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The Folly of Long Payment Terms

If you are a small company with some large clients, you are unhappily aware that many of them have quite long payment terms. A firm for which we recently did strategy work (and was a pleasure to work with) has $50 billion in revenues and minimum payment terms of 60 days. The terms were non-negotiable, at least for a company of our modest size.

I don’t think 60 days makes sense. Not for us, and not for them either.

In the aftermath of the financial crisis, many companies were concerned about preserving liquidity, legitimately so, and they extended payment periods significantly. As my colleague Dave Rosenbaum reported in 2013 while at CFO.com, severe delinquencies (invoices more than 90 days past due) climbed 11% in the first three quarters of 2011.

But today many companies are sitting on mountains of cash. The company for which we did the strategy work has a pile that reaches $50 billion high. And these days, capital is relatively cheap to raise. According to the Wall Street Journal, between January and August 2014, companies sold $1 trillion worth of bonds in the U.S. One featured company raised $500 million at rates between 3.4% and 4.3%.

So how much does a company save by insisting it will pay in 60 days rather than 30? Roughly 4% divided by 12 months, or 0.3% of the bill. That is, on a bill of $10,000, about $33. That’s not a lot, but it is real money, and if the CFO can demonstrate a saving of 0.3% on his payables, it all adds up. For the CFO.

But not by much. My example firm has payables on its balance sheet of about $4 billion. That 0.3% saving due to longer payment terms amounts to $13 million a year. But as a percentage of revenues that’s a miniscule 0.03%.

But wait, you say, that’s free money, so who cares if it’s only a teeny-tiny sum? Every little bit you can add to what you have is a little bit more, isn’t it?

Well, in fact, it’s not free money. One of its consequences is that suppliers put companies with long payment terms lower on their priority list, especially if they are busy. The folks at the company in question may have recognized this as they kindly and voluntarily expedited our payments. But therein lies another cost that doesn’t appear in the financial statements. While the CFO can claim a few million in savings, the people in the field are left with the work of expediting payments when they think they should.

I am sure we are not the only firm that appeals to our senior clients (the only ones with the requisite clout) to intervene with accounts payable when payment is slow. This is an administrative chore that executives shouldn’t have to bother with, and time that’s surely more profitably spent elsewhere.

The alternate strategy, to pay suppliers promptly, is one we believe in and use to our advantage. We have employees, and we work with freelance writers, too. Our freelancers are highly qualified and in high demand. I am not sure we pay them more than their other clients, but I am certain we pay them faster, generally in 15 days. For freelancers, with or without families to support, speed is important, and it helps us get their attention when we want their help, especially as many of them also work for some of those big companies, the ones with long payment terms. And because we pay them promptly, they prioritize us, which allows us to get more work done more quickly, be responsive to clients, and generate more income.

A much bigger company that also pays its vendors promptly is TJX, the blisteringly successful US apparel and home goods off-price chain. While its competitors can take 60 to 90 days, or more, to settle up with their suppliers, TJX typically pays in 30. That helps it snag deals ahead of its competitors, and often at lower prices because its suppliers know that they will get paid faster. This advantage is central to TJX’s strategy. As its execs remark, “the money is in the buy” (because the retail price is rock bottom), and the buy is facilitated by short payment terms.

Naturally, you might expect a smaller company such as ours to complain about long payment terms. Actually, in our experience these terms can often be negotiated; some clients pay on much shorter terms; and because capital is cheap we can cover cash flow with credit when we have to. But it is, indeed, a nuisance, and it seems not to do anyone any good. Unreasonably long payment terms is a bad case of the accounting tail wagging the business dog. And for managers who are not afraid of their bean counters, shorter terms might be an opportunity to be seized.