Significantly increase returns on ‘cash equivalents’

I have outlined below a program through which businesses can significantly increase the returns they are earning on their surplus capital while reducing the associated risk.

The program I am referring to is a supply chain finance program with a partial self-funding capability. Let me explain.

Through a conventional supply chain finance program one gives one’s suppliers the option of selling their invoices to the ‘Investor’, at a discount, in return for receiving early payment. Those that exercise the option are paid (by the Investor) shortly after those invoices are confirmed as payable. One will still pay the invoiced amounts (now to the Investor) as and when they are due for payment under one’s supply arrangements.

The self-funding capability gives one the ability to redeploy capital otherwise invested in term deposits and other ‘cash equivalents’ to part fund the program. One approach is to establish a special purpose funding trust, administered by the Investor. In this case one would not provide a loan to the Investor, but to the Trust. The Trust will then use that capital to purchase invoices from one’s suppliers. The Trust will then become the holder of the invoices. On the date the invoice is payable (on expiry of the credit term) one would theoretically pay the invoiced amount to the Trust, which after deducting an agreed administration fee, will use the proceeds to repay one’s loan. In other words, one pays the invoice amount to the Trust, which deducts its fee, and pays you the balance. In practice rights of set-off apply, so one would only pay the administration fee.

Through this arrangement one in effect gets a discount for paying one’s suppliers early. Under the conventional supply chain finance program the Investor buys invoices from the suppliers at a discount. By part funding the program, one essentially steps into the shoes of the Investor. The effect of the arrangement is that one will pay one’s suppliers less than the amount of the invoices and thereby earn the differential between the invoice amount and the amount one actually pays.

The extent of the differential (the discount less the administration fee) can vary from one supplier to another, from one Investor to another and depends on the relative amount of capital made available to purchase invoices.

From the supplier’s point of view, the program does not amount to a loan made to it, does not impose additional indebtedness on it, does not require the support of personal guarantees from directors or shareholders and is off its balance sheet. As a result one would expect a supplier to be willing to accept being charged a premium for the benefit of receiving its sale proceeds earlier and so reducing its working capital needs. The level of this ‘premium’ will differ from one business to another and from one person to another.

Given the benefits the program offers over a loan, one could expect a supplier to be willing to pay a higher rate than its cost of borrowings, but how much more? One could argue that by releasing working capital the supplier (in particular an operating business within the group) would be willing to pay a rate that is higher than its internal cost of capital. If the capital released is applied to fund the purchase of an asset that can be leveraged (for example, buying a business or plant), one could argue that the comparative rate should be the supplier’s marginal cost of equity. Well, that’s the so called hypothetical situation.

In practice one’s return can depend on the approach taken by the Investor. If the Investor is worth its salt it would maximize the returns earned on the capital made available, with those needing early payment paying the most for it.

The benchmark return I would ordinarily assume that should be earned on capital one allocates to the program would be an assumed weighted average cost of capital. So, in the current (Australian) market I would assume a target return of about 10% pa. Since the 60-day BBSW rate is currently sitting at about 1.65%, the rate one would be getting on one’s term deposits and other cash equivalents could be less than a third of the return one could earn through the partially self-funded supply chain finance program.

In addition to this benefit – a threefold increase in one’s return – one could earn a ‘clip’ (a business introduction fee) on each invoice financed by the Investor. And all of which can be achieved with little time and effort one one’s part and at little risk. The risk for one will be lower than the risk of placing the funds on deposit with a bank. That’s because one is in effect taking a risk on one’s self.


By Mark Morris (July 2017)