A holistic approach to working capital - Why increased payment terms don't always result in a benefit

We have seen many articles and news stories over the past few months regarding the ethical positions of organisations and their procurement teams. I would like to specifically focus on what I have seen happen in the past when firms decide to focus heavily on implementing quick win payment term extensions which, of the 3 elements of working capital (payables, receivables and stock management) the easiest element to focus.

Payment terms negotiated and agreed as part of any supplier contract have a direct impact on the organization’s cost of working capital, the lifeblood of any business.

For Procurement however payment terms can be a double edged sword. Extended payment terms may help lower the cost of working capital but they don’t always support healthy supplier relationships or indeed their finances. Further this easy approach doesn’t make sense as, looking at this holistically, it costs a fortune, especially in our post 2008 world.

With interest rates so low even exceptionally cash rich organisations achieve little more than 1% on their cash holding and extending payment terms for a further 30 days will see them gain minimally (less than 0.01%). The supplier on the other hand may have to pay a 3%+ factoring cost to cover that extra period with additional costs for early payment. Although firms implementing these changes may not see it as such the reality is that these additional costs will not only be passed downstream but back upstream as well.

In many instances procurement departments don’t even consider working capital, and there are benefits to be had from tying the two areas together. Extending payment terms isn’t necessarily the right answer though.

Procurement should look more generally at their supply chain to understand the potential benefits of supply chain finance. By understanding the working capital requirements of suppliers, significant sourcing cost can be generated by imaginative use of discounts in return for early payment. Supply chain techniques like dynamic discounting should be developed and managed by Procurement who should take the lead in identifying and prioritizing suppliers.

It may also be true that a slightly more managed approach, such as supplier discounting, provides an important fail safe mechanism for a supplier during turbulent times and for the buyer, it helps to mitigate the risk of the supplier failing.

So in a nutshell, firms should take a broader view of procurement costs and consider the wider implications of payment term changes in the supply chain. There may be further hidden opportunity costs of not using supply chain finance that simply focusing on extending payment terms can blind you to.

All of this does involve a pretty joined up approach between Procurement, Finance and the Treasury team. Clearly there is a downside to “days payable outstanding” (DPO) for early payment and in a siloed world that’s all that Finance may focus on.

Of course all I have really done here is focus on one element of working capital, namely the payment process, but there may be wider benefit in procurement considering their impact on working capital more generally as well (stock management etc.). For example a buyer, incentivised solely on achieving a favourable unit price, may negotiate a rate at 50% below the market price but if the company ends up with 10 years stock the deal may not necessarily be of overall value to the business.

Working capital provides the financial foundation to any commercial business and has traditionally been seen as being within the realm of a firm’s finance function. A joined up approach with Procurement however may help organisations to develop a more rounded view on the subject. Such an approach may help firms uncover further benefits and, again linking to the recent headlines, avoid such ethical quandaries.