Alistair Baxter, head of receivables finance at Taulia, outlines the challenge soaring prices pose to firms with complex supply chains – and how they can be mitigated.

 

Until recently, inflation was thought to be a thing of the past.

However, the combination of the Covid-19 pandemic’s dramatic disruptions to both the global economy and the supply chains that keep it moving, along with the huge rise in commodity prices and overall uncertainty caused by Russia’s invasion of Ukraine, have restored inflation’s place at the top of concerns worldwide.

In short, soaring demand and the bullwhip effect as the world re-opened has overwhelmed distribution networks, triggering a surge in costs, while the war in Ukraine has caused the prices of energy and food to skyrocket. Either of these would be a problem alone; together they represent a challenge that is almost without precedent in modern times.

Indeed, as far back as October last year, a survey of senior decisionmakers by consultancy firm McKinsey found that supply chain disruption and inflation had both overtaken Covid as perceived risks to future economic growth.

These concerns have been borne out, with inflation in the US in May reaching 8.6%, its highest since 1981. In the UK, it reached 9%, its highest since 1982, while in the eurozone it reached a new peak of 8.1%.

These challenging circumstances will require creative responses from the market as participants attempt to control rampant cost-push inflation in the wake of a generation where it was thought to be largely tamed. Today, technology can enable us to more precisely inject capital where it is needed to magnify impacts – rates are a blunt instrument and tools such as supply chain finance can act as a force multiplier.

Let’s break down the key obstacles businesses affected will have to overcome as we navigate the stormy waters of this new and geopolitically unstable post-pandemic world.

 

Inflation’s impact on costs

It may sound almost reductively basic, but high inflation rates call into question the terms of many payment agreements.

The quoted rates of inflation from most data sources are annualised; for example, an 8% rate broadly translates into a 2% erosion of money’s purchasing power every quarter.

Inconveniently, many payment agreements span a 90-day period; it is very difficult to successfully make money from a transaction where one party can simply hold back on payment until the contracted amount has lost 2% of its value.

This may not sound like much, but in large transactions, this can represent a very significant quantity of value, and when extrapolated across globe-spanning supply chains, this regular loss of revenue can severely impact any operation.

However, companies like Taulia can offer solutions to this problem.

Dynamic discounting (DD) allows buyer companies to use their own funds to pay early, capturing potential discounts and avoiding the inflation penalty imposed on their partner firms. Supply chain finance (SCF), also buyer-led, allows a third party to offer early payment on the company’s behalf.

At the other end of the pipeline lies accounts receivable (AR) financing, where a company can unlock cash trapped in the value of its AR – essentially a line of credit based on debts it is owed.

In a similar way, inflation’s hit to purchasing power means the cost of most goods will be substantially more expensive if we expand our time horizon to between 90 and 180 days – ie up to half a year.

Inventory solutions of the kind provided by Taulia mean companies can purchase goods at today’s price, but have them held for 90 to 180 days before selling them to a client at the original cost plus a carrying fee that may be less than the rate of inflation, thus insulating the transaction from inflation’s hit to value. This strategy can allow companies that face challenges in passing on cost increases to their customers until contracts are renewed to lock in their margins.

Creative application of methods such as these should go some way toward mitigating inflation’s value erosion and its impact on bottom lines.

It’s also worth pointing out that despite the flat figures quoted by central banks and other policymakers, different sections of the economy can be more or less exposed to inflationary pressures – you’re probably feeling the pinch more if you have to fuel a fleet of delivery vehicles on a daily basis – so solutions like these can offer a lifeline to businesses struggling in today’s environment.

 

Broadening credit spreads

For the reasons outlined, we are in a time of economic tension. And, as has happened historically, the gap in spreads (risk premiums paid on debt above a risk-free rate, usually the yield on US Treasuries) between companies with weak and strong credit ratings has grown.

We are now once again seeing this dynamic play out, with spreads for high-yield companies (ie those with less solid credit ratings) growing fast.

Under these conditions, buyer-centric early payment programmes like DD and SCF and seller-centric receivables financing become substantially more appealing, given they are founded on the arbitrage opportunities created by leveraging the strength and credit worthiness of large corporate buyers.

Why is this?

In short, large buyers tend to be more creditworthy than the small and mid-sized companies in their supply chain. SCF, DD and AR solutions take advantage of this credit mismatch and open up stable and reliable funding to suppliers at a comparatively low cost.

Forward guidance from central bankers indicates that interest rates will continue to rise and remain above current levels in the short to medium-term. As such, businesses are faced with an increased cost of debt at the same time as they are combatting the impact of inflation.

Across the global economy, many companies have taken on significant debt over the last five to six years, in particular in the process of managing and mitigating the unpredictable and sometimes devastating impacts of Covid-19.

If profits go down as interest rates go up – as seems likely across a wide range of industries – it is possible there may be a surge in corporate bankruptcies. Businesses that sell to these firms, therefore, face an increased risk that their accounts receivable balances outstanding with collapsed companies won’t get paid.

AR financing solutions offer an elegant solution to managing these risks as they allow businesses to get paid early and promptly, with the risk of the debtor firm being offloaded onto the financing institution.

 

FX exposure from interest rate differentials

It’s time to briefly again go back to basic economics.

When different countries’ economies have different interest rates, the currency of a country with a higher interest rate will tend to appreciate as international money flows across its (virtual) border, increasing demand for the currency and hence increasing its relative value.

We have recently seen a classic demonstration of this basic insight as aggressive interest rate hikes from a hawkish US Federal Reserve has stood in contrast to more dovish action by the European Central Bank.

The result has been a sharp increase in the value of the dollar.

If you conduct your business primarily in US$ but are paid in currencies other than the dollar, this creates a classic FX risk – again, straight from the textbooks.

However, early payment solutions, whether buyer-led like DD and SCF or AR financing, all allow companies to hedge against the risk of further currency appreciation or depreciation as they lock in the spot rate of the day the agreement is entered into.

These early payment solutions do more than aid in managing transactions between developed economies. Importers of goods from China, say, are able to benefit by locking in spot rates that avoid the trend of further renminbi (RMB) depreciation against the dollar as a result of differing monetary policies and market conditions. This means they benefit at the same time from falling local costs and require less RMB for paying in US$ earlier.

Along similar lines, so-called ‘commodity currencies’ like the Canadian dollar, New Zealand dollar, Norwegian krone, South African rand, Brazilian real and the Chilean peso traditionally appreciate in value during times of economic stress and given the nature of the goods traded, it is frequently extremely difficult to find cost-effective alternative options. Early payment solutions offer a strategy for hedging against foreign exchange risk for transactions in these currencies, while still preserving the core integrity of a supply chain.