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 30th 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.
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.
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.
· What are your favorite methods to extend Days Payable Outstanding?
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