Up until now we have looked at the Cash Conversion Cycle components on the asset side of the balance sheet, inventory and accounts receivable, along with various ways we can improve and optimize these metrics.

Let’s not neglect the other side – there are opportunities there as well!

**A Blinding Flash of the Obvious – Why Simple is not Always Best**

If we want to extend Days Payable Outstanding (DPO), which serves to reduce the Cash Conversion Cycle and hence our Working Capital investment,

**the most obvious thing to do is to pay our bills later**!**If we are currently on 30 day terms, we go for 45 day terms. If we are on 45 day terms, we go for 60 day terms.**
There are a couple of big issues around this tactic, unfortunately. If we

**unilaterally**decide to this, pay our bills in 45 days when the supplier wants it in 30 days,**we begin to earn the reputation of a deadbeat**. Our suppliers do not like us anymore, and at some point cut us off.
Even if things are not this dire and we

**negotiate a payment term extension**, this approach is**a zero-sum game**. Yes, we extend our DPO and thereby decrease our working capital investment. But our supplier’s DSO increases by the same amount, thereby increasing their need for working capital.
By forcing our supplier to increase their investments, they will logically require additional return to compensate those investors, and ultimately this will be reflected in the price we pay for our supplies…at least in theory.

Even if they “eat the cost”, there is an element of sleaziness to this tactic that we may not wish to be associated with us.

**Don’t Ignore the Converse**

Extending our DPO is at direct odds with another common supply chain/accounts payable metric – Discounts Taken.

This term refers to the fact that some suppliers will sell on terms where

**if the payment is made within a shorter timeframe, a discount will be granted**. One of the common terms is payment in 10 days gets a 2% discount off the invoice price, whereas 100% of the invoice price will be due if we pay in 30 days. This is called “2% 10 / Net 30”.
The disadvantage to this approach is we need to finance our payables 20 days sooner, so we actually

**end up extending our cash conversion cycle**. Yet, a 2% discount is significant. For 20 days time, this translates into a very, very high rate of return on a per annum basis.
Using simple math and rounding, 20 day cycles occur 18 times per year, so this translates into a 36% annual rate of return. Even investments in hot growth stocks seldom yield this kind of return, and the risk is a lot more than what we face (which is none – payment is in our complete control). So if our cost of capital is 10%, 15%, or even 20%,

**we actually can “lock-in” a gain by paying early**if we get discounts of 2%.
For this reason,

**one needs to be careful using DPO or the****Cash Conversion Cycle****as a metric, as it can incentivize costly behavior**.**It’s All Relative**

If we decide we want to extend our payment terms, we are much more likely to do this with the vendor’s consent (thus making us less “sleaze-bally”) if we follow

**a simple premise from the strategy realm**.
One of the Five Forces of Strategy is

**Buyer Power**. This term is used to describe the situation where the buyer has leverage over the seller in the market.
One way to think about this without the terminology is to think about this question in relation to our ability to get more favorable payment terms –

**is it better to be a small fish in a big pond or a big fish in a small pond?**
If we are our supplier’s “big fish”, they are going to be a lot more likely to be happy about letting us go to 45 day terms from 30 day terms. They might even offer it up!

**Roll With the Flow**

One way to extend our DPO without directly hurting our suppliers is to

**make use of credit card payment systems and programs**.
If our friendly banker has established a

**purchasing card program**for us, if we pay a vendor by credit card on the last day of the invoice term, say 30 days, there is an**additional period of time where we will not have to pay**if we do it by credit card. As a consumer, we will get an additional 25 or 30 days. Most businesses are on a “tighter leash” when it comes to this, but it could be close to the consumer’s profile depending on the situation.
I make the comment that we are not “directly” hurting our supplier because usually it is

**the seller’s account that is hit with credit card transaction fees**. We pay on the 30^{th}day by credit card, they get their money soon thereafter, but they also get charged for our payment with an**“interchange fee”.**So they do not realize the full value of the sale. This compensates the credit card issuer for any time value of money components to additional time between their payment to the supplier and their receipt of funds from us.**Get Trendy**

One of the big buzzwords we hear these days in the working capital world is the concept of “

**Supply Chain Finance”**. Essentially this means that a bank is willing to make a loan, and when they do this they earn interest.
The typical situation presented when they attempt to sell these products is where we wish to extend our DPO but our supplier does not want to suffer from the increase in DSO (it is a zero-sum game, remember?). If the supplier can get their payment earlier, while we make our payment at the same point in the cycle that we always have,

**someone has to bridge the gap**between these days.
Who does this? Our friendly neighborhood bank, of course!

Why do they do this? Because either

**the supplier**, by virtue of executing an early withdrawal, gives up a small percentage of the sale, or**the buyer**(i.e us!), by deciding not to immediately fund the suppliers payment,**pays a little bit extra**(i.e. interest) when paying at the end of the “normal” payment period.**Key Takeaways**

**Extending our Days Payable Outstanding will enhance our Cash Conversion Cycle and therefore reduce our cost of capital**. This can be accomplished by

**paying bills later**,

**working with suppliers where we are a “big fish”**, and

**utilizing banking solutions such as credit cards or supply chain finance**. We need to be careful that we

**correctly ascertain cost vs. benefit trade-offs**in these situations.

**Questions**

· What are your favorite methods to extend Days Payable Outstanding?

*Add to the discussion**with your thoughts, comments, questions and feedback!*

**Please share Treasury CafĂ© with others**. Thank you!
Another great post, David.

ReplyDeleteThe good news is that this line of thinking is catching on. When I had looked at this for a recent short piece, I saw that on average (with all the attendant caveats)the difference between actual (42.5) and target (40.4) DPO for the companies I surveyed was quite small -- and was counter to the traditional expectation of "collect early, pay late". On the DSO side of the equation, however, these companies replied as expected: actual (44.4) was higher than desired (33.1). What I took from this response was a more nuanced approach to AP -- "collect early, pay when it makes the most sense."

What is interesting here is the interplay between theory and application. Discount capture (whether pre-negotiated or dynamic) is reliant on efficient invoice processing, which is not as widespread as we all might hope. And while I have seen a large difference in technology adoption between our SMB and Large Enterprise respondents, it has not produced the expected efficiency gains (10.8 days to process an invoice from receipt through approval for SMB versus 11.1 for Large).

If you offer 2/10 net 30 to a customer who could never hope to pay early enough to take advantage of the discount terms, there's no downside (except perhaps some VAT headaches). I'm very interested to see how these arrangements evolve as efficient processing becomes more commonplace. As you're pointed out, we may just see the battlefield shift backward toward purchase price inflation.

Scott,

DeleteThank you for the great insights. I think the nuanced approach you found was due to the strategic relationship overlay on the metric.

I like your invoice processing comment. Workstation vendors always like to sell you on the forecasting capability, but it does no good to have all this "interfacibility" if the invoices don't get in until the day before they are due!

Thank you for adding to the discussion, I really appreciate your thoughts and insigths.

hey.. Question. I work in the Logistics department for a large company. We spend about $15 million per year with a freight forwarder. We asked them to extend our payment terms from 30 days to 45 days. Can you advise the method in which we could "quantify" this strategic move in both soft and hard costs?

Deletethx, Chris

Chris, essentially you would recoup the amount of cash deferred. So assuming things are spread out evenly 15 per year / 365 days x 15 days would be a little more than $600,000. If we think about it as we pay every day, and then we get this 15 day payment term extension, we have 15 days of cash that we no longer have to pay out so we can do other things with. So if we use it to pay down some debt and some equity, the rate of return our investors require going forward will be that much less. So if the cost of capital is 10%, the payment term extension equates to a $60,000 per year savings. Note that the original $600,000 is not really "savings" per se, because at some point in the future it gets paid to them, so it is really the time value between those two points that is the driver.

DeleteIndia Business Solutions provides Tax Structuring Services & Information Security Management and Finance Consultant services in Singapore. Visit http://www.consultibs.sg/ today!

ReplyDelete