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Friday, August 1, 2014

Early Payment Discounts, Payment Terms Standardization, and Their Impact on Working Capital

Which group in your organization is leading the charge into the networked economy?

It’s not likely the treasury organization. And why should it?

That is becoming a $100 million question.

For many treasurers, improving liquidity through better management of working capital is a strategic priority.  And one way to get there is through collaboration with suppliers over a business network.

 

Credit: Grant Cochrane at FreeDigitalPhotos.net

Credit: Grant Cochrane at FreeDigitalPhotos.net

The transactional efficiency from managing purchase orders and invoices over a business network is well documented, as are the double-digit cash returns from early-payment discounts. While the latter benefit of a business network should appeal to treasury, often that’s offset by the concern over the hit on days payable outstanding, or DPO, a key business performance metric.

That’s where the discussion gets interesting. For it’s the ability to combine an early payment discount program with a payment terms standardization strategy that can deliver a dramatic improvement in working capital that often gets overlooked.

Let’s look at the numbers.

When following best practices, companies are saving $2 million to $3 million in early payment discounts for every billion dollars of spend and, on average, earning 24.6 percent annualized cash returns. The ability for these companies and their suppliers to collaborate in real time on payment timing and enable sliding-scale discounts up to the net payment term present working capital opportunities.

Combining payment terms standardization with an early payment discount strategy to free up working capital will attract the attention of your CFO. The impact on cash earnings, cost savings, and working capital is tangible.

In addition to expanding early payment discount opportunities, top performing organizations are also freeing up working capital by paying closer attention to the payment terms in their ERP or payables systems, or have savvy consultants do that for them. For many companies, these terms aren’t closely managed. They often result from ad hoc negotiations on a supplier-by-supplier basis rather than from a carefully defined strategy. Without closer scrutiny, the number of distinct payment terms can grow to 100 or more. In many instances, payment policies contribute to DPO metrics that are below an industry average.

Consolidating on a few, standard payment terms in line with your industry and tailoring these terms by supplier group, commodity type, region, or time of year can have a dramatic impact on the expansion of early payment discounts and management of working capital. Having reliable data for analysis is critical to success. This is another area where a business network can play a key role — providing transactional data that can be used for both early payment discount programs and payment terms strategy development.

The working capital impact of a terms extension program is about $2.7 million for every $1 billion per day of DPO improvement, and that’s on top of the early payment discount savings — generated by 20 to 25 percent of targeted suppliers for top performers. The net result is you help many suppliers get paid sooner and get the best of both worlds: more early payment discounts coupled with the ability to free up working capital.

For an organization with $4 billion of spend and four-day DPO extension across 60 percent of that spend, that’s nearly $26 million in freed-up working capital. Extend DPO by 15 days, going from 30- to 45-day standard terms and, well, you do the math. While these scenarios may not directly apply to your organization, what should be apparent is the magnitude of opportunity from combining early payment discounts and payment terms standardization.

 

Article published by Chris Rauen. It originally appeared on The Networked Economy and has been adapted with permission.

Chris Rauen manages the marketing of the Ariba Network and the supplier’s financial solutions, including invoice scanning, workflow, and e-invoicing. Before Ariba, he spent more than 15 years in business-to-business marketing at OpenVision, Documentum, Xign Corp., and Rimini Street. Chris has a B.A. in Economics from UC Santa Barbara.

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