Buyer-backed purchase-order financing for SME supplier with uncertain yield

Access to adequate working capital is often a challenge for SMEs, especially if SME faces the risk of an uncertain yield. We identify conditions under which a strong buyer should either offer “backing” or guarantee for the purchase-order finance for a cash-constrained, risky SME supplier, or end the relationship. By offering a backing, buyer shares the default risk faced by the bank, in order to keep the SME supplier in business. To identify the possible benefits of this scheme, we compare the buyer’s operational and financial decisions under three financing mechanisms: buyer-backed purchase order financing, purchase order financing with no backing and purchase order financing with a fixed buyer-backing. The non-linear optimization problem is solved using KKT optimality conditions and sufficiency is established through invexity. We perform numerical experiments for all the models for different levels of yield risks of the supplier. We are able to separate conditions to suggest when (1) no backing is required; (2) when backing should be offered to sustain the supplier, and (3) when an alternative supplier should be located.

We find that backing has the following benefits: buyer can use backing as a substitute to higher purchase price; it helps the supplier to stay operative till a higher shock level; shared risk of default leads the bank to offer financing at a lower rate; finally resulting in consistently higher buyer profits despite the added risk. The separation condition as described above can also be used by managers to compare two suppliers.