The article below is written by Kaush Oza on December 15, 2011

An effective payment terms strategy can yield positive cash flow besides streamlining the compliance process for payments.  Payment terms reflect an agreement between a buyer and a seller specifying the timing and expectations regarding financial settlement.  For example, “2% 10 Net 30”  is payment of the face value of the invoice payable by day 30 or a 2% discount from the face value and paid within 10 days.  The primary focus for most companies relies on extending payment terms (e.g., 30 to 45 days).  However, another approach would be to offer immediate payment for all or a portion of the invoice based on robust analysis of cost of capital driving discounted values.

For a company dealing with a known supplier base or categories a well planned payment term strategy should include financial incentives for its suppliers such that it becomes a “win-win” situation both ways.  A poorly designed payment term strategy can have adverse consequences – a payment term discount is not going to net the client savings if the net discount offered to the supplier exceeds the value of money at a given discounted rate for the client.  It is important to understand the cost of capital prior to implementing a payment term strategy as shown by the following two examples:

Example 1

Cost of Capital Effective Payment Term PO Amount
12% 50%  at order / 50% at 30 days $1.4MM

Assume the supplier has contractually agreed to a $10K discount if paid 50% at the time of order.

Time Value of Money = 50% * $1.4MM * 1/12 * 12% = $7,000

Therefore, the client has netted a $3,000 net discount.

Example 2

Cost of Capital Effective Payment Term PO Amount
18% 50%  at order / 50% at 30 days $1.4MM

Given the same example, but with an 18% cost of capital:

Time Value of Money = 50% * $1.4MM * 1/12 * 18% = $10,500

In this case, the client has lost $500.

Planning and execution of an effective strategy is contingent on not just extending payment terms and net discount rates, but understanding the client’s unique operating and financial situation.  A discussion with the finance group should be a top priority.  In addition:

  • Target high payment value suppliers first with discounts tied to a minimum spend threshold
  • Standardize terms and policies with a governance process for exceptions
  • Develop and agree to the calculation for establishing the baseline average payment terms
  • Prevent payment leakage by developing a scorecard for average payment terms.
  • Ensure data elements are available to automate the measurement of payment terms
  • Ensure escalation and delays are not caused by internal stakeholders through early and continuous communications
  • Develop business rules for evaluating supplier counter proposals and provide buyers with talking points to mitigate negative perceptions
  • Monitor the PO process to ensure compliance with payment terms