A Financial Crisis Is Looming for Smaller Suppliers

By | August 14, 2020
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High-profile bankruptcies, refinancing deals, and drastic cost-cutting involving the likes of Brooks Brothers, JCPenney, Hertz, Neiman Marcus, Ford, and GM are testament to the financial distress wrought by the Covid-19 pandemic. But a less visible crisis deep within supply chains is destabilizing small and medium-sized enterprises (SMEs) and could add to the woes of the global economy.

SMEs tend to be the first to feel the effects of financial crises. But their current plight is exacerbated by punitive payment terms that large companies began introducing in the aftermath of the 2008 financial meltdown. These practices, in combination with the pandemic crisis, have starved countless SME suppliers of working capital and threaten to trigger a tidal wave of failures.

There are ways to avoid this outcome. Governments should provide financial support geared to the needs of SMEs, and large companies can assist by identifying and supporting suppliers at risk. SMEs can help themselves through a more rigorous approach to managing their working capital. And innovative supply-chain-finance solutions, including a new generation of digital solutions, can play a key role in providing sources of credit for SMEs. These solutions must be applied as soon as possible. If SMEs fail en masse, the ripple effects will hit larger companies and could further compromise a global financial system already stressed by the pandemic.

Why SMEs Are More Vulnerable

Over recent decades, companies have striven to become lean organizations by reducing inventory and optimizing operations to increase efficiency. However, these measures have also made their operations more fragile by, for example, increasing their dependence on a finely tuned supply base that is vulnerable to disruptions.

The 2007-2008 global financial crisis deepened these fragilities. For example, during that crisis, banks attempting to reduce their exposure to credit risk either wouldn’t lend to SMEs or did so at usurious rates, further undermining the financial viability of SMEs.

Further Reading

The extraordinary measures taken by central banks to increase liquidity in the financial system by buying financial assets and lowering interest rates to nearly zero didn’t help SMEs. For example, in Europe liquidity was available at low cost to large firms but not SMEs, largely because the introduction of stricter financial criteria, such as the Basel Rules, led banks to reduce lending to SMEs — now considered more risky — and to increase interest rates on loans to small businesses.

SMEs found themselves pressured from two sides: a banking system less willing to offer them loans and customers’ extended payments terms. Companies in need of cash — especially large firms — have increasingly turned to the only source of cash available: their payables. An as-yet unpublished study that we conducted of the top 800 producing firms in the European Union and the United States over a 13-year period through 2017 found that large firms systematically extended their payment terms to suppliers (i.e., how long they take to pay them), and these supplier firms did the same to their suppliers.

Unfortunately, the buck stops at SMEs, which do not have the power to force payment extensions on their suppliers. Consequently, for a number of years, SMEs have had to absorb the cost of punitive payments practices to finance their receivables just to stay in business. During the 2004-2017 period, firms extended their days of payables outstanding (DPOs) from 76 in Europe and 59 days in the United States to 83 and 69, respectively.

SMEs that have been weakened by years of extended payment terms now have to deal with the challenges of the coronavirus pandemic. In addition to the precipitous falloff in demand and mandated shutdowns caused by the pandemic, outstanding invoices are not being paid. Their situation is precarious.

Ways to Avoid a Global Crisis

Can such outcomes be averted? Can governments and larger companies help SMEs weather the current storm, put them on a stronger financial footing, and lower the risk of systematic failures? We believe the answer to these questions is yes — provided that governments and companies take action now. There are a number of remedies they can employ.

Provide SMEs with much-needed cash. Governments need to do more to inject cash into the financial system with safeguards to ensure that the liquidity goes beyond large firms and reaches SMEs.

In the United States, the Paycheck Protection Program (PPP) has been effective in providing some financial support to SMEs. There have also been government programs to increase liquidity. In Europe, both national governments and the EU are offering financial support to business, with a special focus on SMEs. Most of this support is in the form of loans backed by a national or European guarantee, to lower the cost for the borrower. Some countries, such as the UK and Italy, are trying to support supply chain transactions by providing governmental guarantees in place of trade credit insurance that is becoming too expensive. In the United States, the Small Business Administration offers several programs, including some that provide express loans and debt relief.

However, the effectiveness of such measures depends on how quickly and efficiently bureaucratic banking systems can deliver these funds. The U.S. government relief programs described above have distributed funds quickly, but the extent to which they have helped SMEs beyond payroll relief is unclear.

Nurture suppliers. The government relief programs alone will not suffice. Larger firms need to assist their smaller cash-starved suppliers. This strategy calls for identifying critical suppliers and protecting them through the current crisis and the restart of their operations. This can be done by paying them earlier than usual, paying for future orders, or using supply-chain-finance programs to ease credit restrictions on suppliers. (See this HBR article for more ways firms can assist suppliers.)

For example, Gucci (owned by the Kering group), which kept its large network of small Italian craft suppliers alive in the aftermath of the 2008 financial crisis, announced a renewal of this support for suppliers in late May 2020. French mobile telecom operator Iliad chose to pay its SME suppliers cash instead of waiting the normal 60 days in order to give them immediate liquidity. Beer maker Birra Peroni has offered 60 days of extra payment terms to help its distributors while bars and restaurants conduct limited business or remain closed.

Proactive working-capital management. Large firms should orchestrate efforts to improve financial performance by focusing on aggressively reducing all three components of working capital: inventory, payables, and receivables. To reduce inventory, firms should revisit their supply chains and reduce inventory requirements and their cycle time — the time the firm must fund production and distribution operations to the point of sale. This requires them to redesign their supply chains (including the supply chain flows), optimize inventory levels, streamline operations, and rationalize service and product offerings.

Doing all this will take time, but it is a potentially more rewarding one because optimizing inventory is a highly effective way to improve a company’s working capital position without adversely effecting other members of the supply chain. Most firms already aggressively work to reduce their receivables through incentives to their customers and stretch payables, but a more thoughtful approach is required in order to nurture suppliers.

Interestingly, our research found that there was no meaningful change in inventory after the global financial crisis, which suggests that the large firms depended mainly on extending payables and speeding collections to reduce working capital — not on improving operations. This finding indicates that companies are missing an opportunity to free up working capital through inventory optimization or supply chain redesigns.

Supply-chain-finance solutions. There are a number of ways to leverage the relationships among companies in a supply chain to improve the access to credit by its weaker players, especially SMEs. The most common one, reverse factoring, entails a large, creditworthy buyer arranging for its financial institution to buy the receivables of its suppliers. The financial institution can pay the supplier immediately (less a discount based on the buyer’s credit rating) while the buyer pays the bank with the usual payment terms. This solution has many variations, but the core benefit is leveraging the creditworthiness of the party with the better rating, providing credit at more attractive rates for the SMEs. Many large firms — including Siemens North America and P&G — have adopted these methods since the Great Recession and have expanded them in response to the current pandemic.

Here are some other financing strategies that large companies can employ to help their struggling smaller suppliers or smaller suppliers can use on their own.

Exploit better data. With massive amounts and new sources of data now available, large firms should be using this resource to better assess suppliers’ health and viability and then help them. Gucci, for example, provided detailed operational data from suppliers to the banks, which enabled the banks to more accurately assess suppliers’ creditworthiness. Luxury group OTB (owner of the Diesel brand, among others) offers reverse factoring to suppliers who meet quality and reliability requirements. Puma (footwear, apparel) and Pimkie (women’s fashion) include sustainability and CSR assessments in its evaluations of suppliers when selecting them for inclusion in its financing programs.

Leverage digital solutions. SMEs can take advantage of digital supply chain solutions themselves or in collaboration with larger firms. FinTech startups and other parties are using AI and advanced credit scoring algorithms to assess the creditworthiness of receivables to offer immediate payment to suppliers.

Apply novel solutions. Aside from traditional financing options, such as reverse factoring, there are many alternative solutions that achieve similar benefits: ready access to liquidity, spreading risk among supply chain partners, and optimizing working capital usage. They include dynamic discounting (buyers offering early payment in exchange for discounts), inventory finance (loans with inventory as a collateral), purchase order finance (loans backed by purchase orders), and invoice trading (platforms for selling receivables). Ford, steelmaker Feralpi, and cruise ship builder Fincantieri are some of the companies that are using these approaches.

Time to Act

Today, companies are struggling to stay alive until orders rebound or ramp up or expand operations. These challenges require liquidity throughout the supply chain. The approaches we’ve described will make large firms and their supply chains more resilient.

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