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Welcome to Calculum’s content series on Working Capital Management: The Forgotten Cash Flow Lever. As part of this series, we hope to provide an overview and foundational understanding of the importance of working capital management and supplier payment terms for your company.
Supplier payment terms are pivotal in shaping cash flow, but how should companies determine optimized and “fair” supplier payment terms? In the final installment of our content series, we hope to answer that question by examining the Cash Conversion Cycle (C2C) and the impact of company operations and industry dynamics.
We must first unravel the Cash Conversion Cycle (C2C) concept to understand payment terms. This cycle quantifies the time between paying suppliers for goods/services and receiving payment from customers.
Imagine a company that makes steel boxes. The raw steel arrives on day 0. It takes 90 days to manufacture and sell the product to customers and an additional 60 days after the boxes are sold before payment is received. Therefore, in total, it takes 150 days to manufacture the boxes and receive payment from customers. However, the steel suppliers must be paid in 45 days. This sequence generates a C2C of 105 days—reflecting the number of days between when cash goes out the door to pay suppliers and when cash is received from customers.
The Cash Conversion Cycle gives us the proper context to understand how supplier payment terms fit into a company’s operating cycle. Next, we need to understand the purpose of payment terms before determining whether they are fair. Why do supplier payment terms, also called “trade-credit”, exist at all? Why don’t buyers simply pay suppliers once the goods or services have been delivered?
The primary purpose of trade credit should be facilitating sales for both the buyer and supplier. Suppliers provide materials to buyers on credit, and in return, buyers produce the product, sell it, and collect payment from the end customer. As professors Cowton and San-Jose conclude in their research paper titled On the Ethics of Trade Credit: Understanding Good Payment Practice in the Supply Chain, “it is reasonable for the business customer to take trade credit while both it and its supplier wait for a sale to be made and cash received”.
Trade credit is, therefore, reasonable and “fair,” but only up to a point. It should end when its operating purpose has been fulfilled, that is when the buyer receives payment from their customer. At this point, “there is no longer any justification for taking trade-credit”. Beyond this point, the supplier is effectively providing financing to the buyer.
How can we tell if a buyer pays suppliers within this "fair-trade credit period"? By examining their C2C. If a company pays suppliers as soon as it receives payment from customers, its cash conversion cycle will be zero days.
Based on the C2Ce formula, this occurs when a company's Days Payable Outstanding (DPO) = Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO). Therefore, the maximum length of fair supplier payment terms occurs when a company’s average time to pay suppliers = DSO + DIO.
If the C2C dips into negative territory, buyers receive payment from customers before remitting payment to suppliers, effectively turning their suppliers into funders. Conversely, a C2C exceeding zero implies the opposite; suppliers are paid before customers pay the buyer, meaning the buyer is providing financing to its suppliers — a situation detrimental to cash flow. Thus, maintaining a near-zero C2C is ideal.
Note that in the discussion above, we are using DPO and DSO as reasonable approximations for the average time it takes to pay suppliers (DPO) and the average time it takes to receive payment from customers (DSO). This is not always the case, particularly in certain industries. Obtaining an accurate measure of time to pay suppliers or time to receive payment from customers sometimes requires a deeper dive into a company’s financial statements than the high-level view provided by easily calculated DPO and DSO figures.
An important implication of the approach described above is that determining optimized and “fair” payment terms must consider the underlying production and distribution processes within each industry and customer relationship since those dynamics impact DIO and DSO. This is not a one-size-fits-all approach.
For example, fair payment terms for Whirlpool’s suppliers are vastly different from fair payment terms for Kroger’s suppliers since their production and distribution processes are vastly different. We can see this by looking at Whirlpool’s DIO + DSO of 96 days, while Kroger’s equals 28 days. Benchmarking performance against similar peers purchasing similar goods/services is essential to understand how a company's payment terms align with industry operating processes.
A good illustration of this can be seen in the auto parts retail sector. The average DPO for the top 3 companies is 251 days. That high DPO is driven by the need to wait 255 days to get paid after they purchase materials from suppliers due to low inventory turns (Unlike a gallon of milk, brake pads can sit on the shelf for a long time).
Seemingly modest differences in C2C wield significant financial consequences. Even a three-day variance in DPO between companies like Kroger and Publix translates into over a billion dollars in cash flow. The importance of such nuances becomes evident when analyzing financial performance and devising strategies for improvement.
While navigating payment terms and the C2C, companies can leverage platforms like Calculum’s ADA to analyze, compare, and optimize strategies. Not only can ADA compare DPO among peer companies, but it can also compare individual supplier payment terms to the average payment terms for specific commodities and individual suppliers. This empowers companies to harness their payment terms strategically, aligning their financial goals with their operating cycle and industry standards for enhanced performance.
The Cash Conversion Cycle and supplier payment terms significantly impact the lifeblood of companies - Free Cash Flow. Striking the right payment terms balance is a delicate art, balancing ethical considerations, industry dynamics, and cash flow objectives. Companies that master this interplay can optimize their financial results and position themselves for superior growth and shareholder returns.