Friday Rant: Payment Matters
I know of some large corporations that are pushing out their payment terms from 30 days to 60 days. They're trying to squeeze out working capital in order to get a little more profit. If their cost of capital is 8% and they wait another 30 days to pay a supplier a million dollars, they're theoretically saving 8% x $1MM x 1/12 = $6,667 in capital costs. However, this is penny wise and pound foolish. They could very well be increasing their supply risk, not to mention hurting goodwill, because many suppliers are facing liquidity issues in this economic downturn. Furthermore, suppliers I talk with say they figure out ways to increase their charges on future projects to compensate for any borrowing costs they may incur.
Yogi Berra has taught us that it's tough to make predictions, especially about the future... but I'm going to paint a scenario of how the economy could rebound in the next couple of years, and relate it to another reason it's important to pay quickly.
Many who have lost their jobs will not be able to find jobs in large companies. Some of those people, who have harbored business ideas for a while, are using their severances and savings to start new businesses. Those who survive and thrive will create new jobs, which will drive consumer spending again, benefiting large companies too. Quick payment will help new suppliers' liquidity and hence survival rate. And, for new and existing suppliers alike, quick payment stimulates the economy by speeding the flow of money.
Some third parties have taken a step in the right direction of quicker payment. They offer software-based services wherein suppliers who have payment terms of say 30 days, can choose to be paid more quickly, but accept less money as payment in full. So, if a supplier is to be paid $100K in 30 days, they can accept a payment in full of perhaps $97K and get it immediately. Such companies I'm aware of that offer these "supply chain finance solutions" include, Orbian, PrimeRevenue, JPMorgan-Xign, and HSBC. Even if the payment discounts are a bit pricey for suppliers, they at least give them accounts receivable cash-flow flexibility.
If these arguments aren't enough, think about when you've done some work for somebody. You want to be paid as soon as possible, right? Don't you feel that that money is rightfully yours? Historically, it took time to process payments manually and hence the tradition of 30 days payment terms. However, for some time now, payments can usually be made instantly. So, morally and pragmatically, all parties should be moving toward instant payment upon successful completion, with minimal discount.
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It doesn't mean you won't get paid, but it is not a good sign.
Once there is an invoice approved for payment the second part comes into play. This is payment terms. To me, there is a relationship between credit worthiness and payment terms. As you suggested smaller companies are generally less credit worthy and often require more immediate payment to cover costs expended. They have less financial ability to carry costs. Larger firms have the financial capacity to carry costs. Many small businesses accept merchant cards because they get paid more quickly. The cash is more important than the 2.5% discount they pay to accept the merchant card. Large companies might accept merchant cards as a convenience to customers but, not as a method to improve cash flow.
Companies (Banks) offering "supply chain finance solutions" are providing solutions that do exactly what you suggest, they allow suppliers to take payment when the supplier wants \ needs to. If you used 2.5% as a baseline for immediate payment and extended the terms out according to that interest rate (I didn't do the math but, for the sake of example) say at 30 days there might be a 1.8% discount, at 60 days 1%, ... If you do the real math you will be surprised how far out it would still be worth your while to not take the discount and wait for full payment.
I predict in the future you will see a graduated discount rate and longer terms. I believe banks and finance \ treasury organizations will be involved in setting the rates. The banks taking payment from client company the end of the payment term (think 90-120 days) and providing financing for suppliers who need payment before then. This allows the client company to carry the cash longer (or at least receive payment from their client\customers). The banks and client companies will split the money made in financing the suppliers debt.
BTW, payment terms vary widely outside the US. In Italy, many terms start at 120 and go out to 180. Put a calculator to it and you will see why terms will go longer in the future. Terms and operating capital govern payment. I see a future with instant payment upon successful completion with a discount structure and longer terms based on the same graduated discount structure. You pick when to get paid.
In the event that our customers do not pay on time, we measure their non compliance to trading terms and highlight these non conformances at our quarterly management review. At this point, we confront these issues including how best to mitigate risk in terms of product cost increases, and total delivered cost.
Whilst our business is fortunate to manage its cash flow effectively and efficiently, our customers do recognise that non compliance to our terms is benefitting them, at our expense, and therefore measured as savings achieved.
Working capital optimization is such that the buyer does not want to tie up cash in the materials prior to being paid by their customer. Typically this cash conversion cycle means that buyers would have to extend payment terms beyond the historical norm of 30 days.
The question then becomes: how can I extend payment terms to match my cash outflows to suppliers with my cash inflows from customers without putting upward pressure on my cost of goods, increasing supply chain liquidity risk, and delaying payment to suppliers (a detriment to their own cash conversion cycle and hence working capital position)?
The answer is supply chain finance. By offering suppliers access to nearly the present value equivalent of the receivable (SCF suppliers most often are paid greater than 99% of invoice value by the SCF provider), the option to choose when to get paid, the ability to be paid immediately upon invoice approval, 100% visibility and certainty around the timing of payments, and the ability to do business with zero investment in accounts receivable, supply chain finance revolutionizes the buyer-supplier dynamic and allows buyers to extend payment terms while suppliers simultaneously reduce payment cycles; and both parties reduce processing costs in the process.
Supply chain finance is ultimately the most efficient way for buyers and supplier partners to pay and get paid on business to business trade.