Account Payables

The question of when an invoice should be paid and what is good and bad is an evergreen in most companies. Here are some thoughts:

Most CFOs would agree that paying late improves a company’s cash position. More money in the bank for a longer time is always good. However, the optimization of cash-flow should be balanced against other downsides, such as

• Makes you unpopular on the vendor market.
• Some vendors may charge interest on late payments, in which case your cash-flow benefits are gone very quickly.
• Most vendors will try and compensate by increasing the prices. Unless you’re in a commodity market, it is very difficult to stop this simply because you don’t know what the “right” price should be.
• In some cases, vendors will refuse to supply goods to your company.

In many companies, the accounting departments carry out measurements of payment execution. (This is what was reported in NZZ 30.5.07.) Most such measurements are incorrectly conceived and only serve the purpose of satisfying the organization’s need to measure perceived success rates. The NZZ article appears to be an example of this. Let me explain why:

1. It is not meaningful to measure the number of days it takes to pay on average (DPO) unless it is related to the average payment terms a company has with its supplier base. Nowadays, many companies enforce 60 or even 90 days payment terms onto their suppliers. Private individuals obviously don’t have the same possibilities here.
2. When performing the measurements, there is typically a happy mixture between invoices that are paid too early and invoices that are paid too late. How can that be? Who would want to pay an invoice too early? Well, there are many factors that could contribute to this:

   a. I believe the most powerful factor is that the average accountant dislikes to have a lot of open orders in his system and when he prepares a payment run, he tends to include one or two invoices which actually are too early, simply because he wants to “clean his desk”. He can go home on a Friday afternoon, satisfied with the week’s work and less to do for next week. No open files.

   b. In many companies, there is a certain amount of “financial tuning” going on. This means that in a good month when all EBITDAs, bottom-line profits and gross margins look good, there will be a tendency to pay some supplier invoices too early in order to make the next month a little easier. This could also avoid complicated accrual procedures.

   c. I have seen companies where the accounts payable departments where measured on paying on time after having introduced new processes. Then one way of reaching such targets would be to offset late payments by paying some too early. On average you then look fine! See below.

   d. In Switzerland for instance, it is customary to offer a customer 30 days net with a 2% cash discount when the invoice is paid within 10 days (Skonto). There is no financial reason to this, nobody can make that business case fly! It should rather be seen as an incentive for the customer to pay quickly and a friendly discount. Many accounting departments are under instructions to save as much money as possible on the “Skonto”. And they do. And they save a lot of money. But it changes your average cash position.

Another question is of course if it at all makes sense to pay late. What is to be gained from this? Going from 30 days payment terms to 60 days, gives you a single, one-off improvement in cash balance. Nothing wrong in that, again it is always nice to have the money in your pocket. But what with the possible price increases? In companies which are self-financed or at least do not take up large credits, no sensible manager would trade 30 additional days for a price increase. He would be interested in keeping the vendor prices low at all time. The lower vendor prices have a lot of other advantages for him: Long-term profitability, supplier relationship etc.

Why then do some companies do it? One example is a company which has been bought by a private equity firm. Private equity companies typically take up very large credits in the companies they have bought. The end targets of buying the company is to dress it up for a sale within the next few years. This is then achieved by a number of activities, such as general cost cutting and cash-flow optimization so that the credits are substantially reduced until the time comes to sell it off and that the company looks really good in the eyes of a potential buyer.

You can then ask yourself why they don’t bother with supplier prices? The point here is that they don’t. It is much more important to decrease the credits. If the company has a too expensive supplier base, it will be the problem of the next owner. Cash activities have a direct and immediate impact, whereas a supplier contract may run for several years and the impact is delayed. Furthermore, I have seldom experienced a due diligence process where anyone has bothered to bench-mark supplier contracts and evaluate if the contractually agreed prices are good or bad.

Finally by means of illustration I have come across the following. A company measure how it was paying its invoices. Target was to be “on time”, that is 30 days net. At the end of the year, target was met, and bonuses were paid out. However, the numbers presented were averaged. The underlying data looked like the following:

As you can see, not a single invoice was paid correctly on 30 days. But the average was good!

Kloten, May 31, 2007