Topic 10 The trade cycle analysis process

Introduction

In Topic 5, when discussing the financial supply chain, you learned about how ‘cash is king’
and cash flow was cited as being the bloodstream of a business, where the faster it moves
around the business, the healthier that business will be.

In Topic 9 you explored the key metrics that provide the working capital picture of a
company. Measurements such as Days Sales Outstanding (DSO), Days Payables Outstanding
(DPO) and Days Inventory Outstanding (DIO) as well as the Cash Conversion Cycle (CCC) are
indicators related to the movement of cash in a business, and the business’s ability to pay its
way.

When looking at the ‘trade cycle’ as a finance provider, we are aiming to understand the
needs of our clients in terms of risk mitigation, finance and payments. In this topic, we
consider the process of undertaking a trade cycle analysis and explore the conclusions that
can be reached.

Learning objectives

By the end of this topic, you will understand:

• the approach that should be taken when conducting a trade cycle analysis with
different types of clients; and
• the conclusions to be reached following such a trade cycle analysis.

Think...

Consider how a client might approach supply chain finance. How well-informed and
knowledgeable are they likely to be regarding the options available?

How important is it, do you think, that the finance provider is able to diagnose the client’s
needs, especially in cases where the client ‘doesn’t know what they don’t know’?

10.1 Benefits of trade cycle analysis

The trade cycle analysis process can be applied to all trading scenarios, though the
outcomes will be specific to a client’s situation.

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The consistent application of a standard process will deliver numerous benefits to a funder,
including:

• well-informed credit decisions – a standardised model for analysing a financing

opportunity leads to balanced risk assessment and ultimately better credit decisions;
• validation of client needs – the process ensures that the proposed solution meets
real business needs that the client recognises and understands;
• workability and rapid adoption – by validating the needs and explaining the
implications/dependencies of a proposed solution to the client, implementation
shocks and delays are avoided;
• conduct risk compliance – an audit trail of the analysis and validation of needs and
the development of a solution is created, ensuring that the funder can demonstrate
they have sold the appropriate product to a well-informed client who was treated
fairly and given fair value; and
• client satisfaction – the client is happy that they have been sold the appropriate
solution that meets their validated needs.

Undertaking effective trade cycle analysis also directly benefits the client. By ‘playing back’
the outcome of the trade cycle analysis to the client, the finance provider is enabling the
client to see the impact of their trading arrangements on their cash conversion cycle. Many
clients, particularly SMEs, do not fully appreciate the impact on their working capital of their
business operating model and payment terms.

10.2 Scope
As previously noted, the primary parties in a supply chain may both be a seller and buyer. In
order to sell their finished product, the seller needs to source raw materials, components or
subassemblies. In the case of a wholesale distributor, they may be sourcing finished goods
that they are on-selling without materially changing the goods. Similarly, a pure
commodities trader will buy and sell their chosen commodity without processing it or
converting it into a different product.

Analysis of the physical supply chain

The trade cycle analysis process starts with a detailed analysis of the physical supply chain.
The scope of this analysis will depend on the size of the client and the sector it operates in.

Single cycle

For example, where an SME client is buying in finished product from a few major suppliers
in one particular region and selling that product on standard payment terms in its home
market, it will be feasible to undertake an analysis of their entire business in a single view.

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Multiple trade cycles

On the other hand, a larger corporate may have multiple trade cycles depending on where
and how they are sourcing and where and how they are selling. In such a case, the trade
cycle analysis will be pitched at the ‘line of business’ level and may require a number of
different analyses being compiled, and then weighted and placed into a comprehensive
summary that gives a clear picture of the client’s overall business.

10.3 A systematic approach

No matter which approach is appropriate, the intention is to add quantitative and
qualitative detail to the high-level view of the client’s role in the physical supply chain.

Quantitative detail

This includes:

• event timings;
• values;
• credit periods;
• lead times (the period between commitment and shipment);
• transit times;
• shipment methods;
• suppliers (who/where?);
• buyers (who/where?);
• inspection; and
• insurance.

The careful analysis of the above will provide clarity regarding funding gaps, risk exposures
and payment flows.

Qualitative detail

This provides a basis for risk assessment and includes:

• the reliability of any pre-sale agreements (eg is the purchase order robust?);
• the nature, perishability and saleability of the goods (alternative sources of
repayment);
• the price volatility of the goods;
• track record of successful sourcing from suppliers (performance risk);
• track record of successful sale to buyers (credit risk and performance risk); and
• history of disputes and dispute resolution.

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10.4 Beginning the process
The following diagram shows a typical origination and execution cycle. The trade cycle
analysis process starts with data capture and concludes with input to credit approval. It also
informs the execution process as any conditions specified in the credit approval as a result
of the trade cycle analysis must be implemented during the execution process.

Figure 10.1 Origination and execution cycle

The trade cycle analysis output is used to finalise the supply chain finance facility structure
and to specify any non-standard operational or collateral management controls that may be
required. Both the trade cycle analysis output and the proposed facility structure are shared
with the client before the deal is finalised to ensure that the client:

• recognises the trade cycle and agrees with the conclusions regarding risk,
funding gaps and cash flows;
• is comfortable with the operational and collateral management controls;
• is able to make an informed decision regarding the supply chain finance product
solution and structure; and
• is committed to allocating the resources necessary to execute the deal.

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10.4.1 Data capture

To achieve such quantitative and qualitative analysis as highlighted in the previous section,
we need to capture details of all ‘events’ in the physical and financial supply chain. Key
‘events’, with examples of the type of data to be obtained, are as follows:

Sourcing data

• supplier details and track record;

• date/timing of order placement;
• credit terms;
• settlement method (eg open account, Letter of credit (LC), advance payment, margin
deposit, etc);
• manufacturing/supply lead time;
• percentage sourced against confirmed buyer orders/percentage sourced ‘for stock’;
• consignment size/value;
• Incoterms;
• method of shipment;
• date/timing of shipment;
• despatch from and to;
• consignee details (eg named consignee or ‘to order and blank endorsed’);
• pre-shipment inspection (when and by whom); and
• transit time.

Inventory data

• nature of goods;
• saleability of goods;
• warehousing arrangements (eg third party, client-owned etc);
• perishability/durability/special storage conditions; and
• price volatility/hedging arrangements.

Selling data

• order size relative to ‘normal course of business’;

• buyer details and track record;
• date/timing of order received;
• nature of order (eg confirmed purchase order/sale or return/consignment stock etc);
• special conditions (eg ‘just-in-time’ delivery required, subject to ‘call off’ within a
specified period etc);
• inspection (pre-shipment/post-shipment/goods acceptance etc) – pre-shipment
inspection by, or on behalf of the buyer may is also considered under the ‘sourcing data’
heading ;
• credit terms;
• settlement method (eg open account, LC, advance payment, margin deposit etc);
• credit risk mitigation (eg LC, confirmed LC, credit insurance etc);

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• consignment value;
• Incoterms;
• method of shipment;
• date/timing of shipment;
• despatch from and to;
• consignee details (eg named consignee or ‘to order and blank endorsed’); and
• transit time.

Financial flows

• timing, currency and value of payments out/in;

• timing, currency and value of credit instruments issued/received; and
• current financing method.

In addition to the above, time should be taken to research the sector the client operates in
and if possible obtain relevant financial metrics (eg DSO, DPO and DIO) from the client’s
peer group. Such information is useful and often revealing for the client during future
playback if, for example, you can point to sector trends that are different to the client’s
metrics.

10.4.2 Physical supply chain map

The capturing of data enables the construction of a map charting the key events and
associated timeline.

A company with multiple business lines might require the drafting of a number of physical
supply chain maps that will then need to be brought together to provide an overview of the
business as a whole.

Figure 10.2 Physical supply chain

This diagram illustrates the events in a typical physical supply chain, in which the client is
sourcing to meet requirements of a specific end buyer, from whom they have received a

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confirmed purchase order. For the sake of clarity, we have included purchase order and
invoice issuance as well, though these are actually financial supply chain events.

Reviewing the trade cycle as shown above, the following points emerge:

1. The EU-based client in this case is the manufacturer sourcing materials from a China-
based supplier, producing a finished product and selling it to end buyers in the USA.
2. The client receives a purchase order from the US buyer before placing the order with the
Chinese supplier.
3. Having a confirmed order gives greater confidence that the finished goods, once
manufactured, will have an end buyer, providing a reliable source of repayment.
4. However, performance risk is still a key factor as the client will only have an enforceable
debt once they have delivered the finished goods in compliance with the buyer’s
purchase order.
5. There is a critical dependency, therefore, on the client’s ability to manufacture the
required goods on time and to the correct specification, which in turn is dependent on
the performance of the Chinese supplier of materials used in the manufacturing process.
6. Though not highlighted in the trade cycle diagram, the shipping terms (Incoterms)
should also be noted as these will impact costs, rights and responsibilities of the seller
and buyer in respect of freight and insurance and the point at which responsibility for
the goods is transferred to the buyer.
7. In this example, lead times, transit times, manufacturing times and stockholding times
have not been specified but can be derived from the timings of the specified events. In
practice, the timeline will be built up from an analysis of these factors.

10.4.3 Financial supply chain map

Following the mapping of the key events in the physical supply chain, the financial
implications of each event are mapped and placed in the timeline.

Figure 10.3 Financial supply chain

This diagram adds the financial consequences to the physical events included in Figure 10.2.
The combination of the physical and financial event data provides the basis for a holistic
view of the client’s trade cycle.

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On day 10, when the client places the order with the Chinese supplier, there will often be a
requirement for a deposit or advance payment, creating a funding gap for the client. In this
example, the client is required to place a deposit of 20% of the purchase order value.

1. The client’s funding gap from day 10 until day 80, when production starts, can be
expressed as a percentage of the selling price for the purposes of evaluating a pre-
shipment advance. If we assume that the manufacturer has a gross profit margin of 25%
and direct manufacturing costs of say twice the value of the materials, which cost $1m,
we can work out that the client has a funding gap at the purchase order stage equivalent
to 5% of the value of the sales contract. As the sales contract represents the primary
source of repayment, it is often more meaningful to express the pre-shipment funding
requirement as a percentage of the sales contract value, rather than as a percentage of
the sourcing costs.

Table 10.1 Calculation of funding gap at purchase order stage

US$
Cost of materials 1,000,000
Manufacturing costs 2,000,000
Total cost of goods sold (COGS) 3,000,000
Gross profit margin (% of selling price) 25.00%
Selling price 4,000,000
Deposit required (% of cost of materials) 20.00%
Deposit required (% of cost of materials) 200,000
Funding gap at purchase order stage 5.00%
2. From day 80 until day 115, when the invoice is raised by the client on the end buyer,
further costs will be incurred as the manufacturing process progresses, resulting in an
increased funding gap. During this period, the client has inventory (raw materials + work
in progress + finished goods) on their balance sheet.
3. On day 85 the balance due to the supplier will be paid.

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4. Towards the end of the inventory period (day 100), the finished goods are inspected by
the end buyer. At this point, performance risk has reduced significantly.
5. On day 110, a few days before the invoice is raised (day 115), the finished goods are
shipped.
6. It can be seen that the inventory period follows on from the purchase order period. Both
are part of the pre-shipment period.
7. On day 115, having raised the invoice, the client is now in the post-shipment period. The
funding gap at this stage will be 75%, so any funding solution during this period should
provide at least this amount.

Check your understanding

Can you match the types of data you’ve encountered to the correct heading?

Sourcing data: Date of order placement, manufacturing time and pre-shipment inspection.

Inventory data: Saleability of goods, durability of goods and warehouse arrangements.

Selling data: Buyer details, date order received and post-shipment inspection.

Financial flows: Timing, currency and value of payments.

10.5 Risk and funding gap analysis

Having mapped both the physical events and the subsequent financial consequences, this
enables the funder to clearly chart the risks and funding gaps, along with their proposed
solutions.

Table: 10.2 Risk and funding gap analysis

Days Risk and/or funding implication Funding/risk mitigation solution

0–80 • Performance risk on supplier • Unless supplier agrees to an LC then this risk remains
• Cancellation risk on buyer • Verify legal status of purchase order and check
• Funding gap as required to pay creditworthiness of buyer
supplier 20% with purchase • If supplier is unwilling to accept an LC and insists on
order 20% deposit, and if the buyer is unwilling to pay the
client a similar advance with their purchase order to
the client, then there may be a need for the funder to
provide some financing against a confirmed purchase
order received by the client from the buyer

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 80–115 • Client required to pay its • Payment to be made following acceptance of a pre-
supplier on day 85 for the shipment inspection by independent agency or the
balance owing client’s representative
• Client is incurring ongoing • A payables finance solution may be considered which
production costs will facilitate the payment to the supplier but also
provide for the retention of working capital in the
business to cover the pre-shipment period

115–190 • Client loses physical ownership • Prior to accepting the buyer’s purchase order, the
of goods as they are shipped client could have considered using credit insurance to
• Buyer ability/willingness to pay mitigate the risk of non-payment (can’t pay as
against the client’s sales invoice opposed to will not pay)
• As per example, the client’s • To mitigate the risk of dispute, the client agrees to the
funding gap is at its highest at buyer carrying out pre-shipment inspection with
75% resultant formal confirmation that goods are as
specified in the purchase order (covers dispute risk)
• In this post-shipment phase the client may take
advantage of any payables finance solution used by
the buyer or may put in place its own receivables
purchase/financing solution

Having completed the trade cycle analysis, it is good practice to share this with the client.
This serves two purposes:

• It validates the accuracy of the events, event timings and resulting financial
implications with the client.
• For less knowledgeable clients, this can be a highly enlightening process in its own
right. Many smaller corporates will be unclear regarding the true financial impact of
their role in the physical supply chain.

10.6 Possible solutions

As can be seen from the trade cycle analysis, a number of client needs will be uncovered
and a range of potential financing solutions identified in respect of the financial implications
arising from physical supply chain events. However, not all the risks faced by the client can
necessarily be mitigated by a supply chain finance solution. The intention, therefore, is to be
able to demonstrate and quantify the risks being taken by the client and to assess whether
they are acceptable or need to be mitigated. It could be, for example, that during the pre-
shipment phase, the client considers using the protection afforded by an LC solution or it
might be, if that is not forthcoming, that they negotiate better terms with the buyer and
their own supplier to try to lessen the impact of the risks being taken.

Eliminating pain and realising gain

A key determination in such a discussion with the client is to gain a clear understanding of
the client’s main drivers and priorities. The big question is ‘what is the client seeking to

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achieve?’ To put this another way, client benefits can be positioned as either eliminating a
‘pain’ or realising a ‘gain’. There may be elements of both at play simultaneously. A related
question is ‘how important is the elimination of the ‘pain’ or realisation of the ‘gain’ – or
both?’

The importance of the first question should be self-explanatory but can easily be overlooked
in the rush to close a deal. Failure to understand the client drivers is a recipe for frustrated
implementation and a lack of adoption. It may even result in miss-selling – a clear and
serious conduct risk compliance failure. One obvious driver is accelerated cash flow and,
though this is a very common driver, it is not the only one. Typical drivers are listed in the
following section.

10.6.1 Addressing clients’ priorities and needs

Table 10.3 Client motivation for selecting a supply chain finance solution

Driver Example
Cash flow acceleration • Addressing a funding gap
• Accessing additional funding to finance growth
Risk mitigation • Limiting funder’s recourse to the client
• Taking the finance ‘off balance sheet’ with a ‘true sale’ solution
• Bundling finance with risk protection (eg credit insurance)
Increased debt capacity • Decoupling provision of finance from the client’s debt capacity
with an ‘off-balance-sheet’ solution
Reduced finance cost • Exploiting the arbitrage potential by accessing finance closer to
the rates available to a stronger party in the supply chain
Reduced COGS (cost of goods sold) • Negotiating discounted pricing from suppliers as a corollary of
facilitating early payment and/or cheaper finance
Reduced DSO (days sales • Improved working capital efficiency
outstanding) • Enhanced balance sheet ratios
• Off-balance-sheet finance
Increased DPO (days payable • Improved working capital efficiency
outstanding) • Enhanced balance sheet ratios
• Trade creditors not reclassified as bank debt
Efficiency gains • Avoiding unnecessary effort and delays in managing and finance
the physical supply chain
Enhanced supply chain stability • Ensuring continuity of supply of goods by facilitating access to
finance by suppliers
Corporate social responsibility • Treating suppliers fairly
Enhanced competitiveness • Providing extended deferred payment terms to buyers
• Offering a finance solution to buyers to help them pay for the
goods
Reduced DIO (days inventory • Improved working capital efficiency
outstanding) • Enhanced balance sheet ratios
• Taking inventory off the balance sheet

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This is not an exhaustive list but is typical of the drivers that clients will use to make a
decision regarding embarking on a supply chain finance programme. The most important
point is that the funder needs to ask the client the right questions. In the case of mid-
market companies or major corporates, key stakeholders may be from:

• finance;
• procurement;
• sales; and
• logistics.

10.6.2 Cost–benefit analysis

Having determined which product or products best meet(s) the client’s needs through
effective trade cycle analysis and validation of client drivers, there is still one last step
before the funder can be confident that a supply chain finance programme will be
successfully implemented and (critically) will be adopted in sufficient volume to generate
the expected benefits for the three key supply chain finance stakeholders – seller, buyer and
funder. This is the relationship between the value of the benefits relative to the cost/ease of
implementation.

In simple terms, a solution with a high benefits value and a low cost of implementation will
gain adoption quickly. Conversely, a solution with a low benefits value and a high cost of
implementation will probably never be fully implemented, let alone gain any level of
adoption. Somewhere between these two extremes there is a judgement call and a decision
to be made. It is much better to have exercised the required judgement and made the
decision before the funder commits to implementation, rather than afterwards.

10.6.3 Credit approval

The trade cycle analysis and the conclusions reached should form a key part of the credit
submission in the funder’s decision-making process.

From a credit analyst’s perspective, providing them with a trade cycle analysis enables them
to more readily identify with the needs of the client and the solutions being proposed to
cover off those needs.

In addition, knowing that many credit analysts may not have a trade or supply chain finance
background, it is useful to present them with an accompanying transactional control matrix
whereby the submission not only outlines the solution being offered, but also lists the
conditions and parameters to be included that will provide risk mitigants for the funder. In
such cases, it is best practice to have already highlighted these to the client because there is
nothing more embarrassing than having transactional controls agreed through the credit
process, only to find that the client is unable to abide by the conditions and parameters
being offered.

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10.7 Matching solutions to stages in the cycle
You have now learned how a trade cycle analysis of a client’s business provides both the
client and the funder with the clarity needed to understand the working capital cycle and
cash flows associated with the way in which the client is currently trading or is planning to
trade.

The following diagram illustrates where the main products can be used relative to a typical
trade cycle. It should be noted that the trade cycle analysis might highlight risks and funding
requirements that cannot be addressed using supply chain finance alone. In such cases, a
finance provider might conclude that a structure incorporating trade finance as well as
supply chain finance provides the optimum solution.

Figure 10.4 Mapping products to supply chain stages

This diagram illustrates where the products can be applied relative to the supply chain
events. It also shows how the funding gap and risk exposure (performance risk and credit
risk) evolves as the trade cycle progresses.

Also, as highlighted previously in this course and evidenced by Figure 10.4, supply chain
finance solutions, as currently offered, are predominantly instantiated by the issuance of a
sales invoice. It may therefore be appropriate for the funder to offer trade finance to cover
pre-shipment and inventory periods with the SCF solution as the source of repayment once
they become applicable in the post-shipment period.

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10.8 Successful execution
Successful execution and adoption of any supply chain finance solution means:

1. The client’s needs are being addressed as foreseen by both the provider and client.
2. The finance provider can legally execute the solution and has the correct legal
documentation constructs in the jurisdictions of the client.
3. There are no legal impediments to their providing the finance, taking the security or
ownership of the assets (existing or future) being financed, and to enforcement.
Such considerations become more complex when the financing programme is cross-
border, covering the debt and relationship with trading partners in multiple
countries.
4. The client is able to fulfil any transactional reporting or control conditions attached
to the facility.
5. The finance provider is able to operationally manage the facility that has been
offered.

During the sale and subsequent implementation of any supply chain finance programme, it
is important for the finance provider to check back with the client to ensure that the needs
remain the same and, in the case of the larger corporate, this may mean liaison with
different departments that may not necessarily share the same goals.

It is also important that the finance provider can identify and keep track of the assets that
are being loaned against or being purchased. For example:

• inventory is segregated either in the warehouse of the client or is kept in a third-

party warehouse under the control of the finance provider; and
• receivables are clearly identified and a segmentation exercise is undertaken to
identify which parcels of receivable are attractive to the finance provider, taking into
account the points made earlier in this section.

Conclusion
Effective trade cycle analysis enables a finance provider and their client to have a shared
understanding regarding the risk mitigation, funding and payment needs to be met by a
supply chain finance solution.

Based on this understanding, the finance provider can propose a range of options for the
client to consider.

At each stage in the trade cycle, multiple supply chain finance techniques can be applied.
The aim is to find the combination of techniques that best meet the client’s needs and are
consistent with the client’s drivers.

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Think again...

Now that you have completed this topic, how has your knowledge and understanding
improved?

For instance, can you:

• outline the benefits of a structured approach to understanding a client’s needs;

• explain how trade cycle analysis uses data from the physical and financial supply chains
to create a shared understanding with the client of their supply chain finance needs; and
• discuss the benefits to the client and the finance provider arising as a result of effective
trade cycle analysis?

Test your knowledge

1. Which of the following are benefits of trade cycle analysis?

Select from:

A. It ensures that a finance provider has security over the source of repayment.

B. It provides clear validation of client needs.

C. It facilitates well-informed credit decisions.

Feedback

Effective trade cycle analysis will help to highlight the need for, and the opportunity to take,
transactional security, but it does not actually result in the security being taken. (See section
10.1.)

The correct answers are: It provides clear validation of client needs and it facilitates well-
informed credit decisions.

2. Which of the following are examples of the quantitative data used to complete a trade
cycle analysis? Select all that apply.

Select from:

A. The transit time in respect of goods shipped by sea.

B. The gross, net and tare weights of the consignment loaded on the vessel.

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 C. The payment terms granted to customers.

Feedback

The weight of the consignment is not material to the trade cycle analysis. (See section 10.3.)

The correct answers are: The transit time in respect of goods shipped by sea, and the
payment terms granted to customers.

3. Which of the following are examples of the qualitative data used to complete a trade
cycle analysis? Select all that apply.

Select from:

A. The nature, perishability and saleability of the goods.

B. The enforceability of the purchase order.

C. The track record of sourcing from suppliers.

Feedback

These can all impact the probability of the client being able to successfully conclude the
trade cycle and, as a result, complete the cash conversion cycle. (See section 10.3.)

The correct answers are: The nature, perishability and saleability of the goods, the
enforceability of the purchase order, and the track record of sourcing from suppliers.

4. If a company sources goods for $1.5m and is required to make an advance payment of
20% as a deposit for the goods, and has confirmed purchase orders for the goods to the
value of $5m, what level of pre-shipment finance will be required (expressed as a
percentage of the selling price)?

Select one:

A. 20%

B. 10%

C. 6%

Feedback

20% of $1.5m = $300,000;

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$300,000 as a percentage of $5m (the selling price) is 6%.

The correct answer is: 6%

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