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Cash flow problems? No worries, squeeze your supplier

Financial times may be tight, but if you want to keep your cash flowing, the answer’s simple: get your customers to pay up promptly and hang on to that cash for as long as possible. If others have to pay the price, so be it.

This may seem an efficient way of reducing financial costs, but is it fair? And have things now gone too far?

Author Joanne Simpson looks at the new “fashion” for late payment, its hidden consequences and ways that small firms can protect themselves.

In tough economic times, businesses large and small look for ways to manage their cash flow more effectively. When money is tight it’s common for firms to seek to widen the gap between creditor and debtor days, and demand extended payment terms (trade credit) from their suppliers.

But now, it seems, trade credit is increasingly being used as a deliberate tactic by big firms to delay making cash payments. Extended and, arguably, unfair terms, seem to have become the new norm.

IACCM’s survey report Do Large Companies Abuse their Power?1 confirms that payment terms are a significant area of growing contention - driven, it seems, by the policies of a minority of large corporations - and leading not only to longer payment periods, but more difficulty in getting paid.1

Why do large firms push for extended payment terms?

There’s nothing inherently wrong with trade credit. It’s a widely-used and long-established feature of commerce, and one of the main alternatives to bank loans for small-to-medium enterprises (SMEs).2,3 It is an invisible source of finance that does not require strict compliance with payment terms or cash reserves, thus, when capital availability is limited it may be easier to obtain. Trade credit can also stand in for bank financing where it is difficult to obtain (e.g. in emerging markets), allowing time for the payment process.4

Trade credit is often used as an alternative to bank credit as a source of funding (e.g. overdrafts), and is often cheaper for a large firm than bank credit because they may be charged little or no interest by the supplier. For smaller firms, a stable history of providing and successfully managing trade credit may make them a more attractive credit risk to a lender.5

When a firm uses trade credit, it is deferring payment to its suppliers as a means of better managing short-term cash flows.

Pushing out supplier terms while keeping customer terms short gives firms free cash for other projects. Customers may specify their debtor days in the contract as a stated policy (i.e. how quickly payment is to be received). But firms will sometimes defer payments even further past the agreed terms because of inefficiencies or out of a misplaced desire to protect the company. In the absence of late payment penalties, they may seek to delay payment. Even when interest rate penalties are present, they may not be enforced, and firms may be willing to take the risk of being charged interest rather than be exposed to default on bank credit.

But is such behavior really in that firm’s best interests? What it gains in improved cash flow may be lost several times over in increased charges, reduced quality and reputational damage. Meanwhile, small firms waiting much longer for payment have difficult decisions to face, and may be forced to cut innovation, capital investment and training, and postpone hiring and expansion.

Suppliers have long memories

While suppliers or service providers may have little choice in difficult economic times, they have long memories. If there are alternative customers available when business improves, suppliers may charge a premium or simply refuse to do business with a firm that offers unreasonable terms. If a supplier has to go to court to recover debt, any court-ordered charge or lien will be a matter of public record, and will appear in a credit risk report. A history of delinquency will reduce the willingness of a supplier to do business with a delinquent customer or client.

On the buy-side, the benefits to a firm of enforcing extended payment terms will erode over time. Chronic delinquency will lead suppliers to insist on payments in advance, credit risk reports, use of securities, shorter payment terms, and, inevitably, higher prices.

Small firms can protect themselves

Suppliers often feel intimidated into accepting terms that are unfavorable.6 As a small firm it’s not easy to negotiate for reasonable payment terms, but if they can, some protective mechanisms include:

  • A simple, unconditional trigger for the payment terms to commence, e.g. from the end of the calendar month, or from the date of receipt of goods or performance of service;
  • An explicit charge for late payment (or an equivalent discount for payment on time);
  • Shorter payment terms consistent with a firm’s cost cycle, e.g. 30 or 45 days;
  • Payment terms that allow for delay (e.g. specifying 15 days, expecting that it will more likely be 45);
  • The right to suspend or terminate for delayed payment or unreasonable refusal to pay;
  • Costs of debt recovery to be charged to the client or customer;
  • A bank guarantee or other security to offset the credit amount;
  • Pre-payment for major purchase orders, or an advance payment for the first month’s services.

Faced with an intransigent customer or client, where it is simply impossible to negotiate reasonable terms, a small firm can implement other financial protections. These include:

  • Interest on late payment - Many firms charge interest on late payment. And in some jurisdictions this is legislated. In the UK, for example, late payment legislation allows a firm to charge both interest and a fixed sum for the cost of recovering a late commercial payment, as does the EU 2011 Late Payment Directive.
  • Invoice factoring - Invoice factoring involves the sale of invoices to a third-party at a discount in return for prompt payment. While this allows a firm to manage its cash flow and avoid overdraft costs, invoice factoring costs around 2 - 7%9 of the value of the receivables factored.

These protective measures all add costs that a firm must recover, however. Additional protections therefore translate into higher prices, lower margins or cuts elsewhere.

Costs may not end there …

Even before the debt collection agency is called in, a firm is likely to have invested significant administrative effort in trying to obtain the delinquent payment. Small firms may not be able to obtain overdrafts large enough to cover long-term delinquent debt (e.g. more than two months), and therefore need to seek other, higher-cost sources of credit.8 And despite all measures taken, a percentage of bad debts will simply not be practicable or economic to pursue.

Overdrafts/line-of-credit
Small firms pay higher financing charges, so extended trade credit is economically inefficient: in 2012 larger firms could borrow from the bond market at an average 3.35%, while rates on small-business loans charged by banks and alternative lenders ranged from 6% to more than 20%.9

Debt collection
Debt collection agency fees are typically charged on a commission basis and range from 10% to 20% depending on the size and age of the debt. Debts over 12 months old may be considered delinquent or “written-off,” and may be subject to a higher commission. Special rates may apply to volume accounts or large debts. And as debt collection agencies do not typically pursue legal action for chronic debts, a firm will pay additional costs if it chooses to pursue a debt all the way to court.

Extended payment terms: a ‘fashion’ that’s here to stay?

IACCM’s payment terms survey report1 suggests that although 30-day terms are still the norm, small businesses are still struggling with this issue, and survey respondents expected continued pressure to extend payment periods.

  • In a blog post10 IACCM’s CEO Tim Cummins criticized the tendency to put the onus on suppliers to protect themselves, arguing that the introduction of supply financing simply adds costs to the supply chain.
  • Bloomberg argues that the recent increased focus on cash flow is driven by the rise of private equity and increasingly sophisticated corporate financing strategies, observing observed that “delaying payments to suppliers is ”11
  • The Reserve Bank of Australia12 estimated in 2013 that 30-day payment terms were offered by over 80% of businesses. Larger businesses tended to offer longer terms, as did capital-intensive industries such as construction. But in April 2015, the New York Times13 cited many examples of terms from 90 to 120 days, which are further extended in practice by delinquencies and delays.
  • In 2013 the Reserve Bank of Australia estimated trade credit owed by Australian businesses at over AUD80bn, or 8% of total 3
  • In late 2015, Atradius14 estimated that in the Asia-Pacific region, between 9% and 11% of B2B invoices by volume and 18% by value remained unpaid 90+ days after their due date.
Governments’ increased focus on fair contract terms

There is increasing interest however from regulators in protecting small firms from unfair contract terms, and both the UK and Australia have recently adopted or reinforced existing unfair terms legislation.15

The 2000 EU Late Payment Directive 2000/35/EC16 observed that “heavy administrative and financial burdens are placed on businesses, particularly small and medium-sized ones, as a result of excessive payment periods and late payments.” The 2011 EU Late Payment Directive 2011/7/EU17 further noted the negative effect such late payments have on liquidity, competitiveness and profitability.

When calling for consultation on proposed amendments to the “grossly unfair” provisions of the Late Payment Act 1998, the UK Department for Business Innovation & Skills18 considered factors such as:

  • Relative bargaining positions;
  • Good commercial practice;
  • Nature of the goods or services concerned;
  • Any objective reason to offer longer-than-average terms;
  • Whether the supplier received an inducement to agree to the terms; and
  • The extent of the term.
Extended payment terms – who really pays the price?

Firms operating on small margins and with limited power to raise prices become increasingly fragile when faced with extended payment terms. Trade credit may increase the probability that a financial shock will propagate through a sector dependent on trade credit.

If small firms aren’t getting paid on time, "they’re not making a lot of investments in research and development or hiring.”2 If a firm has extended trade credit to finance its customer’s capex, it’s rational to expect those funds are not now available to invest in its own business. For example, a one-month delay in payment by Wal-Mart is associated with a 1.2% reduction in capex for a Wal-Mart supplier.19

Small firms forced to extend trade credit will cut other discretionary areas of their business that might otherwise benefit their customers, e.g. innovation, capital investment and training. And they may be forced to postpone hiring and expansion because of the longer wait for payment.

While, from a large firm’s perspective, extending payment terms appears to be a simple and efficient method to manage cash flow and reduce financing costs, it does indeed have many hidden consequences - and some that are all-too apparent.

REFERENCES and END NOTES

  1. IACCM – International Association for Contract & Commercial Management: Payment Terms: Do Large Companies Abuse Their Power?
  2. Carbó-Valverde, Santiago, Francisco Rodríguez-Fernández, and Gregory F. Udell. Trade credit, the financial crisis, and firm access to finance. Central Bank of Ireland Conference on the SME Lending Market. Vol. 2. 2012.
  3. The Use of Trade Credit by Businesses, Amy Fitzpatrick and Bobby Lien: Reserve Bank of Australia: September 2013
  4. Owusu-Manu, DeGraft, Samuel K. Afrane, and Kenneth Appiah Donkor-Hyiaman. Towards Developing Trade Credit Policies in the Ghanaian Construction Industry: An Analysis of Constraints. Journal of Economics and Sustainable Development 5.8 (2014): 166–180.
  5. Dass, Nishant, Jayant R. Kale, and Vikram Nanda. Trade credit, relationship-specific investment, and product market power. Review of Finance (2014): rfu038.
  6. United Kingdom Department for Business Innovation and Skills, Enterprise Bill: A Small Business Commissioner, 26 July 2015
  7. The Factoring Discount Rate, CFS Commercial Finance Solutions Inc.
  8. Small business commissioner to target late payments, BBC News, 26 July 2015
  9. Small Firms’ Big Customers Are Slow to Pay, Wall Street Journal, June 6, 2012 (Angus Loten)
  10. IACCM Commitment Matters post: The dizzying debate over payment terms, 30 November 2015, Tim Cummins, CEO IACCM
  11. Bloomberg View: Big Companies Don’t Pay Their Bills on Time, Justin Fox, September 20, 2015:
  12. The Use of Trade Credit by Businesses, Amy Fitzpatrick and Bobby Lien: Reserve Bank of Australia: September 2013
  13. New York Times: Business Day: Big Companies Pay Later, Squeezing Their Suppliers: Stephanie Strom
  14. Payment Practices Barometer Australia 2015 – Atradius – Managing risk, enabling trade - 21 October 2015
  15. See, e.g., 2015 amendments to the Australian Consumer Law and the Australian Securities and Investment Commission Act 2001 (Cth) which extended unfair contract term protections to small businesses, and proposed amendments to the UK 2013 Late Payment of Commercial Debts Regulations.
  16. Pace International Law Review, Vol 19, Issue 1, Spring 2007, Late Payment Directive 2000/35 and the CSIG, Pilar Perales Viscasillas
  17. DIRECTIVE 2011/7/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 16 February 2011 on combating late payment in commercial transactions
  18. Late Payment: challenging grossly unfair terms and practices: Department for Business Innovation and Skills: issued Feb 2015:
  19. The Implicit Costs of Trade Credit Borrowing by Large Firms, White paper report by Justin Murfin, Ken Njoroge (2013).

 

About the Author

Joanne Simpson is Director of Corvative Pty Ltd, a contract and commercial services consultancy based in Perth, Western Australia. She has 20+ years of procurement, contracts and commercial experience in major studies, projects and operations in the resources industry. She holds Masters Degrees in Business Administration from the University of Western Australia and in Construction Law from the University of Melbourne in Australia.

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