Vendor payment terms are making headlines lately. Big firms are moving to extend terms to as long as four months. On the flip side, Obama’s SupplierPay initiative and Britain’s Prompt Payment Code, both of which aim to get big companies to commit to paying small vendors faster, are gaining traction. Between the extremes of cash on the barrel and turning suppliers into de facto lenders, what makes sense?
This is something every company should consider carefully. Why? Because business is like a game of 6 Degrees of Kevin Bacon, in which every company is both a buyer and a seller. If you dig far enough back into their accounts, most companies are connected by fewer than six degrees of separation.
But when they’re in the buyer role, they’re only thinking about payables, cash flow and how long they can hold on to their money. When they’re the vendor, they’re only thinking about receivables, how fast they can collect their money and any collection efforts they might have to make if they don’t get it. And that’s the way it’s always been done.
I think companies do themselves a disservice by thinking that way, because everyone’s fighting the same battle and wasting a lot of resources in the process.
Late payment ripple effect
If a vendor is waiting on a $1 million check from a buyer, there's a lot tied up in that million dollars. They’ve got to make payroll and buy inventory and supplies to keep their business going. If they don't get the money on time, payments to their vendors will probably be late, too. They may even have to borrow money, and the cost of that may be passed back to the buyer.
The business disruption resulting from a single delayed payment ripples out and hurts productivity and relationships at many other companies downstream. It may even wash back and hurt the late payer at some point in time.
That’s why it’s time for a more strategic approach to vendor payment terms, one that uses technology to enable and support a more cooperative approach and a more nuanced strategy.
Finance departments have never been more ready for this due to a convergence of trends and technology. As a result of the Great Recession, with its imperative to do more with less, many companies have moved toward a shared services environment where accounts payable (AP), accounts receivable (AR) and procurement all sit under one roof or report to the same C-level person. As a result, they’re starting to compare notes and see the bigger picture.
Automation is another way of doing more with less, and the advent of lower-priced, easier-to-use cloud solutions is bringing automated solutions within reach of more companies. There’s also a post-recession push for finance to shift from being a cost center to being a strategic asset.
Believe it or not, vendor payment terms are strategic. For example, initiatives like increasing your vendor payment terms from 30 days to 45 days and having 15 more days of cash on hand could make your balance sheet stronger. That could increase your credit rating from a Triple B to an A and reduce the rate at which your company can borrow money.
On the other hand, payment terms that are too long could hurt your relationships with suppliers. Increase payment terms too long and you’ll lose some. Shortening them could help you attract the best vendors and talent. Construction is a great example of an industry where payments are notoriously late. If you can pay your subcontractors on time, or even faster than the competition, it could give you an edge for attracting and retaining the best talent.
Unfortunately, what managing vendor payment terms too often comes down to is a constant tug of war between days payable outstanding (DPO) and days sales outstanding (DSO), often conducted on a case-by-case basis regardless of the stated payment terms and depending on whether it's a strategic vendor or if it's just somebody that you get your cleaning supplies from.
The strategic vendors that you can't operate without obviously have more pull. They're going to be able to shorten their DSO, therefore shortening your DPO. But if it's a vendor that’s less pivotal, or a category where you've got options, you have more pull. The real goal should not be the application of brute strength but to keep that red flag right over the middle so that both sides are happy and the tug of war doesn’t become a drain on productivity.
**This article was originally published on Spend Matters.
This is the first in a two-part series. Part two will examine the role automation and tools like self-serve vendor portals can play in optimizing supplier relationships.
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