Ways of extending payment terms without hurting suppliers

Saranya Sundararajan -- Team Lead and Sujeet Pandey -- Senior Research Analyst; additional inputs by Sakthi Prasad

Working Capital Management has been considered as one of the top 5 priorities for CFOs every year. It plays a key role in determining the solvency of a firm, maintaining goodwill, and for smooth business operations.

Working capital management system ensures the right balance of inventories and cash in the business.  Optimizing working capital helps companies by improving their cash flow and reducing their inventory and capital costs.

While there has been no significant change in the working capital days in the last five years -- having deteriorated by 0.8 days -- it appears this may have been achieved in a manner which is placing increased pressure on the supply chain, PWC said in a recent report. The firm added that higher Days Payables Outstanding (DPO) “may be indicative of increased creditor stretching activity, which might not be sustainable in the long term.”

In an ideal scenario, a supplier gets paid on invoices almost immediately -- but that almost never happens.  A delay in customer payments or ad hoc extension of payment terms can be a frustrating experience for any supplier.

Efficient working capital management, hence, becomes crucial and it needs to be done in a manner without stressing out the supply chain.

Objective: The aim of an effective working capital management system is to increase the accounts payable period, while reducing the accounts receivable period and inventory.

Measures to improve Working Capital:

Driven by the targets to increase cash flow and increasing pressure from stakeholders, companies undertake various actions as follows:

Extending Payment Terms:

Of all the options listed above, let us examine how best to extend the payment terms without stressing the supply chain.

Large organizations usually have a standardized payment term, which is favorable for their cash flow position, and all deviations would require high level authorization.

Segmenting Vendor Groups: Companies should segregate group vendors and then choose those groups, who provide the best opportunities for altering the payment terms.

• Strategic Suppliers: These are the core vendors who represent the highest savings potential for a buyer. However, care should be taken not to antagonize these suppliers. As the savings potential is higher from this segment, payment terms need to be negotiated carefully. Otherwise, it would amount to killing the goose that lays the golden egg.
• Non-strategic Suppliers: All vendors below a certain limit of spend could be unilaterally changed to the standard payment term (unless on better terms) via a master data upload.

Setting up a Help Desk: Secondly, a help desk should be set for better handling of supplier queries.

Optimize Discounts for Early Payments:  Where buyers are willing to pay early, companies should optimize the dynamic discounts with the suppliers.

Benefits: This will lengthen the DPO profile, helping release large amounts of cash. Extension of payment terms can account for 5-20 percent uplift in the value of accounts payable balance.

Risks: Any short term progress will be eroded over time without the right organisation and tracking mechanisms. Visibility of performance will prevent this occurrence.
 

Ideal Communication process to suppliers for Payment Extension

• For new suppliers: The desired payment term to be mentioned in contracts to make it a contractual obligation.
• For Existing suppliers:  Formalize by letter to non-strategic suppliers.  For example, existing PT +15 days as DPO from now on.
• Invite strategic suppliers for a collaboration on increase in any potential days (+) without cost impact and gradually plan a way forward to the existing payment terms for next fiscal year or in next two years.

Develop a possible Reverse factoring program with local Banks/Fintech service providers who can provide attractive discount rates.
 

How best to drive Payment Terms with Suppliers?

• Supply Chain Financing or Reverse Factoring is the most used Procurement Lever deployed by many Fortune 500 companies in case challenges are faced in extending the payment terms through direct negotiation with suppliers.
  The model works best with medium and small suppliers who are short on cash. Organizations have successfully implemented SCF by interacting directly with the finance team and bypassing the sales team in case of large suppliers. Markets such as U.S. and Europe have lower bank interest rates -- hence SCF is easier to implement.

• Fortune 500 organizations first negotiate with their immediate suppliers with regards to payment terms extension. However, in cases where the Tier I supplier doesn’t agree, organizations negotiate the terms with Tier II suppliers and ask Tier I suppliers to pass on the same benefit. In most cases, Tier II suppliers agree to the extended payment terms owing to the brand value of the client organization. This option is applicable to select Direct Category suppliers.

Engagement Models

With the advent of Reverse Factoring programs, Best-in-Class organizations started partnering with a single bank. However, they later moved on to a multi-bank approach while deploying the program in more regions, or expanding the program to smaller suppliers, owing to the fact that different banks are leaders in different regions.

Currently, organizations are moving towards Fintech companies as Reverse factoring partners. Fintech companies have simpler onboarding process, hence easier to on-board smaller suppliers.  Moreover, Fintech companies help in on-boarding more suppliers on the platform who do not have a system such as e-invoicing functionality.

Even though traditional banks are tied down by various regulations, they still offer a secure and risk free option when it comes to cash availability.

Single Bank vs Multi-Bank

With time and expanding supplier base in different regions, best-in-class organizations have moved to a multi-bank approach. Instances have also been seen where a bank partners with multiple banks in order to expand its scale of operations.

Key Takeaways:

• One of the top concerns of CFOs is working capital management.
• Working capital management is critical as it ensures business operations are going smoothly, it can help determine company solvency, and it ensures goodwill is maintained.
• Working capital management can help a business know whether it has the correct cash and inventory balance.
• Working capital optimization can enable firms to reduce capital costs, inventory, and help improve cash flow.
• PWC stated that despite recording no big change in working capital days for the past 5 years, this outcome was likely due to an increase in pressure in the supply chain.
• Ideally, the supplier should get paid as soon as he does his part but this isn’t usually the case because of situations such as extending payment terms to customers.
• Ad hoc extended payment terms affect suppliers negatively as they don’t get paid on time. Hence, efficient working capital management is the need of the hour.
• A system where the accounts payable period is increased and the inventory and accounts receivable period is decreased is called an effective working capital management system. 
• Cash flow impact of payment terms is important to understand because it dictates the actions that the company can take. 
• By carefully segmenting vendor groups, firms can choose those which enable them to change supplier payment terms. 
• Strategic suppliers can help firms save the most and so negotiations with these suppliers should be done systematically. 
• Companies should opt for standard payment terms when it comes to their non-strategic suppliers with the help of master data upload. 
• A help desk can be set up so all supplier queries regarding extending payment terms to suppliers can be handled clearly.
• Companies can opt for dynamic discounting with suppliers if they are able and willing to make payments early.
• Tracking performance is the only way to ensure proper progress is being made.
• When a letter to the supplier to change payment terms is being written, it should be done according to whether the supplier is an existing one or new.
• The required payment term should be made clear in the contracts for new suppliers.
• The existing non-strategic suppliers should be sent a letter where the details of payment terms should be clearly mentioned. 
• For existing strategic suppliers, aiming for collaboration will be fruitful while ensuring there is no cost impact. 
• Reverse factoring programs should be built with local banks to get access to discounts. This is ideal for small and medium suppliers who don’t have much cash available at hand.
• Reverse factoring is easy in Europe and U.S. because of their low bank interest rates.
• Organizations are leaning towards Fintech companies so they become their reverse factoring partners. This is mainly due to the simplicity involved.
• Top organizations are using a multi-bank system for easy expansion as they deal with suppliers from various regions.
• "What actions can suppliers take to respond to the lengthening of the payment terms" depends on the brand value of the firm they are dealing with and their relationship.
• A sample letter to extend payment terms with suppliers or a sample letter to negotiate payment terms with suppliers can help businesses understand the most effective way to articulate their terms.

Conclusion:

Intensifying competition in the field of Supply Chain Finance (SCF) has created many options to optimize payment terms.  If planned well, a firm’s supply chain can act as a source of inexpensive capital without having to ruffle the buyer-supplier relationship.