at least 60 percent of the supply base.
Important differences
While the technique's underlying mechanism is factoring, there are three important differences.
First, since the technique is buyer-centric, factors do not have to evaluate heterogeneous buyer portfolios and can charge lower fees.
Second, since buyers are usually investment grade companies, factors carry less risk and can charge lower interest rates.
Third, as buyers participate actively, factors obtain better information and can release funds earlier.
As a process, SCF is slightly more complicated than factoring. The advantages of this technique are clear, yet it is far from being a mainstream phenomenon.
Some companies have hesitated to adopt SCF because it is unclear how much buyers and suppliers really save.
Innovators treat their figures confidentially or report numbers that are hard to compare.
Additionally, it has not always proved to be a failsafe solution - stories about companies where the implementation of SCF has failed have been making the rounds leaving other firms in the dark as to what it takes to succeed.
A recent worldwide survey conducted by Springer's Supply Chain Magazine and IMD examined how much executives using SCF were able to reduce their working capital.
The survey's aim was to assess the benefits of SCF, both quantitatively and qualitatively, and to statistically derive the key success factors. Replies were received from 213 executives in 55 countries, covering all major industries. Of the respondents, 23 reported using an SCF solution.
Are SCF programs worth their money?
The 23 executives using an SCF solution reported an average reduction in working capital of 13 percent.
Based on average assets of ?8.5 billion, an assumed working capital ratio of 30 percent, and an average cost of capital of 5 percent, these reductions represent annual savings of ?16 million.
Even if the savings are lower than suggested by the above business case, the program should still break even in less than a year.
Similarly encouraging is the observation that SCF seems to help suppliers too. The same 23 executives reported that, on average, their suppliers were able to reduce working capital by 14 percent by participating in the SCF program.
Admittedly, getting these three factors right - choosing the right banking partner, ensuring CEO sponsorship, and involving at least 60 percent of the supply base - is a difficult and time-consuming task and is one of the reasons that companies have been slow to adopt the technique.
But persevere and the payoffs, in terms of working capital reduction, will be worth working for. SCF will not solve the liquidity issues that some companies will face over the next months, but it seems a sustainable approach to reducing working capital in the long run.
While it may no longer be the new kid on the block, it seems working capital reduction will continue to create a buzz for some time to come.
Professor Ralf Seifert is Professor of Operations Management at IMD (www.imd.ch). He is the program Director for Mastering Technology Enterprise and teaches on the Orchestrating Winning Performance and Managing the Global Supply Chain open enrollment programs. He also teaches on IMD's Partnership Programs.
Daniel Seifert is research assistant at IMD
