With the onset of difficult times, one business practice which may become increasingly common is that of firms delaying payments to their suppliers beyond the due date of payment.
This is commonly referred to as ‘stretching your accounts payable,’ and the practice raises some intriguing questions – about whether it is fair and whether or not it makes business sense.
In my view, there are very strong arguments against this practice, and it should be avoided in all but the narrowest of circumstances.
Today, I would like to discuss the benefits and drawbacks of the practice from the viewpoint of a firm which is in a satisfactory state regarding financial position and cash flow.
Next week, I would like to discuss the viewpoint of firms which are facing financial or cash flow difficulties.
Why wouldn’t you pay on time?
What would a firm which is in a reasonable cash flow position have to gain from not paying supplier invoices on time?
Firms with considerable bargaining strength may be tempted to adopt such an approach in order to gain an extension to what is essentially an interest-free loan.
Trade credit is usually provided on interest free terms. Where procurement of supplies involves use of such a facility, the supplier concerned is effectively making a short term interest-free loan their customer.
Firms can immediately employ the cash outflow temporarily saved by the use of trade credit to meet operational funding requirements of their business, or to pay down debt on interest bearing loans, and thus reduce the daily or monthly balance upon which interest is calculated.
By the purposeful act of stretching its accounts payable, a firm effectively extends the time-frame of this interest free loan, thus increasing the value of the benefits it receives from its use of trade credit.
Why you should pay on time
Nevertheless, there are considerable drawbacks to such a practice, and these clearly outweigh any benefits in the case of firms with the capacity to meet payment deadlines.
These drawbacks include:
• Etiquette.
Basic etiquette dictates that all financial obligations should be paid in full on or before the due date, and supplier invoices are no exception.
The practice of purposefully neglecting to comply with supplier credit terms represents both disregard for common business etiquette and a lack of respect for the supplier concerned as a stakeholder in the firm.
• Reputational damage.
Late payment of supplier invoices on a regular basis has an adverse impact on a firm’s reputation as a customer, which in turn has a further adverse effect the quality of service which the firm receives from suppliers as well as the terms upon which supplies can be procured.
Customers who consistently meet payment deadlines generally receive higher priority service as well as more generous discounts and/or credit terms than those who fail to meet payment deadlines.
• Costs to suppliers.
Late paying customers place an unfair burden upon suppliers, including costs associated with follow up of the payment (processing, debt collection agencies and labor costs), difficulties in terms of cash flow planning and the potential for their ability to meet their own payment deadlines to be compromised.
All of this, not to mention the opportunity cost associated with the late receipt of cash, makes late paying customers a burden which suppliers should not have to bear.
• Perception of financial difficulty.
Late payments can lead to the suspicion that the firm may be facing financial difficulty.
Where such a suspicion arises, the impact extends well beyond the firm’s relationship with suppliers. Customers may become reluctant to deal with the firm due to concerns relating to product warranties or continuity of service. In addition, staff may be tempted to consider leaving due to concerns about ongoing employment prospects and payment of entitlements.
Add to this the reaction of investors, and it becomes clear that suspicion of financial difficulty should be avoided at all costs.
• Late payment fess/early payment discounts.
Last but not least, late payments can involve a direct financial cost, either due to the incurrence of late payment fees or the forfeiture of any applicable discounts for early payments.
A better approach – more favorable credit terms
Add all this up, and it is not difficult to see that firms whose cash position is sufficient to meet their payment commitments should avoid the practice of stretching their accounts receivable.
Firms with a considerable degree of bargaining strength have a far better option – the negotiation of more favorable credit terms, which provide similar benefits in terms of an extended interest free loan but without the drawbacks listed above.
This approach is available only to firms with sufficient bargaining power. Nevertheless, any firms with sufficient capacity to meet its payment obligations by due dates should do so.
Both ethical and business case considerations demand no less.
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