Effective net-terms management is key to maximizing liquidity for both buyers and suppliers.
As the epilogue of a semi-famous song, country-music legend George Jones asks a very important question:
“When you reckon we gon’ get paid for this?”
The answer to this question is critical in any business transaction, can be the source of tension between suppliers and their customers, and can make or break the health of a supply chain. Suppliers want the answer to be as soon as possible and customers want the answer to be as long as I can stretch this out.
Enter payment terms.
Terms are the payment rules agreed upon by suppliers and their customers. Payment terms are imposed to ensure that payments are received by suppliers within a reasonable period of time.
While this may seem pretty straightforward, the world of payment terms can be anything but, with things like “net 10,” “net 30,” “net 45,” “ net 10 EOM,” “1/10 net 30,” or “2/10 net 60.”
As definitions: “Net” means that the full amount is due for payment. Thus, terms of “net 20” mean that full payment is due in 20 days. Discount terms are provided as a two-part statement, where the first item is the percentage discount allowed, and the second item is the number of days within which payment can be made in order to receive the discount. Thus, terms of “1/10” mean that a discount of 1 percent can be taken if payment is made within 10 days. The abbreviation “EOM” means that the payer must issue payment within a certain number of days following the end of the month. Thus, terms of “net 10 EOM” mean that payment must be made in full within 10 days following the end of the month.
The Case for Longer Payment Terms
Longer payment terms mean longer days payable outstanding (DPO). A higher DPO is more advantageous for the buyer (and disadvantageous for the supplier). Higher DPOs result in more near-term liquidity; if a buyer can wait longer to pay its bills, it can put any excess cash reserves to work on short-term investment opportunities. For many businesses, this line of credit with their supplier is more practical than bank loans. Couple a longer DPO with shorter days sales outstanding (DSO) and a company creates a shorter cash-conversion cycle that further increases liquidity and allows the company to grow.
Suppliers are not thrilled with this, but they do accept extended payment terms if they trust the buyer and know that they will eventually get paid (or if they lack the leverage to negotiate). The reality is accepting extended payment terms more agreeable to the buyer can help a supplier win more business.
The Case for Shorter Payment Terms
While the buyer in a supply chain relationship wants longer terms, shorter terms are more advantageous for the suppliers. The faster they get paid for their invoices (short DSO), the more cash they have to keep their operations running and invest in their business growth. Shorter DSOs are important to small businesses because they depend on shorter payment windows to maintain cash flow. Small businesses generally do not have large cash reserves so incoming cash is critical.
When looking at payment terms management, discounts play an important role. Some companies pay early to take advantage of discounts (those 1/10 net X terms) or to avoid paying late fees. These terms can be advantageous for both the buyer and the supplier. For the buyer, the discount allows them to improve the cost of goods sold (COGS) and leave them extra cash to invest back into their business.
For the supplier, receiving the payment earlier – and being able to put the cash to work sooner – is more valuable than the usual one- or two-percent discount (or a decaying percentage over time in a dynamic discounting program). In addition to the supplier’s improved cash flow influx, discounts improve the relationship with the customer and gives the customer an incentive to pay early (or pay at all, in some cases).
Do You Know Your Terms?
Other than the folks in accounts payable or procurement departments, executives are unaware if they have standardized their payment terms to suppliers. This is because there are often many different decision makers who agree to terms with suppliers across departments. If unmaintained, and no terms standardization strategy is in place, over time, a large company may find it has more than 50 different net terms agreements in place.
So while the goal for buyers is to extend terms or leverage discount terms, many don’t know which suppliers’ terms are already extended or discounted. On the other side, many suppliers struggle to manage terms across their customers.
Effectively Managing Terms
Managing liquidity between buyer and supplier is the key to lasting relationships. While every business relationship is different for myriad reasons, the best answers to the payment-terms dilemma are the ones that strike a balance between keeping suppliers and buyers healthy and maximizing working capital and reducing risk across the supply chain.
The first step for a buyer looking to get a handle on payment terms is to gain an understanding of how and when they are paying their suppliers. Depending on the accounting software systems a company is using, this is easier said than done.
LSQ helps businesses understand the current state of their accounts payable practices and where they stand in relation to industry benchmarks, where liquidity is being strained, and how to unlock working capital. We evaluate credit, apply benchmarks, and suggest areas where companies can see the most improvement through better terms management.
LSQ’s experienced data team evaluates all dimensions of accounts payable spend and accounts receivables, including payment terms – by type, discounts, and fragmentation (one supplier having multiple terms). This data can be used to make recommendations about new accounts payable practices, like the standardization of terms to be more in line with industry benchmarks, that can improve liquidity and save money. For their accounts receivables, suppliers can use the data to examine the terms on which they are being paid by their customers to help with standardization across their customer base to create better cash-flow forecasting and improve liquidity overall.
Payment Terms to Mitigate Risk
Additionally, the data is useful in identifying vulnerabilities in your supply chain based on seasonality, location, or supplier concentration. LSQ also uses the data to help you understand which suppliers could benefit the most from an early-payment program to mitigate risk to their business and boost their liquidity.
For suppliers, LSQ’s experience provides suppliers the credit services to help evaluate the financial strength of their customers to be able to pay for the invoices or the amount of credit and what payment terms are appropriate for that business relationship.
Terms Management at Scale
One of the key features of LSQ’s data resources vís-a-vís payment terms is the ability to scale across 1000s of suppliers and customers and exponentially more transactions. It’s easy to disaggregate and analyze data for a handful of supplier/customer transactions. But beyond say 25 relationships, many finance or procurement departments are stretched too thin and don’t have the data, credit and terms expertise to handle the amount of data, much less make informed decisions about how to effectively manage terms.
There isn’t a single payment terms answer that applies to all transactions for all businesses in all industries – there are tons of variables. But no matter the case, reducing risk and maximizing liquidity is crucial to supply chain health and productive buyer/supplier relationships. And that’s where LSQ excels: our 25-plus years experience can help your business understand its terms position and help you properly manage your accounts payable and accounts receivable to keep your business growing and thriving.
And make sure everyone knows when they are getting paid.