Following the new year EBG will intensify the knowledge sharing efforts made through interviews and articles from both end users and experts. We start off by sharing the response to some questions to Ariba (www.ariba.com) on dynamic discounting. I had a conversation to a supply chain expert who didn’t buy the idea of not using capital within the business rather than giving it to suppliers. Thus we need to dig into the discussion – also to find out – is dynamic discounting and supply chain financing THE bridge between finance and procurement?
The raised questions were:
- The reason for extending payment terms being to use suppliers as the “bank” – how can you evaulate that you will not make the 2 or so percent anyhow through using the money as an investment in the production or in your own business for instance?
- Have you come across companies that have extended their “real” payment terms from for instance 60 to 90 days just to go back and asking for early payment discount after 60 (which then are their “real” and accounted for terms?
- Can you give examples of industries (buyers) and products/services (suppliers) where dynamic doscounting or early payment is growing and why?
- Is dynamic discounting and early payment bringing finance and procurement closer together?
Q&As from Drew Hofler| Senior Solution Manager, Working Capital Management Solutions| ARIBA, Inc.
1) “The reason for extending payment terms being to use suppliers as the “bank” – how can you evaluate that you will not make the 2 or so percent anyhow through using the money as an investment in the production or in your own business for instance?”
Response #1: If I understand this question, it appears to have 2 statements to it. The first statement around extending terms to essentially use your suppliers as the “bank” is certainly one perspective around payment terms…i.e., Buyers are essentially “borrowing” from their suppliers for 30, 45, 60 days or more by withholding payment on delivered goods and services for that time period. This is one way to look at terms (and thus terms extension), but I am not sure how to respond to that as it is not so much a question and is indeed pretty standard practice.
I think the question comes in with the idea of taking these long payment terms once in place and offering a supplier the opportunity to get paid earlier (for a 2% discount in your question/example above)….that is, why would a buyer pay a supplier early in exchange for a discount instead of investing the 45 days worth of working capital in their own business and getting a return on that investment? If that is indeed the question, then it is certain a valid one and one that all treasurers/CFO’s must ask themselves when considering deploying dynamic discounting. But the evaluation really comes down to a comparison of the level of return for the various options. Typically, companies use their Weighted Average Cost of Capital (WACC) or an Internal Rate of Return (IRR) number to define what they would expect to earn (in an annualized percentage basis) on any funds that they invest in their own business. On average, this number is right now usually in the 8%-12% APR range. So if they keep their funds and invest them internally instead of paying supplier early (Dynamic Discounting), this is what they can expect to return on that investment. By comparison, taking a 2% discount to pay a supplier 30 days early earns an annualized return of 24% APR…while paying 45 days early makes that 2% discount worth 16% APR.
Finally, another way of viewing Dynamic Discounting (and the correct way, in my opinion) is as an alternative short term liquidity investment. That is, most companies these days have a certain amount of liquid cash sitting in short-tenor investments indexed to Libor or some other short term benchmark that they are holding on to as a buffer against uncertainty. Dynamic discounting is essentially a way to use this cash for a similar short term investment (i.e. paying suppliers 30 days earlier than you would otherwise), but one that yields far more than the <1% APR most liquidity investments are yielding today.
2) ” How do these strategies “stand out” in comparison with other financial strategies?”
Response #2: I think I answered this question a bit in the 2nd and 3rd paragraphs of my response #1. Essentially, if you look at Dynamic discounting as an investment strategy for a company’s cash then the comparison is either against a longer term investment (e.g. equipment, capital, expansion, etc.) and the WACC/IRR equation, or it is a comparison against similarly short-term uses of cash. Against either, Dynamic Discounting can compare quite favorably from a return on investment standpoint. Obviously, however, a decision to invest capital for expansion of the business is of a more strategic nature and is not merely a comparison of short term returns. Thus, I state again that I think the best way to look at Dynamic Discounting is as compared to other short term liquidity investments for a company’s short-term cash.
3) ” Have you come across companies that have extended their “real” payment terms from for instance 60 to 90 days just to go back and asking for early payment discount after 60 (which then are their “real” and accounted for terms?”
Response #3: Short answer is yes. Longer answer is that we see companies using dynamic discounting as an integral part of their terms rationalizations/extension efforts. That is, many companies are rationalizing their sometime very diverse payment terms down to 2-3 standard terms, or they are wanting to extend their terms across their supply base (as in your example here 60 to 90 days). When they do this, they will incorporate dynamic discounting as a way to both mitigate the impact of these extended terms (by offering access to early payment to those suppliers that want/need it) and as a way to save money through earned discounts.
The root of the question you posed is, I believe, “why extend terms If you are just going to go back and pay suppliers early? Isn’t that just creating pain for suppliers for the sole purpose of earning discounts?” And I would have to say that is not what we see. In most cases, about 20-30% of suppliers will participate in dynamic discounting, which means that 70-80% will have their terms extended and not request earlier payment. The result is that net DPO is extended for the buyers, but they are also able to capture savings and provide cash flow to those who could not handle the extension.
4) ” Can you give examples of industries (buyers) and products/services (suppliers) where dynamic discounting or early payment is growing and why?”
Response #4: I could give industry examples as some industries such as retail, logistics & construction are particularly ripe, but I think that would paint a misleading picture. The fact is that we have over 20 buyer industries represented in our Discount Professional(tm) customer base, and over 400 industries represented by the suppliers taking advantage of it. Dynamic Discounting is just a very horizontal type of product that works for almost any industry. The key factors for successful uptake is longer payment terms (30+ days) and big middle of the supply base. Particularly in this environment, desire for accelerated cash flow on the part of suppliers is not limited to particular industries, but is more a dynamic of payment terms and supplier size & access to capital. Granted, some suppliers are more prone to offer discounts that others (such as construction or temp labor as they have to wait 45 days for payment but have to sub-contractors more frequently), but there is a large appetite for it regardless.
And one final point there, it is not just small companies that offer discounts. A surprising number of larger, investment grade suppliers will offer dynamic discounts for the other benefits it gives them of lowering DSO and removing receivables from their books, particularly as window dressing at the end of quarters.
On the note of bringing finance and procurement closer together…
Yes, absolutely we have seen increased cooperation between finacnce and procurement. It is not absolutely necessary, as we have successful customers where the product is completely owned and operation by Procurement and others where finance is the owner. But having worked with quite a few, I can definitely call it a best practice when the two areas work closely together…and we see this more and more. It just makes sense as Finance is interested (and incented) in the return on cash, and procurement usually owns the relationship with the supplier and can use accelerated payment opportunities to help position extended terms, etc.
Thank you Drew and Ariba! Responses from Taulia will follow shortly