By CPA Michael M Nzule
An interesting lesson in accounting, which is usually a challenge to entrepreneurs, is balancing cash generated from business ventures with reported profits. They are mesmerised when their accountants present them with their financial reports showing profits, yet they can’t trace the corresponding cash in their bank accounts.
To demonstrate where the cash can be found in the business, attempts have been made to describe what is known as the cash merry-go-round. From capital cash contribution, cash mutates to inventory acquired, credit sales (debtors), fixed assets, and inputs necessary for production. Money is also applied when payments are made for expenses. All these business events occur at different times (timing differences). They can starve the business, requiring a cash flow (cashflow) if the conversion of money back to the merry-go-round is not done faster. The primary motivation of entrepreneurs is to get some money from the profits made and keep the business growing. Profits not represented by money can be frustrating!
Delaying cash movement out of the business is a critical source of financing. It helps cure the mismatch in timing of cash inflows (mostly from selling efforts) and outflows. Cash outflows are mostly payments arising from business obligations. The residual cash is available for investing activities or to pay the owners of the capital, the shareholders, or entrepreneurs.
Limited sources of business financing exist. These sources always have associated costs, such as interest, legal fees, stamp duty, charging costs for collateral securities, and guarantee charges. Access to finances determines the scale of business and ultimately the returns to investors.
Let us turn our interest to small and medium-sized enterprises (SMEs). As indicated above, some challenges these businesses face include access to external funding like debt from financiers, keeping up with strict borrowing covenants (which include liquidity and security) and the ability to scale up and grow. Therefore, getting cheaper business financing alternatives becomes attractive for these businesses. Supply chain financing (SCF) is one of the more affordable options for businesses to leverage their relationship with business partners from both the supply side (the traditional supply chain) and the demand side (the market and selling side). The singular focus of SCF is to unlock cashflows as fast as possible at optimised costs and delay outflows without impinging on business performance and relationships with suppliers.
SCF offers SMEs access to working capital by facilitating financing along the supply chain. This improves liquidity and reduces financing gaps. Further, the SMEs are encouraged to access credit, purchase inventory, and increase sales through diverse product offerings. Such arrangements help to buttress great relationships with suppliers. SCF provides comfort in business transactions and helps manage risks. Due to its nature, it leads to leveraging technology for efficiency in financing and more engagement among business partners in the supply chain.
To illustrate this, a large retailer may agree to pay its suppliers on extended terms of 90 days instead of the standard 45 days, but proceeds to offer an option for early payment, say 7 days, from a financial institution at a discount. The large entity in this example extends its goodwill and scale with the financial institution to the SME suppliers. The discounts unlock liquidity and support growth.
SCF can take different forms. The general and simple ones are as follows:
- Invoice financing: The financial institution provides funding to the supplier based on the value of their invoice, with the buyer repaying the institution later.
- Reverse factoring: The financial institution pays the supplier immediately upon receipt of the invoice, and the buyer repays the institution later.
- Dynamic discounting: Suppliers offer discounts to buyers for early payment of invoices.
There are many envisaged benefits of supply chain financing programs. These accrue to both suppliers and buyers. To suppliers, this leads to receiving payments at shorter periods and improved working capital and liquidity. Suppliers can access low-cost financing (at lower interest rates) compared to traditional borrowing, as the cost is linked to the buyer’s credit rating. The suppliers (SMEs) ride on the rating of the buyer, who has scale and better standing with the financial institutions.
On the other hand, buyers benefit from better and stronger supplier relationships. This is from a demonstrated commitment to improving their financial health. Additionally, buyers benefit from improved supply chain stability. This brings about confidence and certainty of supply as liquidity bottlenecks are eliminated, and the suppliers can even scale up to meet the buyers’ higher demand or capacity requirements. Buyers can negotiate longer payment terms with the financial institutions and improve their cash flows and working capital. Therefore, it is easy to conclude that SCF can lead to a win-win outcome for suppliers and buyers.
Other benefits SMEs can derive from SCF include increased sales and access to expanded markets. With enhanced access to sufficient working capital, SMEs can grow their product offerings, leading to increased sales. Size matters, and SMEs can access broader markets with referrals from buyers. Another critical benefit of SCF to SMEs is risk management and mitigation. SCF programs provide the SMEs with secure transactions and practical risk management tools. These may include secure payment platforms, risk covers on inventory (for both inputs and finished products), deployment of technology in tracing cargo in transit and tailor-made cash management solutions. SCF solutions incorporate risk mitigation measures to protect buyers and suppliers from potential financial losses.
A greater and overarching benefit that SCF can deliver is sustainable growth. Improved liquidity enables SMEs to invest in their businesses and adapt to changing market conditions, enabling sustainable growth.
Another critical way to optimise cash for business operations is through factoring accounts receivable or debtors. Releasing cash from accounts receivable involves a business collecting the money owed to it by customers for sales made in a short period. This process accelerates cash collection and returns it to the company’s merry-go-round.
It is worth noting that the conversion of accounts receivable to cash doesn’t change the total assets on the balance sheet (total assets remain the same). It, however, significantly improves the company’s liquidity and the ability to meet its financial obligations. Factoring accounts receivable is a financing method where a business sells its unpaid invoices to a third party, known as a factor, for immediate cash. The factor then collects payment from the customer and keeps a portion of the invoice as a fee. This allows the business to access money faster than waiting for their customers to pay, improving cash flow. SMEs may consider this if it is cost-effective, and the benefits of collecting the cash earlier outweigh the costs.
This is how factoring works. A business sells goods or services to a customer on credit, creating a receivable (debtor) evidenced by an invoice for payment. The business then sells the invoice(s) to a factoring company at a discount. The factoring company provides the industry with a cash advance, usually a percentage of the invoice value (e.g. 80-90%), immediately. The factoring company collects the full invoice amount from the customer’s payment. The factoring company retains its fee and forwards the remaining balance to the business. The benefits of factoring are similar to those explored under SCF above and can be used to optimise financing supply chains from the sales side.
SMEs also worry more about inventory availability to meet production or selling opportunities. This is where inventory financing comes into play. Inventory financing allows SMEs to use their inventory as collateral for a loan, helping them purchase goods and manage their supply chains without overdrawing cash. Inventory financing is a short-term loan or line of credit where a business uses its inventory as collateral. This approach is beneficial for SMEs with limited credit history or other assets to secure traditional bank loans.
Inventory loans are also a form of financing. Big suppliers offer their inventory to SMEs to support sales and agree to terms of payment after the inventory is sold. Inventory financing can help SMEs manage fluctuating demand, ensuring that they have enough inventory during peak seasons. It can also help SMEs avoid high storage and insurance costs associated with carrying large amounts of inventory.
The cash merry-go-round is the lifeline of business. Making it continue and grow is healthy. Financing supply chains supports the optimisation of operating working capital, preserves cash, and helps to find the balance and trace where cash is and why it is not equivalent to profits. SMEs are encouraged to focus on the effectiveness of the cash cycle in their business ventures. As they say, profits are opinions; cash is the king! Find the cash in the profits.
Views expressed here-in are personal.
CPA Michael Maithya Nzule is the Finance & Strategy Director of Mitchell Cotts Freight Kenya Limited. Michael holds an MBA in Accounting and a Bachelors of Commerce (Accounting Option Hons) from the University of Nairobi. He is a member of the Institute of Certified Public Accountants of Kenya (ICPAK).
