The Relevance and Irrelevance of Payment Term Extension
You may be aware of payment term in supply chain management which is a mutually agreed upon invoice clearance period for a buyer to pay its seller. This is usually a 45-60 day time-frame. Now this term can also be affected by several anomalies that can lead to an extension in clearing the invoices known as payment term extension.
For example, in the pharmaceutical industry, the buyer may decide to stall an invoice until it is sure that the raw materials sourced through its seller have produced desired results and were not fake or substandard. So, from a 45 -60 day period, the buyer can suggest deferring the payment by an extra number of days which the supplier is ready to honor because more than the buyer, it is compliance; after all why should a buyer pay for counterfeit supply that can potential affect many lives.
So then you may be thinking what about companies like AB InBev, Kellogg, Diageo, and Mars in the FMCG industry that extend their payment terms anywhere from 90 to 120 days? Well here you are where we discuss the relevance of it, the niche that benefits from it and the niche that’s hurt.
Suitability of Payment Term Extension
Scenario 1: We know why a pharmaceutical company, large or small, may ask for a payment extension. But for most other firms that are large and sit on wads of cash, asking for such extension implies multiple stakeholders and unwarranted processes complicating on-time invoice clearance. Here it is more of prevalence than relevance.
Scenario 2: Payment Extension is relevant for firms who need trade credit, an alternative to high-interest bank credit as they are operations heavy. Large operation heavy firms are strategic about payment extensions and if they are sure about it in the event of cash crunch or re-deployment of its fund as an income instrument, they offer perks to earn the supplier’s buy-in. This practice is nothing new but pretty old and completely fair where both buyer and supplier have benefits to harness.
You may ask so should payment extension be a prerogative of large firms and their competent suppliers? Well, there is nothing absolute about it but we know that while failure to make a scheduled payment could result into a loss of reputation for the buyer-enterprise, failure to accept a payment extension can result into loss of financial credibility of the supplier and its long term business potential with the buyer. Below are a few ways by which extended payment terms affect suppliers and buyers.
The Cons of Payment Term Extension
Burn out: SMB suppliers with limited manpower and production capability can only take up limited projects and contracts. At such juncture, having funds withhold by their buyer precludes them from investing in enablers (include payments to their very own suppliers) for ongoing sustenance. Imagine this snowballing into cash crisis or depletion of working capital and even an out-of-business scenario?
Employee Productivity: Are we forgetting how a company’s financial burn out impacts its employee productivity and work morale? Payroll being a major cost, a payment term extension has a major impact in it. While in most cases efforts are put in to pay the salaries, but it is not imaginary that SMBs fail to pay their people which in turn impacts productivity and employee wellbeing.
Credit Crisis: It is needless to say that SMBs are not a bank’s favorite investment option. And SMBs have nowhere to go seeking credit except for these banks that either charge a hefty interest or mostly refuse funding which is as high as 50%.
No Escape: Unreasonable in invoice clearance impacts buyers too as it levies risk in the supply chain. i) A supplier may compromise in the quality or delivery time that may affect buyers’ production and catch them unaware, or ii) a trustworthy supplier when forced out of business or pushed into poor productivity because of pending clearances, it affects the entire ecosystem.
Pay Penalties: Oh well, when you see big companies going for trade credit, do not take it for granted that it is always by force but also by accepting to pay penalties (in case of failure of the new revised payment date) as included in the contract. If it is not a big but small supplier, they incorporate the loss amount from penalties in future purchases.
Losing to Competitors: The essence of your product lies in the ingredient you’ve used and its quality and exclusivity. Losing such supplier to your competitor with friendlier payment terms impacts your business and the market desirability of your product.
The most favorable and win-win strategy is to go with advance payment method that helps both buyer make strategic savings by paying early and suppliers get better cash liquidity to help sustain their production profitably.
Managing credit between buyer and supplier is the key to lasting relationship. There is no hard and fast rule about whether to go with payment term extension or not to. It all depends on your cash management strategy; whether you really need a low interest tax credit, or need to disinvest your fund for an expedited return, or totally go against the tide of payment extension and offer your suppliers an advance payment option that takes care of the overall wellbeing of our supply chain environment. This strategy depends on the size of the buyer, credit needs, nature, and size of supplier network. However, to perfect the balance for better relationship, what we would recommend here is to go with an agile technology that can facilitate both payment extension and payment advancement as per the changing business needs. This agility will help switch your payment strategies conveniently and gain competitive edge by building long-lasting stronger supplier networks.