Payment Terms: from Suboptimal to Supercharged

Working capital optimization is essential for unlocking maximum growth and increased shareholder returns in companies. However, a lack of focus on payment terms often impedes the realization of this potential. In this article, Robert Kramer, Chief Product Officer at Calculum, explores strategies to adopt a comprehensive approach.

As a recognised expert in payables optimisation and supply chain finance, Kramer shares valuable insights and practical methods that can empower companies to transform their working capital management and foster sustainable business growth.

Q: In today's dynamic business landscape, with increasing costs, supply chain complexities and economic uncertainties, why is effective working capital management more important than ever?

Kramer: Working capital is a substantial investment for companies. According to data from CapitalIQ, the median US company with over US$1bn in sales invests about 20% of its revenue in working capital. This means that a US$5bn revenue company would need to invest US$1bn in working capital, surpassing typical investments in things like property, plant equipment or capital expenditures. However, unlike those investments, working capital generates no return. Not only that, but it crowds out other more productive investments, such as investing in business growth or using the capital for shareholder returns.

It’s also a drag on growth because every year you expand, you have to invest more in working capital. For instance, if that average US$5bn revenue company grew by just 5% annually in terms of revenue, it would have to invest an extra US$150mn in working capital over three years.

To further quantify the impact, an interesting research paper titled "Working Capital Management and Shareholder Wealth" by authors from the universities of Dallas, Georgia and Pennsylvania, reveals that shareholders value every dollar invested in working capital at only 52 cents. In contrast, each dollar converted into cash holds a value of US$1.49, nearly three times the amount.

This really demonstrates the significance of effective working capital management. Companies can essentially earn three times the return by reducing investment in working capital, an asset that generates no return and competes with other investments, and converting it into cash instead.

Q: Why are payment terms a critical factor to consider in working capital optimisation, and what are the potential consequences of neglecting to take action?

Kramer: Payables, along with receivables and inventory, play a crucial role in working capital. However, the management of payment terms often lacks the resources and tools that are available for managing receivables and inventory. That’s why what Calculum does is so interesting; it’s the only application designed to help companies optimize and manage payment terms. Leveraging advanced data analytics and information from millions of suppliers and trillions of spend, Calculum fills the gap in supporting payment term optimization.

Procurement teams generally understand that longer payment terms are preferable, but that’s often as far as it goes. While they have abundant data, tools and training for negotiating prices and optimizing margins, the same level of support is lacking for payment terms. Yet, suboptimal payment terms tie up capital just like suboptimal inventory, emphasizing the need for dedicated tools in this area.

Without these tools, you're going to have all the problems associated with poor working capital management, with excessive capital invested in working capital.

Q: When assessing their financial strategy, how should companies determine if they should be optimizing their payment terms? 

Kramer: Any company that is not effectively managing payment terms at the commodity and supplier levels, and that lacks incentives around working capital and payment terms, should really start addressing it.

While benchmarking payment terms against peers is an important first step, it often overlooks other valuable areas of opportunity. Companies also need to analyze their spend, by both commodity and geography, to discover specific areas for improvement and cash flow optimisation.

In particular, companies in relatively mature industries with lower revenue growth rates need to focus on asset efficiency in general, and working capital efficiency specifically, in order to generate superior cash flow growth.

This is also true for companies engaging in new markets with new suppliers, where support from applications like Calculum becomes crucial to determining optimal payment terms in unfamiliar areas.

Q: What are some proven approaches and best practices to successfully optimize payment terms?

Kramer: To optimize payment terms, you need to consider three things: people, process and tools. The first step is to evaluate the payables process, including payment frequency, the way in which payment terms are negotiated – whether that’s based on objective data analysis or just on the way things have always been done – if incentives are in place, and how exceptions are handled.

Then, it’s looking at what tools and applications are available. This is where solutions like Calculum can help determine appropriate payment terms and how to optimize them, which we do through peer analysis and detailed examination at the commodity, geography and individual supplier level using data analytics.

At this point, it’s also important to incorporate the procurement team's detailed knowledge of suppliers and supply chain relationships using diagnostic tools.

Once you have all that information and have determined the optimized payment terms, the next step is to create an execution plan. This must include aspects such as supplier prioritization, a communication strategy with customized messaging, a timeline, and an outline of incentives.

This is where the people component becomes really important because you need to gain organizational alignment, train the procurement team and provide support for effective communication and negotiation.

You also need to manage the plan, which is essential for long-term success, so as to avoid reverting to original payment terms. It’s vital to continuously track and review results. 

Finally, it’s also really important to share best practices across the organization. For example, we had a client who achieved excellent results with payment terms in Europe but struggled in the US. Through careful tracking and management, we discovered that they were doing some things differently in Europe which was the key to their success. We then implemented those tactics in the US, resulting in improved performance.

Q: Drawing from your vast industry experience, what are the common pitfalls and challenges that lead to the failure of payables optimization programmes, and what strategies can businesses use to overcome these obstacles and ensure programme success?

Kramer: Payables optimization programmes sometimes fail to meet their objectives when the focus solely revolves around supply chain finance and neglects payment term optimization.

This is often a result of inadequate programme design and the absence of appropriate data analytics at the supplier and commodity levels. Not having access to that kind of insight frequently leads to poor supplier messaging and communication that isn’t customized to specific suppliers or segments, which hinders the achievement of desired payment terms.

So, essentially, some of the steps I mentioned earlier might be skipped in programmes that view supply chain finance as the sole solution. It’s important to remember that it’s just one piece of the puzzle.

A lack of procurement training, tools and applications can exacerbate issues. The procurement department is at the sharp end, responsible for negotiating payment terms with suppliers, and requires proper support to achieve favorable outcomes in these discussions.

Q: How does all of this tie into what Calculum is working on?

Kramer: Calculum is a solution that supports all steps of a payables optimization programme, from opportunity analysis to program design to program management and execution. It utilizes extensive data analytics based on analyzing over a million suppliers and over US$$1trn in spend to determine the ideal payment terms.

New features introduced recently are designed to support multiple steps in the process. So, in addition to determining optimized payment terms, Calculum can assist with developing an execution plan, including messaging, supplier prioritization, timeline development and negotiation strategies.