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Calculum Inc

Oliver Belin

Having the Right Goals & Making the Right Decisions When Optimizing Payment Terms

May 8, 2023
Read time:
8 min

Calculum Inc

Press kit

March 5, 2020
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1 min

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Success Factors in Optimizing Payment Terms with Suppliers

A company’s objectives supporting the optimization of its payment terms across its supplier base have a crucial impact on the decision-making, the implementation process, and the selection of suppliers to adjust its payment terms. There are essential steps in defining the goals and making the decision. Recognizing the fundamental building blocks of this process is necessary and encompasses the following:

  • First and foremost is the assessment, which includes understanding the “as-is” current state.
  • Dividing the goals into short-term and long-term targets to be achieved through such Payment Terms Optimization Program, including financial gains, geographies, and several entities. 
  • Understanding the different options to achieve the goals affects the company’s bottom-line results.
  • Reviewing if goals are achievable.
  • Ongoing review of specific milestones accomplished to achieve the goals.

Assessment of the current state

The assessment of the current state of an organization can be divided into an internal and external macro level. To define realistic goals, the following key areas must be reviewed internally:

  • What amount of spend based on the different direct and indirect spending categories and divided into the various business units or buying entities within the organization and throughout the other regions or countries?
  • Understanding the current payment terms. Contract policies and terms are crucial for the analysis of optimizing them. Was there a recent payment term initiative, and what were the results and lessons learned?   
  • Does the company have one centralized ERP (Enterprise Resource Planning) system? Are there any projects within the ERP environment that must be completed for the Payment Terms Optimization Program implementation?
  • On average, how long does it take to approve invoices in the ERP system, and does the company use electronic invoices with its suppliers? 
  • Are there any other significant projects in process or planned shortly that would be prioritized against the Payment Terms Optimization initiative and postponed the implementation? In addition, it is vital to understand if any major supplier initiatives are in progress, such as undergoing a supplier rationalization.

Targeting multiple Improvements

After the internal and external assessment of the current state, multiple goals must be reviewed and defined. In most cases, companies focus not only on one specific purpose but also on numerous improvements.

Organizations want to optimize payment terms based on their unique objectives and supply chain characteristics. Considering the longevity of Payment Terms Optimization programs, with some already in place for over 20 years, is crucial.  Therefore, it is essential to define short-term and long-term goals. Why are corporates optimizing payment terms?

Over 60% because of working capital and liquidity needs, and 30% to achieve better margins through early payment cash discountsThe rest want to reduce the risk and instability in their supply chain. Another goal often used when setting up a Payment Terms Optimization Program is aligning payment terms to a certain level, usually based on an industry average or a specific competitor’s DPO. One of the reasons to align words is that analysts use DPO and other working capital metrics to compare companies and measure a corporation's competitiveness. In general, buying organizations are looking to set up Payment Terms Optimization Programs based on the following three goals:

  • Supply Chain Risk
  • Working Capital and Free Cash Flow
  • Margins
  • Corporate Social Responsibility Initiatives

Analyzing Risk within Supply Chains

As supply chains have stretched across the globe with multinational buyers on one side of the equation and a diverse spread of suppliers in emerging markets on the other, businesses have become concerned with the viability of their supply chains and the risk of disruptions. Some tragic events, such as Fukushima in 2011, made the risk visible for first-tier suppliers, second-tier sellers, and the entire supply chain. For instance, Western Digital, Honda Motor, Toyota, and many other companies were forced to suspend production because of supply chain disruptions due to the massive flooding in Thailand in 2011. Recently, the focus has moved from the physical supply chain to the financial side, with suppliers needing more working capital and better access to credit opportunities from their local banks. Direct lending from financial institutions has been reduced since the financial crisis in 2008. A recent study revealed that supply chain disruptions significantly impact a company's economic performance. Over 60% of the firms surveyed reported that their performance had dropped by at least 3% due to supply chain disruptions. Analyzing financially weak suppliers and supporting them with early payment terms initiatives can help vendors with affordable working capital during economic downturns. But there’s not only a risk of supply chain disruptions during downturns. During short growth periods, manufacturers depend on strong suppliers and on having the necessary liquidity to cope with the growing demand. 

Optimizing Working Capital and Free Cash Flow

According to a recent survey, extending payment terms (82%) and accelerating collections (41%) are the most common approaches to improving working capital. Therefore, improving working capital and generating free cash flow by increasing payment terms is also the dominant factor why buyers are implementing Payment Terms Optimization Programs. For example, such programs simulate and calculate financing facilities such as Reverse Factoring or Supply Chain Finance. In such a facility, the buyer is not only focusing on its working capital goals but also easing the burden of slowing payment terms on its suppliers by offering them the option to get paid early.  In most cases, the goal is not directly working capital but a more strategic objective such as maintaining or improving the company’s credit rating, increasing shareholder value supported by share buybacks, or paying dividends. 

Generating Margins

Why does working capital matter when companies are awash in cash? Yes, companies are awash in money, but most of it comes from reducing capital expenditures. Today, companies are urged to deploy cash, not squeeze more out of their daily operations.  It has become a barometer of operational efficiency. Profitability is at the top of the priority list for most senior executives. It is one of the critical success metrics of a firm, and its leadership team is often personally measured.  In particular, procurement and supply chain professionals are accountable for the profitability equation's cost-reduction side. They are tasked with finding ways to reduce the cost of purchasing materials and operations. However, they often need to take advantage of significant opportunities from the cost savings made possible by reducing their suppliers' capital costs.  By implementing Payment Terms Optimization Programs, companies can simulate Dynamic Discounting facilities creating a mechanism for suppliers to receive accelerated payments and for buyers to improve their margins by funding the program themselves and generating discounts or rebates for those early payments. With Dynamic Discounting, buying organizations can achieve their margin goals with much better results than the 0.5% interest they usually get in the market for the cash they have on hand. On the other hand, small suppliers often pay 10% to 20% or even more for short-term loans to provide cash for their operations. By splitting the difference, the supplier gets early funding at rates less than half of what he is currently paying, while the corporate treasurer gets five to ten times the current rates for cash on hand.

Corporate Social Responsibility and ESG Initiatives

Sustainable supply chain management has become an increasing area of focus for large buying organizations as they address competitive pressures arising from new regulations. With that, we see more and more companies using Payment Terms Optimization Programs to drive better ESG standards amongst their suppliers too. Sustainable, ethical, environmental, and social corporate responsibility is not just a trendy transient topic. Corporate Social Responsibility (CSR) is frequently invoked in the news, in business schools, and within the management board of large organizations. In response to rising pressure from different stakeholder groups, corporates are beginning to find in their supply chain hints to improve their overall sustainability profile. For instance, in 2007, the global toy manufacturer Mattel suffered a backlash when lead paint was discovered in its toys. The paint's source was traced to a third-tier supplier in China that Mattel needed to be made aware of. More recently, the BBC (British Broadcasting Corporation) reported on human rights violations in the apparel industry, where they uncovered that underage Syrian refugees were working for Turkish clothes suppliers of retailers such as Marks & Spencer and Zara.

These issues highlight the importance of extending a company’s commitment to sustainable business practices to its value chain to mitigate financial and reputational risks, reduce costs, and enhance branding. These far-reaching benefits have been highlighted in a recent survey among supply chain executives from diverse industries and regions. Companies were ranked into three categories concerning sustainable supply chain initiatives. The study found that the best-performing organizations on cost and service were the frontrunners in implementing sustainability across all their end-to-end supply chain links. As a result, companies encourage their suppliers to improve their sustainability performance in various ways – from ensuring that they report on their impacts, which raises their awareness and ability to make changes, to setting concrete targets to reduce emissions or water use. However, such ‘stick’ approaches are costly, difficult to verify, and do not always work. Today there is a ‘carrot’ to encourage suppliers to become sustainable – Payment Terms Optimization Programs.

With a handful of corporate brands now using Payment Terms Optimization Programs for ESG initiatives, could this be the start of something used by an increasing number of companies in the market? Perhaps, but the devil lies in the process rather than the incentive. The buyer needs a dedicated compliance team to visit and monitor suppliers worldwide through regular audits. In addition, procurement teams need access to ESG scoring solutions, such as InvestVerte, not only on large, publicly-listed suppliers but also on smaller, privately-owned vendors.

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