By David Brown, Chief Product Officer, Previse
Late payments from large corporates to their suppliers are on the rise, driven at least in part by the view from some treasuries that these late payments act as an interest free loan for the buyer. But, as we all know, there is no such thing as ‘free’ money.
In the run up to the 2015 election, David Cameron pledged action to crack down on late payments, and the Conservative party followed up with legislation. In the recent general election, Labour leader Jeremy Corbyn called for a ‘war on late payments’. Yet, despite government intervention and cross-party focus, why are late payments to small to medium enterprise (SME) owners increasing?
Treasuries tend to take the view that outstanding payments to trade creditors, almost regardless of the time period, are part of the “normal course of business” as opposed to loans on the balance sheet. Auditors often confirm this view, as do market analysts who do not consider trade creditors when it comes to looking at a corporate’s debt-to-equity ratios.
As a result, creating working capital in the form of longer payment terms to suppliers is frequently the first borrowing option of any large buyer. However, this makes far less commercial sense than may first appear.
The actual result of these ‘interest free loans’ from SMEs to large corporates are that the corporate buyers end up paying for the suppliers’ finance cost (which is high) through the purchase price of the goods and services.
Swapping good loans for bad
To demonstrate this, let’s ‘follow the money’. A major corporate who can access finance in the market at say 2% annually, opts to forgo this attractive finance rate and instead chooses to ‘borrow’ from their SME suppliers by waiting to settle their invoice for more than 90 days. In order to cover their cash flow between issuing the invoice and receiving the payment, the SME supplier now needs to borrow money at say 18%+ annually. This cost of borrowing inevitably gets passed down to the end user, at least in part, inside the cost of the goods or services supplied.
This makes little financial sense, particularly given the ultra-low interest rates ubiquitously available in the market to large corporates. Low interest rates for credit worthy buyers do NOT equate to low borrowing rates for cash starved suppliers. As a result, buyers are effectively swapping cheap credit on very good terms for far more expensive credit via their suppliers.
Why does this happen? Firstly, it is hard to quantify how a supplier’s expensive cost of borrowing is priced into the cost of the goods or services supplied. But, it is easy to quantify the benefit from extended payment terms and an “interest free” loan from your suppliers.
This problem is exacerbated by the fact that large corporates operate in silos, with the cost of goods or services purchased typically the responsibility of the procurement department and the cost of capital the responsibility of treasury, and very few CFOs combining the two metrics in a sufficiently sophisticated way to optimise the holistic result.
In addition, as I’ve already mentioned, Outstanding payments to trade creditors are not considered debt by treasuries, their auditors or the market analysts. They should be.
A fresh approach
Let’s suppose then, that instead of following the crowd and pushing payment terms to their limits, a buyer decided to have its suppliers receive their money as fast as possible. For a start, the cash flow certainty which this would give suppliers would allow them to reduce the prices they charge the buyer. Not only would they be able to stop taking out the expensive loans, but greater certainty would allow them to invest back into the company. They could reduce costs with new equipment or growing to take advantage of better economies of scale.
The buyer would also quickly gain a reputation as the ‘buyer of choice’ in its market, able to use its reputation as a good client to negotiate better prices from suppliers and attract deals with the best suppliers in the market. A market leading supplier may agree to a large exclusive contract for the promise of guaranteed prompt payment, for example. In this way, paying suppliers on time, or earlier, becomes a significant competitive advantage.
In case you are not sold on the upside to corporates from paying earlier just yet, here is one final thought. There is also a stark moral dimension to the problem of late payments. After all, how many small businesses have been bankrupted by this late payment culture? How many businesses have closed, people laid-off and how many lives ruined because of these extended payment terms? There is a significant economic and human cost of late payments. But the commercial incentive for large corporate buyers is just as clear, particularly for those businesses which take the first mover advantage in their vertical.
It’s time to do more than just talk about these problems. We need action. Find out more at Previse