Terms and Endearments: Managing the Balance Sheet and Supplier Relationships
The financial crisis has taught the corporate world two important lessons: the importance of cash and the need to diversify your sources of funding. Between the beginning of 2008 and the middle of 2014, UK corporate cash piles increased by around 25%, according to a survey by the Association of Corporate Treasurers (ACT). Moreover, 43% of companies said they expected to continue to carry higher cash balances than they had in the past, with very few expecting to run down cash as the economy recovers.
“Since the start of the financial crisis, companies have said that they want to be less reliant on banks,” says John Grout, policy and technical director of the ACT. They are also more wary of capital markets.
Increasingly, one of the sources of finance that companies are turning to is their own suppliers as they lengthen their payment terms. “Most sensible chief financial officers [CFOs] would look at their working capital to see if there is a way they can release cash,” says Jennifer Pinney, a director at REL, a working capital consultancy within The Hackett Group. “You look inside your own garden first.”
The problem, Pinney says, is that suppliers can be perceived as “an easy target”: in trying to optimise the cash conversion cycle, it’s easier to insist on longer payment terms than it is to “change customer behaviour or change your inventory and production processes”. What happens then is that companies introduce blanket terms – in some cases, as long as 120 days. “That’s unsustainable,” she says.
Reputation risk tops the list of most experts’ warnings about longer payment terms, with the danger that large companies are perceived by consumers and regulators to be bullying small and medium-sized enterprise (SME) suppliers.
There is, however, a growing push-back against such practices – and some of that is coming from within the organisations that have been forcing through longer payment terms. “Not all suppliers are created equally,” Pinney says. “The stakeholders in the business that are dealing with suppliers on a day-in, day-out basis are putting forward very good and robust arguments as to why their suppliers won’t accept 120 days.”
Peter Loughlin, managing director of Purchasing Insight, a procurement consultancy, says: “There is a conflict between procurement and finance, with finance wanting to optimise days’ payables outstanding [DPO] and extend payment terms, which is a bit ‘old school’. In contrast, procurement is concerned about supplier relationship management. It works with the business in a strategic way, supporting innovation, for example, and building new supply chains for new, innovative products.”
Pinney and Loughlin both say that suppliers typically manage to creep up their prices after a year or so, so the imposition of longer payment terms can be a false economy. At the ACT, Grout adds: “Some companies have seen that their supply chains are important to them: they have critical suppliers, suppliers that it would be time-consuming and perhaps costly if they were to change them.”
The new toolkit
To support suppliers, a number of tools have been increasingly coming to the fore in recent years. One of them is dynamic discounting. Historically, suppliers would offer a fixed price discount in return for early payment by a specified date. The problem, as Grout says, was “some large firms discovered that they couldn’t make a decision on whether to pay an invoice within the time their contract said they had to pay it.” They simply weren’t capable of processing invoices quickly enough to be able to capture the price discounts available. “A lot of work has gone on in some very large companies to try to shorten that approval of invoice period.”
Dynamic discounting has the benefit of a sliding scale of supplier price discounts, so if a customer misses the opportunity for a cheaper price by paying on, say, day 20 it can still perhaps get some benefit even if paying on day 35, for example.
Supply chain finance (SCF) is another tool being deployed by more and more companies, offering suppliers the opportunity to receive cash for their invoices from a finance provider but at more favourable terms that reflect the strength of their customer’s balance sheet. “The cost to the supplier of the finance falls as a percentage therefore cushioning the fact that they are being asked to extend more credit,” says Grout.
Loughlin recently wrote a blog in which he said, “Supply chain finance is not a zero-sum game. It actually adds economic value and the question we should ask is not if it should be encouraged but rather, how the value within the financial supply chain should be best distributed.”
Pinney says of SCF and dynamic discounting: “These solutions are great ways to approach a supplier to say, why don’t we both share the pain and gain of this using this solution.”
The benefits of these so-called treasury solutions are only really felt when payment terms are longer, but Pinney stresses that they cannot be used as an excuse to push payment terms out excessively. “Thinking about it in a more rounded way rather than just pushing everyone to 120 days is the right thing to get to optimal DPO. Then it’s an honest, open conversation between you and your supplier to a gain-share model that works for both sides.”
Technology has made the business case for these tools “much more compelling”, says Loughlin. “It couldn’t have been done 10 years ago. The technology wasn’t mature enough, agile enough, or user-friendly enough. It just couldn’t be done. What they do now is very, very simple. But they execute it beautifully.”
Just as important however, is that procurement and finance should work together: payment terms and financial tools should not be left for finance to deal with alone. “It’s one of these fields that requires procurement and finance to collaborate closely,” says Loughlin. Typically, however, there are silos between the operational end of the two functions, even if at the top level procurement reports to finance or sits round the same board table. These silos need to be broken down, Loughlin says. “That’s not always easy to do. But when they do there’s real synergy. It’s crazy not to do it.”
* This article was originally commissioned for the Working Capital Forum, sponsored by Taulia, which has organised two round-table meetings to discuss the issues raised. They will take place in London and Zurich in June 2015.