Optimal Interest Rates for Supply Chain Payables Finance

Abstract

Problem definition: Payables finance, also known as reverse factoring or supply chain finance, is a form of trade finance arrangement that provides a supplier with the option to receive a buyer's payables early while allowing the buyer to extend its payment due date. Its recent adoption of the blockchain technology has made the process more efficient and secure. In this paper, we study the supplier's optimal cash management policy under such a payables finance arrangement, based on which we quantify the value of payables finance to the supplier and also determine the equilibrium payment term extension for the buyer. Academic/Practical Relevance: Our work presents one of the first rigorous analyses of the optimal cash management policy with payables finance by extending the classic cash management models to allow all interest gains and costs to accrue together with the cash balance. Methodology: We develop a finite-horizon random cash management model and transform it into a cash flow cost minimization problem with a dynamic program formulation. Results: Our analysis reveals that the optimal cash policy has a cash balance-dependent (L, M, U) structure, which differs from the threshold policies found in the classic cash management models. We show that it is the cash liquidity enabled by payables finance to hedge cash flow uncertainty that generates value to the supplier. Such value increases with a lower payables finance interest rate and/or a higher payables finance amount. We further show that the equilibrium payment term extension for the buyer increases with a lower payables finance interest rate, but not necessarily with a higher payables finance amount. To tackle the computational challenge of the problem, we show that the myopic policy for this problem has a simple threshold policy structure. For performance evaluation purposes, we also derive an easy-to-compute cost lower bound based on a system with slightly modified cash balances. Our numerical study shows that both the myopic policy and the optimal policy of the modified system achieve near-optimal performance in the original problem. Managerial Implications: Our study provides theoretical support for the wide adoption of payables finance for small suppliers with poor credit ratings and tight cash constraints. Our model analysis also suggests that the adoption of the blockchain technology can offer greater value to such suppliers. The computational methods developed in the paper can be used as a means to evaluate the value of payables finance and the payment term extension, especially in a frictionless blockchain setting.