A borrower’s vendor payments are the largest category of cash outflow in most manufacturing and trading businesses. In a manufacturing borrower with Rs 50 crore of revenue and 65% raw material cost, Rs 32.5 crore flows through vendor payments annually. If the lender wants to know where the borrowed money went, the vendor payments are the first population to examine, because they provide the most natural cover for diversion.
Every vendor payment has a business description (raw materials, consumables, services, maintenance), a purchase order, an invoice and an approval. The volume is high (hundreds of payments per month), the individual amounts are often below internal review thresholds and the business justification is self-evident (the factory needs raw materials to produce). The cover is inherent in the nature of the payments.
The Vendor Funding Test examines whether the vendor relationships are commercially genuine, the pricing is arm’s length, the counterparties have substance and the money stays where the documentation says it went.
Signal 1: Vendor concentration without commercial justification
One vendor receives 40% of all procurement payments. The product the vendor supplies is a commodity available from dozens of alternatives. There is no patent, no exclusive distribution agreement, no quality specification that only this vendor can meet, no geographic monopoly. The concentration has no commercial explanation.
Legitimate vendor concentration exists: a sole manufacturer of a specialised component, an exclusive distributor in a specific region, a vendor with unique technical capability. The Vendor Funding Test does not flag concentration itself. It flags concentration without justification. When 40% of procurement flows to a single vendor for a commodity product, the question is not whether the vendor is competitive. The question is what the vendor provides to the borrower that no other vendor can, and if the answer is “nothing except a willingness to participate in the arrangement,” the concentration is a signal.
Signal 2: Vendor substance deficit
The vendor was incorporated within 12 months of its first transaction with the borrower. Its paid-up capital is at the statutory minimum (Rs 1 lakh for a private company). It has no visible employees (no PF/ESI filings, no professional tax registration). It operates from a residential address or a virtual office. It files GST returns intermittently (active only in months when it transacts with the borrower, zero returns in other months). It has no other customers of significance (its GSTR-1 output tax corresponds almost entirely to transactions with the borrower).
This entity was not created to supply goods. It was created to receive payments. The goods, if they exist, are supplied by a genuine sub-vendor and routed through this entity to create a documented justification for the payment. The margin retained by the entity (the difference between what it charges the borrower and what it pays the sub-vendor) is the extraction: the amount transferred from the borrower’s facility to whoever controls the entity.
Signal 3: Pricing inconsistency
The vendor charges 15% to 20% above the market rate for the same product. The borrower, which negotiates aggressively with every other vendor (demanding competitive quotations, benchmarking prices, switching suppliers for 2% savings), does not negotiate with this vendor. The vendor’s pricing has not changed in two years despite market fluctuations. The vendor does not offer volume discounts despite being the largest supplier.
The pricing anomaly is quantifiable. The market rate for the product is Rs 200 per kg. This vendor charges Rs 240 per kg. On Rs 10 crore of annual procurement, the overpricing is Rs 1.67 crore per year. On a business earning Rs 3 crore of net profit, the overpricing destroys 56% of the profit. The overpricing is not inefficiency. It is extraction.
Signal 4: Onward transfer pattern
The vendor receives a payment of Rs 50 lakh from the borrower. Within 48 to 72 hours, Rs 45 lakh is transferred to another entity. The receiving entity is connected to the borrower’s promoter through ownership, directorship, family relationship or financial entanglement. The vendor’s account shows no gradual drawdown for operating costs. It shows a large credit followed by a large debit, with the vendor retaining 5% to 10% as a facilitation margin.
This is the pass-through pattern. The vendor exists to receive the borrower’s payment and route it to its actual destination. The documentation (PO, invoice, GRN) was the cost of the arrangement. The pass-through was the purpose.
Signal 5: Cyclical payments creating circular flows
The borrower pays Rs 1 crore to the vendor. Within 7 to 14 days, the vendor (or a connected entity) deposits a similar amount into the borrower’s account, classified as “sales revenue,” “advance from customer” or “security deposit.” The money circuits: out as procurement, back as revenue. The P&L shows both a Rs 1 crore cost and a Rs 90 lakh revenue from the circular flow. The cash effect is net negative Rs 10 lakh (the facilitation cost). The financial statements are inflated by Rs 90 lakh of fictitious revenue and Rs 1 crore of fictitious cost, creating an appearance of commercial activity that does not exist.
The vendor risk matrix
Every significant vendor (above 2% of procurement) is scored against all five signals. A score of 1 (one signal) is noted but not escalated. A score of 3 or more triggers escalation for detailed investigation. The investigation includes: direct vendor verification (site visit to the vendor’s premises), pricing benchmark (comparison to independent market rates), fund flow tracing (where did the vendor payment go after it arrived?) and MCA/GST data cross-reference (is the vendor connected to the borrower through any channel the self-declaration did not capture?).
The matrix is a standard deliverable in Northrop’s forensic and monitoring engagements, produced from the borrower’s own data (purchase records, bank statements, MCA filings, GST data) without requiring the borrower’s cooperation on the analysis. The borrower provides the data. The analysis is independent.
Northrop applies this test in forensic reviews and continuous credit surveillance. [email protected] | +91 92899 25657.