With interest rates hovering near their all-time lows, finding a good yield on an enterprise’s cash has been all but impossible for the past few years. Things have gotten so tough that the US Department of Treasury recently issued five-year bonds that had a negative yield – where investors in these bonds were, in effect, paying the government for the opportunity to invest in these bonds (bond investors usually receive payments). For the government, this is better than a free lunch, investors are paying the government to eat lunch (Poor Milton Friedman of “No Free Lunch” fame) Investors buy these bonds presumably because they expect inflation from the expected investment of the Fed in treasuries in what is being called the “QE2” (Again, poor Milton Friedman of monetarist fame).
And while this low interest rate environment has been great for borrowing companies with bullet-proof credit ratings like Wal-Mart and Coca-Cola, credit remains tight for smaller companies and those with mediocre credit ratings. For the CFO at the little guy, cash is king, but access to it can be difficult. For the CFO at the big company, cash may be king, but it is just as likely to be “dead money,” particularly as these big companies remain hesitant to invest in either capital projects or human capital initiatives.
I am pleased to say that in recent times, more CFOs (but far from all) have an understanding of all of the levers that the Chief Procurement Officer and the procurement department can use to improve cash management. Truth be told more CPOs (but far from all) have a better understanding of how they can impact cash too. A few tools in the CPO’s cash management drawer:
- Demand Management – save 100% by not buying
- Contract/Price Compliance – don’t pay more than what you negotiated
- Implemented Savings – savings retained by the enterprise
- Strategies to Reduce TCO – reducing inventory and holding costs for example
- Process Efficiencies – manage the department under budget
- Payment Terms & Strategies – how and when you pay suppliers
The last bullet “Payment Terms and Strategies” is the free money that I refer to in this article’s title. We will look at how “free” and how effective the extension of payment terms across a supply base actually is in our next article. Here, we’ll look at the “payment strategy” of paying suppliers who offer early payment discounts. As we will see, this strategy can help suppliers with cash needs AND buyers looking for better returns (or yield) on their cash.
An Early Payment Discount Example
Suppose a supplier offers you payment terms of 2/10 net 30. What this means is that if you pay a supplier within 10 days, you may take a 2% discount and only pay 98% of the total due. If you fail to pay within 10 days, you must pay 100% of the amount within 30 days.
So…. 2%? Big deal, right? Actually 2% in this case is a huge deal. If you make your 98% payment on the 10th day instead of 100% on the 30th day, your annualized rate return on that early payment is 36.73%. That is a big deal.
Here is the standard Rate of Return formula for early pay discounts:
The Annualized Rate of Return = [Discount % / (1-Discount %)] times [360 days / (credit period – discount period)]
2/10 Net 30 terms give us the following inputs:
“A” = Discount % = 2%
“B” = Credit Period = 30 days
“C” = Discount Period = 10 days
The “standard” formula: The Annualized Rate of Return = (A/(1-A)) times (360 days / (B-C))
The two-step calculation using the numbers from our example:
1. The Annualized Rate of Return = (2%/(1-2%) X (360 days/(30 days – 10 days))
2. The Annualized Rate of Return = (.0204) X (18) = 36.73%
The Annualized Rate of Return for paying early on 2/10 Net 30 is 36.73% – and that Rate of Return is ‘risk-free’ in the classic financial sense. Compare that return to LIBOR, another risk-free alternative and you get……… Free Money!
Are you taking advantage of these opportunities? Do you have visibility into payment terms? Are you setting them? How engaged are you with AP or with the CFO and treasury to develop and/or manage a payment strategy?
Working with the CFO (and treasury) to develop a payment strategy that maximizes your return is one sure way to formalize procurement and finance alignment. And then there’s all that FREE MONEY!
Postscript: The presentation that I delivered in London at the end of October as a prelude to my upcoming research study The CFO and the CPO: One World, Two Worldviews is now available from a link at the end of this press release (registration required) – courtesy of Sievo. My presentation was also covered by Paul Snell of the UK trade journal, Supply Management, here. I plan to discuss some of the highlights from this presentation in an article next week.
