Why Payment Terms Are Shrinking

The Hackett Group periodically analyzes the working capital performance of the 1,000 largest U.S.-based public companies operating outside the financial services sector. This fall, the firm issued a “2022 Midyear Update” based on data from Q2/2022 and year-over-year comparisons with Q2/2021. It reveals that days payables outstanding (DPO) fell by 1.1 percent year-over-year and 5.5 percent compared with Q1/2022.

Treasury & Risk sat down with Istvan Bodo, a director at The Hackett Group and co-author of the report, to explore some of its key findings.

Treasury & Risk:  It seems the headline news from the “2022 Midyear Update” is that although DIO [days inventory on hand] and DSO [days sales outstanding] performance remained pretty stable in the second quarter, DPO degraded noticeably.

Istvan Bodo:  That’s right. We saw a significant decrease in DPO in this study. Previously, DPO performance was consistently improving. By the end of 2021, it was still improving, but the rate of improvement was slowing. And then, in Q2/2022, we saw actual deterioration in DPO for the first time in a decade.

T&R:  What do you think was driving this shift?

IB:  Well, key drivers include the continuing global supply-chain bottlenecks, inflation pressures, and political risks. The current market environment is shifting leverage from buyers to sellers. And I think many suppliers have reached the upper limit of customer payment terms that are feasible for their organization.

For 10 years, procurement teams in many large organizations saw payment terms as low-hanging fruit for improving their company’s working capital. They leaned on suppliers and got extension after extension of payment terms. Now that supply chains are facing so many issues, though, the suppliers are pushing back. They’re telling their large customers, ‘We can provide the services and quality you’re requesting, but only if you pay us in a shorter period of time.’

T&R:  Understanding that you don’t have a crystal ball, do you expect this trend to continue?

IB:  This is purely hypothetical, but given all the supply-chain bottlenecks, increasing interest rates, and high inflation, I expect payment terms in each sector to continue shrinking until they’re closer to the industry’s historical norms.

Think about it: If the inflation rate is 8 percent and you’re getting paid 90 days after you issue an invoice, by the time you receive that payment, your purchasing power with those funds is about 2 percent less than it would have been on the date of the invoice.

And one more factor, especially if the economy dips into recession, is credit risk. A seller that gets its money earlier is reducing the risk of customers going bankrupt before they’ve paid the invoice.

T&R:  So, with inflation as high as it is, should suppliers be prioritizing efforts to reduce customers’ payment terms?

IB:  At the very least, the treasury team should be assessing whether the payment terms the company is offering still make financial sense for their business. Depending on the industry, they might find that offering higher discounts to customers who pay sooner would be beneficial to the organization.

This is also a good time for treasury groups to take a close look at collections. Inflation means that every additional delay in a payment eats into the seller’s margins more than it would have a couple of years ago. Companies that have repeatedly extended payment terms over the years should not be giving customers even more days to pay than what they’ve agreed upon.

Enforcing a strict credit policy is becoming increasingly important, as well, as we face the possibility of an economic downturn. Companies that let credit risk management practices slide a bit over the past few years need to start paying more attention.

T&R:  Some of the liquidity metrics in your study are also very interesting. Revenue is up by nearly 20 percent year-over-year, yet cash on hand as a percentage of revenue dropped to an even larger degree.

IB:  We found that cash on hand as a percentage of revenue decreased by almost 30 percent, when we compared Q2/2022 with Q2/2021, and debt as a percentage of revenue decreased by more than 15 percent. The shifts in these two metrics suggests that companies are using the cash they previously hoarded.

Many management teams built a cash cushion when interest rates were low and throughout the pandemic. Now they are using those funds to pay down debt in anticipation that interest rates will continue to rise.

T&R:  So, do you expect that companies which have reduced the liquidity they have on hand will start paying closer attention to working capital management in 2023?

IB:  Yes, definitely. There is a lot of opportunity for improvement right now, not just in DPO and payment terms, but also in DSO and inventory. When interest rates were low and it was easy to access cash, companies were less interested in working capital improvements. Now, more and more companies are looking to optimize working capital and release cash flow. This is typical when interest rates rise because it becomes significantly cheaper to fund strategic investments or general operations using internal cash versus borrowing.

We also expect companies to reconsider their sourcing strategy in 2023. The Hackett Group highly recommends evaluating suppliers’ geographic risks in terms of both the political situation and the potential for supply-chain bottlenecks. The pandemic demonstrated how important contingency planning is in procurement and supply-chain decision-making.

And then on the opposite side of the transaction, companies should look at whether it would make sense to try to negotiate bigger early-payment discounts from their suppliers in 2023.