If you were to ask your suppliers to list the top five things they don't like about you, delays in paying their invoices would be on every supplier’s list.
To add insult to injury, many financial executives have now decided to unilaterally extend payment terms from the typical 30 to 45 days outstanding to in some cases 60 to 90 days before a supplier is paid. They rationalize that there is a substantial one-time cost benefit on working capital balances by extending the terms of payables. I am not so sure.
I often ask chief financial officers who have adopted this practice of extending payables three simple questions:
- What percentage of your suppliers pay higher financing fees to borrow working capital than you do?
- What percentage of your total expenditures to suppliers does this subset of suppliers represent?
- What increases have you incurred from those suppliers to compensate for their added cost of borrowing in order to cover their increased working capital needs?
I am optimistic that I will eventually find a CFO who can answer at least one of those questions. As of yet, I have not.
The logic is that if you are not able to answer those simple questions, then you may not be able to answer the basic question: has the company profited from extending payment terms? Clearly, the financial institutions and banks are net winners in this approach, but I am unsure if the buyer or seller can benefit.
Economics 101 would support the convention that the person with the least financing costs should carry the cost of receivables. That would mean that if you, the buyer, can borrow working capital at 5 percent and your suppliers must borrow capital at 7 percent, then you should pay the supplier within the agreed upon terms and deduct from the invoice the estimated supplier’s financing costs of borrowing for any additional time (e.g., 30 to 60 days). That way, you—not the banks—realize the benefits.
Otherwise, would not the wise and efficient supplier simply raise the purchase price to cover the extra cost of financing in doing business with the company that has extended its payment terms? This would negate any benefit that might accrue to the buying organization by extending payment terms. That's a classic definition of arbitrage—a short-term advantage in the marketplace that in the wise and efficient market quickly disappears. In fact, it may be more damaging to the buying company because any percentage price increase by a supplier often has two characteristics: first, it is based on just-in-case assumptions; that is, given a choice, the supplier will pick the larger rather than the smaller increase; and, second, price increases last a long time and are the basis for future increases.
Accounts payable is such an important issue with suppliers we often miss an opportunity to use it to reward good suppliers and punish bad ones. Treating all suppliers in the same arbitrary way is certainly not effective supplier relationship management. While in most companies the responsibility for managing accounts payable rests within the finance department, in all companies, the resolution to conflicts in accounts payable involves the procurement and supply department. Effective accounts payable impacts procurement and supply; it is not just a financial issue.
Therefore, I challenge you. Do you have the answers to any of the three questions above? And if you don't, how can you be sure that extending suppliers’ payment terms is actually advantageous to you?