| A temporary cash shortfall can be a death sentence for a small business. The small business owner's limited access to capital leaves little room for error. That's why it is critical to understand how to manage the three components of your cash cycle: accounts receivable, inventory and accounts payable. In the final segment of this series, we take a close look at accounts payable, examining common errors in management and reviewing cost effective strategies that can shorten your cash cycle. Accounts payable is the forgotten stepchild of the cash management system. Volumes have been written about credit, collections and receivables management. Inventory control is a current fad with Just-In-Time inventory plans and computerized, bar coded inventory management systems coming into the price range of even some smaller companies. But the payables system is often seen as just a bill paying mechanism and what, after all, can be done about that? The bills must be paid as close to "on time" as possible and the only opportunity for efficiency seems to be in automating the process to let the computer write the checks and keep track of what is owed to whom. Nothing could be further from the truth. In fact, we will find that payables are perhaps the bestrecensioni sugli alberghi Hvolsvollur place to start to improve a small business's cash position. To understand why this is so, it is necessary to review the relationships between payables, receivables, inventory and the overall cash cycle. Readers of the first two articles in this series will remember that a company's 'cash cycle" is the period of time that the company's money is in the hands of others (before it comes back in the form of payment of a bill for services rendered or products sold). The operating cycle of the firm starts with the purchase of inventory and ends with the collection of receivables. The cash cycle of the firm results from the offsetting effect of accounts payable in reducing the time that cash is out of the company's hands. Accounts payable management, therefore, is fundamentally different in its immediate objective from the other two elements of the cash cycle. The objective of receivables and inventory management is to reduce collection and holding periods. In the case of payables management, the firm is best served when average payment time is increased. In all cases, the objective is to minimize the overall cash cycle. As with our analysis of receivables and inventory management, the first step is to know where you are now by calculating the average age of your payables (AAP). That calculation is really just the mirror image of the calculation for the average age of receivables. Compare annual purchases with average payables balances to derive an average "holding period" for invoices—the average number of days that elapses until a bill is paid. The only tricky part of the calculation comes in identifying "total annual purchases," which is not a balance sheet or operating statement item for a manufacturing firm. The insert on the following page provides a step-by-step explanation of how to calculate AAP. This article will examine the role that payables can play in providing a source of financing for the firm. It will start with an explanation of the significance of payables management and demonstrate how a combination of automatic financing and a multiplier effect act to free up a significant amount of cash as a result of even relatively minor adjustments in payment policies. It will then examine in detail how the payment decision can be made to maximize the cash benefits available and at the same time balance the need to treat one's vendor relationships with care and honesty. The role of payables in cash cycle management is a seemingly contradictory one. On the one hand, payables are usually the first element of the cycle to be affected in a time of extreme cash shortage because businesses that are short of cash don't pay their bills on time. Yet that is about the worst time to rely on payables for cash cycle help. On the other hand, payables are usually the last system to be addressed in any systematic effort to improve operating efficiency, in spite of the fact that efficiency gains from payables are among the easiest and most immediate to achieve. Why are the gains from effective payables management relatively easy ones? For a very simple reason: payables are under your control. Payables offer the best opportunities for immediate impact on the cash cycle simply because you are in charge. Inventory management frequently means negotiating with suppliers, changing merchandise mixes and studying turnover rates over the long term. Collections and receivables management mean changing other people's behaviors (getting them to pay their bills on time, or earlier). But payables management means you decide when to pay. The benefits that accrue to the company's cash position are the same, whether the cash cycle was shortened as a result of reducing the firm's Average Age of Inventory (AAI) or as a result of increasing the Average Payment Period (AAP). Can those benefits be significant? Let's take the example of a small wholesaling firm with annual sales of, say, $4 million and gross profit margins of 50 percent. The company has total annual purchases for inventory of $2 million. In addition, there will be non-inventory based purchases of supplies and services that may amount to an additional 10 percent or more of sales, for total annual purchases of $2,400,000. If the firm is now paying within an average of 25 days on average terms of NET 30, then the average accounts payable balance is ($2,400,000/360) x 25 = $166,666. If the firm instead were regularly paying just five days late, their average accounts payable balance would be ($2,400,000/360) x 35 = $233,333. The difference of $66,666 represents a relatively permanent source of financing at 0 percent interest. If the firm is currently borrowing working capital on a bank line of credit at 14 percent annual interest, that permanent source of automatic financing is worth almost $10,000 per year in saved interest. What is more, accounts payables represent a source of automatic financing as the firm grows. Without changing the payment terms at all, the amount of financing provided to the firm increases automatically as sales increase. But the relative effect of the automatic financing feature of accounts payable is increased with longer effective payment terms. Consider, for instance, two retailers: Bob's Barrows and Sam's Sleds. Bob's and Sam's are right down the street from each other. Each sells just one product, each has the exact same inventory levels, credit and collections policies, pricing strategies and markups. Each sells exactly $400,000 a year at a 50 percent gross profit margin. Bob, however, pays all his merchandise bills in 25 days. Sam pays his in 35 days. Here are their relative accounts payable balances:
Bob: [($400,000 x.5)/360] x 25 = $13,888
Sam: [($400,000 x.5)/360] x 35 = $19,444 Sam has received an additional $5,556 in financing from his suppliers. If both he and Bob are paying 14 percent per year in interest, Sam will have $778 more profit at the end of the year than will Bob. That much is already obvious from our discussion. But what if both Sam and Bob have a really great year and sell $500,000 worth of barrows and sleds? Watch what happens to their relative accounts payable balances:
Bob: [($500,000 x.5)/360 x 25 = $17,361
Sam: [($500,000 x.5)/360 x 35 = $24,305 Both have received an automatic increase in the financing available from accounts payable. Neither had to ask for a bank loan to get this benefit, they merely ordered more from their respective suppliers and continued to pay according to the same terms as always. Neither had "stretched" their payables any more or less than before. But notice that the effect of Sam paying just five days late is that Sam's increase is larger than Bob's: Sam got $4,861 in free financing compared to Bob's $3,473: almost 40 percent more! Perhaps even more significantly, Sam had a much larger percentage of his average inventory increase paid for by his vendors. That thought bears looking at more closely. After all, the addition of a few thousand dollars in financing doesn't seem very large compared to the total additional cost of $50,000 more in goods to support $100,000 in increased sales. But the increase in average inventory necessary to support those increased sales isn't $50,000. From the calculations in the second article in this series, the increase in inventory necessary to finance $100,000 in increased sales (if both Bob and Sam are "turning" their inventory six times a year) is just (100,000 x.5)16 =.$8,333. Sam paid for almost two-thirds of his increased inventory (58 percent) with free financing. Bob got automatic financing for only 42 percent of his increase and had to go to the bank and pay 14 percent interest on the other 60 percent! The Bob and Sam example is important, but not just because you should be able to perform those calculations to see how much you've saved. It is also important to appreciate the significance of good payables management. There are two reasons that the actual significance is greater than it may at first seem: - There is an automatic financing benefit that derives from good payables management. As sales (and thus purchases) increase, the amount of financing available from payables increases in proportion to the length of the average payment period and as sales increase. This increase in financing occurs without stretching payments or altering payment policy.
- There is a multiplier effect that derives from good inventory management. As sales (and thus average inventory) increase, the proportion of the inventory increase paid for by the automatic financing feature of the payables system increases in proportion to the length of the average payment period and the frequency of inventory turnover.
In other words, as we have seen before in this series, the cash management system of the company is an integral one. In this case, good inventory management combines with good payables management to significantly reduce the cash needs of the business. Remembering Who You Work For (Hint: It's not your suppliers.) The number one error that most small business managers (and some large business managers) make when managing their payables is forgetting who they work for. Payables management too often becomes the management of the vendors' receivables systems instead of management of your company's disbursement system. In addition to speeding collections as much as possible without damaging customer relations, one of the jobs of the financial manager of any firm is to hold cash as long as possible without damaging credit relationships. This is important enough to say again with feeling: The payables objective is to bold on to cash without damaging credit relationships.
Unfortunately, some managers confuse good management with unethical behavior. The question of ethics in payables management is one that should be addressed, because the business manager without a clear set of priorities is unlikely to manage payables properly. Consider the following analogous situation: You are responsible for buying merchandise for a business and you are attending a trade show to look over vendors' products. In one booth sits a sales representative displaying quality products at extremely attractive prices. In fact, the prices are 30 percent below those of the competition, the quality of the products is comparable in every way and the sales representative has testimonies to the company's ability to deliver on time and service customers in exemplary fashion. With your own knowledge of the industry, you come to the conclusion that this company is seriously underpricing its product and the owners are unlikely to make a profit with this pricing strategy. Do you: A. Inform the sales representative that you find it ethically objectionable to underpay for this product and insist on paying a higher price, since to pay less would be effectively stealing from the vendor, Or: B. Order at these attractive prices, take a higher markup (or sell higher quantities less expensively) and effectively pocket the increased earnings that would have gone to the vendor had he priced more realistically. If you answered "A" then most of the rest of this article is probably not going to be of interest to you (see Footnote 2). If, however, you decided that it was not your job to manage other companies' pricing systems, that your job is to maximize wealth (see Footnote 3) for your own stockholders, then it perhaps also makes sense that your job as a payables manager is not to manage your vendor's receivables system, but to manage your own disbursement system. This problem of effectively managing receivables for your vendors is not a small one. Payables are actually the least managed, most neglected component of the cash cycle, simply because most small business managers assume there is little that can be done about them. Psychologically, they have ceded control over their payables to their vendors and simply adopted the receivables standards of their suppliers. In short: not all bills should be paid on time. Many large companies figured this out some time ago. Consider, for instance, this recent news story concerning Sears Roebuck and Co. and how they manage their relationships with their vendors: A trade group representing many of the nation's apparel manufacturers Wednesday reacted angrily to a plan by Sears, Roebuck and Co. to give itself 30 more days to pay for the merchandise it sells in its stores nationwide. A Sears spokesman said the retailer is simply reacting to a changing competitive environment - and adopting the terms other retailers are demanding—but many manufacturers cried foul. "Larger companies with substantial resources can either acquiesce in Sears' demand or reject it because their size and diversity puts them in the enviable position of being needed by Sears," said a spokesman for the Apparel Manufacturers Association. "Not so the little guys ... many do not have the capital to support the additional demand Sears is making on them." A Sears spokesman defended the retailer's action as necessary to remain competitive. (see Footnote 4) Notice that Sears did not say they were going to formally renegotiate selling terms with each of their suppliers. They simply unilaterally decided to pay their bills 30 days late and see if they could get away with it. They did. Large companies manage their payables aggressively because they are in the power position and can get away with it. Smaller companies frequently assume that they have no such power. They are wrong and are as a result passing up good opportunities to affect their cash cycle through aggressive payables management. Let's take a close look at whether you should pay your bills early, on time, or late. Remember the basic payables objective cited earlier: to hold cash as long as possible without damaging credit relationships. There is obviously a trade off going on here. After all, if there were never any damages or penalties associated with paying late, the ultimate policy would be to never pay at all! But clearly that won't work, as eventually our suppliers would stop shipping, finance charges and penalties would become exorbitant and legal fees would be added to the ultimate bill. In fact, payment policies at either end of the extreme are unlikely to be optimal: never paying, or always paying every bill on time (or early) is likely to maximize total payables financing opportunities. If we paid every bill as soon as it arrived we would never have a penalty or finance charge and would be the darling of our suppliers. But neither would we get any financing benefit from our payables. What it comes down to, then, is this: - When should a bill be paid early? When the incentives for early payment exceed the benefits of holding the money longer.
- When should a bill be paid on time? When the benefits and costs for either early or late payment exactly offset each other.
- When should a bill be paid late? When the benefits of holding the money longer exceed the cumulative costs of penalties.
Each of these questions has a mathematical solution that measures the offsetting effects of the increasing costs of not paying against the benefits of holding on to our suppliers' money. Why do the costs of not paying increase? The increase in penalty costs over time is not linear. The increased cost of being two days late instead of one may be slight. But the increase in cost from day 30 to day 31 may be extreme, if on day 31 your supplier initiates legal action and imposes a finance charge. In fact, it is probably obvious that the longer your supplier waits, the angrier he gets with each passing day. The mathematics of figuring out when a bill should be paid may seem to be difficult, but in fact can be reduced to a relatively simple series of calculations. The "on time" situation, we will find out, is merely the case of "early" or "late" where everything comes out a wash. There are really only two questions: (1) "Should I pay the bill late? If so, how late?"
(2) "Should I pay the bill early? If so, how early?" Let's take a closer look. Should I pay the bill late? If so, how late? The informal approach First, we should recognize that we don't have to stretch all of our payments in order to have an effect on the average AAP. In fact, it is extremely unlikely that such a strategy would be optimal. Not all vendors are created equal. Our job is to figure out which ones are more equal than others. In doing so, there are practical rules of the game that have to be acknowledged: - Stated terms are irrelevant. Only actual practice counts in deciding who to pay and when.
- The question of who is more important to whom determines who gets to decide what the actual terms are going to be.
- Some suppliers' real terms can only be established through trial and error.
Let's look at each of these "rules" more closely:  Stated terms are irrelevant
Your author served a sentence as C.E.O. of a small wholesaling company in Nebraska and has the following illustrative data branded in his brain: The company had 3,600 accounts in 26 states, 13 sales representatives on the road and a secret in the accounting office. This was the secret (accounting clerks were warned by penalty of death to never tell the sales reps about this policy): Our computers were programmed to automatically write off to an "overage and underage" account all underpayments less than $10.00, including unpaid finance charges. It simply wasn't worth collecting a balance under $10.00. (Refer to the first part of this article for a discussion of why this might be so). Sure, the company made a pretense of assessing penalties and finance charges and every once in a while a customer actually paid them. (Why did the company even bother? The corporate attorneys warned that if the company did not assess finance charges against all late accounts, it would be unable to collect finance costs of large, seriously overdue accounts taken to court for payment.) But it was largely a bluff. Customers were too important for the company to bother them about the unpaid charges and minor errors of a few dollars cost more in clerical time, phone calls and postage to clear up than to write off. Of course, if the sales force had ever found out about the practice, they would have let their "special" customers know and there would have been an avalanche of payments $9.99 short.
Here is the rule: What the vendor states as terms for payment on the invoice doesn't count. Even finance charges assessed don't count if you never actually have to pay them. Further on in this article, a process will be suggested to test for real terms. But the costs and benefits associated with paying late (or early and taking discounts) must be assessed against the actual terms being enforced by the vendor. Who gets to decide depends on who needs whom?
Don't forget the Sears story. Sears was able to get away with their aggressive accounts payable management style because they are more important to their vendors than any one vendor is to them. Whenever you are trying to decide how assertive you can be with a vendor, ask yourself about your relationship in those terms. But the basic approach to determining how far you can stretch a unessential vendor is relatively simple. With the next invoice received, pay five days late. See what happens. If finance charges are assessed, don't pay them. See what happens. If nothing happens, pay the next invoice 10 days late. See what happens. Keep moving the payment date back until either (A) something happens or (B) you can't stand it any more. When you finally do get a polite call from your vendor asking for payment (or a polite note requesting that you remember their invoice), you have established the "safe" limits of their system. Until that first response, they didn't notice that you were late. Back off from that point by a few days and you now know their real terms—the terms that their system is programmed to enforce. By the way, pay no attention to statements. They are programmed to go out at a certain point in the month to all open accounts, regardless of whether they are late, early, way past or just past. Wait for a phone call or late notice. The formal approach It would be nice if every "Pay Late?" decision could be made simply with the informal approach outlined above. Unfortunately, some billing situations require a somewhat more sophisticated approach. When, for instance, should you go beyond the "safe" limits of their system and continue to withhold payment even though you have received the first polite request—and perhaps even a notice—for assessing penalties? The question is actually rather complex and involves some fancy mathematical footwork. Because the final decision is going to rest on some subjective factors, it is important for the small business manager to understand something of the underlying relationships that will dictate the final decision. First, therefore, we will review (in somewhat simplified terms) how some larger companies (with their armies of statisticians to figure some of these things out) approach the problem. For receivables and inventory management, however, we will find that there are some quick and easy approaches to the concept that (once armed with an understanding of the factors at work) the small business person can use to make a close-to-optimal decision. As stated before, the question of when to pay a bill is really one of balancing two offsetting factors: The increasing costs of lateness versus the benefits of holding on to money. The benefits of holding on to money for an additional period of time are probably obvious and moreover can be relatively easily calculated. The costs of not paying, however, are somewhat more subtle and can include subjective elements such as damaged relationships with key supplier and damage to one's business reputation. If we are to compare the two, however, we must use a mathematical basis of comparison. We cannot make a rational comparison, for instance, between a benefit measured in dollars and a cost measured in feelings. Somehow we must quantify both benefits and costs and put them in the same unit of measure (see Footnote 5). The unit of measure which we will use is that of a daily interest rate. Calculating the benefit of holding money in terms of a daily interest rate is indeed simple: just take the annual interest rate that you are paying for money you borrow short term and divide it by 360 days in a year. Call that your Daily Savings Rate. The relevant rate is the one that you are borrowing at, because if you can free up some cash you will have to borrow less and can therefore save at that rate. (Readers of the second part of this article will remember the financial concept called Opportunity Cost. Applying the concept of opportunity cost to a source of financing produces an Opportunity Cost of Capital—what you could yield from the money if you had it). If you are borrowing on a line of credit at, say, a 14 percent annual rate, then your Daily Savings Rate is .14/360 = .00039. That is the benefit you get from paying late. What about the costs? There are really two kinds of costs that are associated with paying later: direct costs and indirect costs. Direct costs are those that accumulate on a steady basis as a result of nonpayment past a due date. Finance charges placed on overdue accounts, for instance, increase at the same rate as the increase in lateness. They are therefore directly related to increasing lateness. These costs, all added together, can likewise be translated into a daily interest rate, which we will call the Direct Cost Rate. Suppose, for instance, that a supplier charges you 9 percent annual interest on late bills. Divide the annual 9 percent rate by 360 to yield a Direct Cost Rate of .000250. If that was all there was to the matter, the decision would be easy indeed. After all, if money costs us 14 percent a year and we are being charged only 9 percent for being late, we should always be as late as possible, ultimately never paying our bills. But, of course, there is more to the matter. Other costs, sometimes monetary, sometimes nonfinancial, increase indirectly as lateness increases. These other costs tend to increase at an increasing rate (as our supplier gets angrier and angrier, for instance; or as legal or collections costs are added to bills due). It is beyond the scope of this article to explain how large companies estimate indirect costs associated with lateness (see Footnote 6). What is important for the small business owner is to understand the nature of those costs and have some way of turning a subjective "feeling" into a measurable unit to make a rational decision about when to pay. The best way to do that is to develop a "vendor classification" system that places each of the company's vendors into a category based on several factors. Those categories can then be used to develop relative indirect costs associated with nonpayment and, in turn, an optimal payment date. The result of the classification decision is to identify an Indirect Cost Rate that is also expressed in terms of a daily interest rate. Consider what we now have: a Daily Savings Rate, a daily Direct Cost Rate and a Daily Indirect Cost Rate. Those three numbers can be combined to produce an optimal payment time for each vendor the company deals with. Here again, the mathematics get a little murky. The basic concept behind the formula, however, is this: The difference between the daily benefit and the daily direct cost is simple, as long as the cost is lower than the benefit then we should delay payment. But the difference is being constantly eroded by the effect of the daily indirect costs. We can find out how many days it takes to fully erode all the benefits by dividing the difference in daily benefit and daily direct costs by the daily indirect costs: Daily Savings Rate + Direct Cost Rate
Indirect Cost Rate The result is the number of days late a bill should be paid for optimal benefit to your company. Delaying payment past that time actually costs more than it saves. Let's take an example and see how this all works. Consider a service company (TBA, Inc.) with two vendors in need of categorization. The first vendor, a local hospital, provides a variety of laboratory tests and other services to TBA. The hospital is one of several in the area and competes with other hospitals and physician's offices to provide such services and maintain the contract with TBA. Transaction costs associated with switching to another provider, however, would be high, as client records would have to be transferred, a service contract would have to be renegotiated and many personal relationships severed. The hospital's bills are on NET 30 terms, with a 0.75 percent per month finance charge (9 percent annual rate) on past due accounts. The finance charges do not go away if they are unpaid. Past due accounts receive a form letter at 40 days (10 days overdue) and a phone call at 44 days (two weeks overdue). There is, however, little or no communication between the hospital's billing office and patient care services and the quality of service is not affected by the status of the client's account. The other supplier is a wholesaler of medical supplies. The medical supply house ships directly to TBA from a central warehouse in another state on NET 30 terms. They assess a finance charge of 18 percent per year (1.5 percent per month) if the bill is late, but if TBA doesn't pay the charge it disappears from subsequent statements. There are several other supply houses available and the cost to switch suppliers would be minimal (the cost of a few telephone calls, a credit application and reprogramming the computer for a new vendor). TBA has tested the system and the supply house sends its first request for payment in the form of a polite "reminder" letter at 45 days. A second letter arrives at 70 days and a phone call comes at 80 days. Shipments from the supplier continue uninterrupted, though the second letter indicates that if payment isn't immediate, shipments will be halted. TBA, incidentally, maintains a line of credit at a local bank on which it pays 12 percent interest. Interest rates have been dropping over the past six months, but TBA's rate is based on a contract that is only renegotiated annually. While both accounts are a judgment call, this author would classify the hospital account in Category B (High Cost) and the medical supply account in Category D (Low Cost). What are their respective optimal payment dates? Let's take it step-by-step: Step I - Calculate TBA's Daily Savings Rate
TBA has an Opportunity Cost of Capital of 12 percent/year.
Divide .12/360 = .000333. Step II - Calculate the Direct Cost Rate for each account
The hospital's Direct Cost Rate is found by dividing the annual rate (9 percent) by 360.
.09/360 = .00025.
The supply company's Direct Cost Rate is 0. Why? Because TBA has determined by experiment that they will drop any finance charges that TBA ignores. The real rate is therefore 0 percent. Ignore the 1.5 percent that they threaten. Step III - Assign a Category and choose an Indirect Cost Rate
If the hospital is assumed to be in the High Cost (B) category, then its Indirect Cost Rate is .0000095. If the medical supply house is in the Some Cost (C) category, then its Indirect Cost Rate is .0000075. Step IV - Calculate an Optimal Payment Delay Period
Using the formula, substitute the appropriate values: For the hospital, [.000333 -.00025]/.0000095 = 8.8 days. The optimal time to pay the hospital's bill is at 39 days (30 day terms + 8.5 late days = 38.8 days, rounded to 39 days). For the medical supply company, [.000329 - 0]/.000075 = 44.4 days. The optimal time to pay the supplier's bill is at 74 days (30 day terms + 44.4 days = 74.4 days rounded to 74 days). Of course, it would also be prudent to note when the final phone call is coming and back off several days from that as well. Are there companies that really go to this much trouble to decide when to pay their bills? First, it isn't as much trouble as it might seem. The calculations only have to be performed once (then only reviewed periodically to see if underlying assumptions have changed). After the optimal payment date is determined, enter the appropriate delay period into the payables system on your computer and the checks will simply be printed according to that schedule. What's that? You haven't yet installed (or even purchased) the accounts payable routine on your computerized general ledger system? DO IT! It will pay for itself in saved time and hassle in two months—or even less. Second, yes, companies really do go to the trouble because it pays off in lower interest bills (and higher profits) at the end of the year. TBA, in fact, really exists. Your author owns it. And the two accounts described are paid on the schedule calculated above. Should I pay the bill early? If so, how early? Now that we've finished the hard part, let's do the easy part—figuring out when to pay bills early. If discounts for early payment are offered, the critical question becomes, "Is the value of the discount greater than the cost of the money for the period of time under consideration?" Look at it this way: if you don't take the discount, you will be able to keep the amount owed for the period of time until you do pay the bill. You are effectively borrowing the money for that period of time at some interest rate. Figuring out the interest rate you are effectively paying and comparing it to other sources of borrowing is what matters. In the first part of this series, we found out that it is usually not worthwhile to offer discounts for early payment because the effective interest rate for the offer is usually higher than the cost of borrowing elsewhere. It takes no great leap of faith, then, to come to the conclusion that it is usually not wise to pass up a discount on the payables side of the transaction. Nevertheless, we may find occasion to do so. When calculating the effective interest rate for an offered discount, there are two essential rules to remember when making the calculation. - Remember that the real amount of the invoice is the discounted amount. If you receive an invoice for $100 with a 3 percent discount, the real price for the goods or services is $97. The other $3.00 is interest paid on using the money for an additional period of time.
- Remember that the amount of additional time you get to keep the money is measured by the real terms offered by the vendor, not the stated terms on the invoice. The only way you can measure the real terms is by experimenting, as we have already discussed in this article. Following these two rules, it is possible that some discounted terms would not be very attractive. Consider, for instance, the situation for TBA if the medical supply house were to offer a 2/10 NET 30 discount (they do). What is the effective rate being offered to TBA?
Step I - The real amount of the invoice is $100 - $2 = $98. Step II - The interest being paid is $2. Step III - The interest rate being charged is 2/98 =.0204. Step IV - The length of the "grace period" is from 10 days (when the discounted amount is due) until 74 days (the optimal payment day calculated earlier). The total grace period is 74 - 10 = 64 days. Step V - The "annualization factor" is 360/64 = 5.6 Step VI - The annual percentage rate being charged to not pay the bill early (keep the money and pay the $2 interest) is 5.6 x .0204 = .1 14 = 1 1.4 percent. Since that is less than the interest TBA is paying on its fine of credit (12 percent annually), TBA is better off passing up the discount! Summary It turns out that accounts payable offers some of the best opportunities to have an immediate and often substantial, effect on the cash cycle of the firm. It can be helpful to remember that increasing the length of the payables has the same effect on the cash cycle as reducing the inventory holding period. The essential questions to be addressed for effective payables management are: (1) "When should the company pay late? How late?" and
(2) "When should the company pay early? How early?" The answer to the first question is found by categorizing vendors and treating them according to their relative importance to the firm. The answer to the second question is sometimes best determined experimentally. A quantitative approach is possible when direct costs and benefits can be determined. The answer to the "Early?" question is primarily a matter of correctly calculating the effective interest rate of an offered discount and comparing it to the firm's short-term cost of capital. Perhaps the most important concept to be addressed in this article, however, involves the appropriate attitude taken by the manager of a small firm toward his or her vendors. Large companies (Sears was mentioned earlier) routinely assume an aggressive attitude toward their suppliers and demand (often very arbitrarily) extended payment terms. They can do so because they are in a power position relative to their vendors. Small firms too often cede control over their payables to their suppliers. While they may not be able to be as consistently aggressive as mass merchandisers frequently are, small companies can nevertheless adopt a more assertive stance and test the waters for delay opportunities before floating their checks toward the opposite shore. 1 A wholesale or retail company can find its average annual purchases by combining operating statement and balance sheet figures. Total Cost of Goods Sold (from the operating statement) plus changes in inventory (from last year's and this year's balance sheets) represent total purchases during the year. For instance, if a firm sells $250,000 of goods during the year with a 50 percent Gross Profit Margin, then total COGS must be $125,000. If inventory levels haven't changed in the past year, then everything that was sold was exactly replaced in inventory. COGS must therefore represent all the purchases during the year. If inventory went up or down, then either you purchased more or less than the value of what you sold. The change in inventory value therefore represents an adjustment to COGS to derive annual purchases. This analysis does assume that all purchases were for credit and that other, administrative purchases are relatively minor. Manufacturing firms must adjust COGS for materials and components versus the cost of labor, with the cost of labor not being a portion of purchases. Likewise, changes in inventory levels would have to take the cost of labor out relative to annual purchases. See the sidebar titled "How to Calculate the Average Age of Payables" for a step by step explanation. 2 If you find the ethics involved in "stretching" accounts payable to be questionable, then of course you will want to avoid the practice. It may still be helpful to read the remainder of this article, however, if for no other reason than to identify the elements in a seller-buyer relationship that may lead to your customers stretching their payments to you. 3 Note the use of the term "wealth maximization," which is a financial concept separate from "profit maximization." Although it is beyond the scope of this article, it is important to make the distinction. There are many short-term business behaviors and strategies that may maximize profits on this year's operating statement but that, in the long run, do not maximize the wealth of stockholders. Cheat your customers today and lose them tomorrow. Likewise, the concept of wealth maximization looks at total organizational value in terms of future cash flow benefits that accrue from today's decisions. Accounting records, being merely historical records of the past, cannot reflect increased wealth that derives from the expectation of future benefits. 4 Chicago Tribune August 15,1991. 5 A tip of the hat here to Ned C. Hill and William L. Sartoris, authors of Short-Term Financial Management (Macmillan, 1988). The mathematical relationship which follows borrows from their work. 6 There are several approaches to the problem. Hill and Sartoris suggest that indirect costs can be expressed as a coefficient of the square of the time the payment is stretched, making it a geometric function. Logarithmic and exponential functions can also be devised. The central concept, however, is always the same: indirect costs are nonlinear; that is, they increase at an increasing rate.
Calculating Average Age of Payables (AAP) - Average Age of Payables The third and final factor determining the firm's cash cycle is the offsetting benefit derived from the company's accounts payable. Inventory holding period and receivables aging combine to determine the firm's operating cycle and accounts payable offset a portion of that operating cycle to determine the cash cycle. A firm with a positive accounts payable balance, therefore, is using spontaneous trade credit (credit from suppliers) to reduce the effect of the operating cycle (AAI + ACP) on the cash cycle of the firm. The following is an explanation of how to calculate Average Age of Payables (AAP). Step I - Determine last year's total credit purchases
This number may not be easy to get at, as it does not appear on your balance sheet or operating statement. There are a couple of possible shortcuts, however. If you are a manufacturer, wholesaler or retailer, then the vast majority of your credit purchases are for goods or raw materials to manufacture your product. If you are a wholesaler or retailer, then Cost of Goods Sold (COGS) on your operating statement is a good approximation of total credit purchases if all your suppliers ship on credit. If some goods are received COD, you should check your shipping records and remove from total annual COGS the dollar value of COD goods received. If you are a manufacturer, then you must estimate what portion of the COGS is labor and what portion is raw materials. Remove that portion of COGS that represent the cost of labor and the remaining is a good approximation of credit purchases. If you receive many purchases COD, then you too must remove those from the total to yield annual credit purchases Example: Suppose that last year's year-end operating statement shows: | Sales | 1,000,000 | | Cost of Goods Sold | 50,000 | | Gross Profit | 450,000 |
Suppose that 40 percent of the cost of producing your product is labor, which means that 60 percent of the cost must be materials. Multiply the COGS shown on your operating statement by the portion of costs that is materials: $550,000 x.60 = $330,000. Suppose also that a random check of your receipts for several months shows that about 15 percent of all receipts (in terms of dollar value) is shipped to you COD. The 85 percent of materials must have been received on credit (100 percent - 15 percent = 85 percent). Multiply $733,000 x 85 percent to estimate total annual credit purchases at 330,000 x .85 = $280,500. Step II - Determine Last Year's Average Monthly Accounts Payable Balance
Add up the month-end payables figures on each of last year's months-end balance sheets and divide by 12. Use a monthly average to avoid seasonal variations that would distort the numbers. Example:
| January | $23,000 | | February | 24,500 | | March | 22,300 | | April | 26,850 | | May | 25,975 | | June | 23,000 | | July | 23,500 | | August | 24,000 | | September | 21,000 | | October | 20,500 | | November | 22,250 | | December | 24,000 | | Total | $280,875/12=$23,406 |
Step III - Find the Accounts Payable Turnover Rate
Divide the year's total credit sales (from #1 above) by the Average Accounts Payable balance (from #2 above) to yield the annual accounts payable turnover rate. This number represents the number of times that you paid the complete value of your accounts payable during the year. Example: Suppose your annual credit purchases were $280,500. If your average payables; balance is $23,406, then Payables Turnover is $187,000/23,406 = 12.0 times. Step IV - Calculate the Average Payment Period (APP; also referred to as Average Age of Payables, AAP)
Divide the Payables Turnover Rate from Step III into the number of days in the year (360). Example: If the payables turnover rate is 12.0, then the average age of the payables (the average number of days that an invoice from one of your suppliers remained unpaid) is 360/12.0 = 30.0 days. Calculate your company's cash cycle by adding together the Average Age of Inventory (AAI) and Average Collection Period (ACP), then subtracting the Average Age of Payables (AAP): Cash Cycle = AAI + ACP AAP
But Is it Ethical to Pay Late? Those who are concerned about the ethics of testing the patience of suppliers should give themselves the pleasure of reading the works of Fredrich A. von Hayek, the University of Chicago Nobel laureate in economics (1963), who makes an important distinction between "personal altruism" and what he calls "rules of the extended order." Personal altruism, he argues persuasively, is often misdirected and even dysfunctional in an economic context and can actually lead to behavior which is more harmful to the economy (and thus the community and its aggregated individuals) in the long run. Hayek suggests, for instance, that the injunction to treat all men as neighbors and further, to treat your neighbor as yourself, may be an appropriate personal, altruistic standard. But in the interactions of the "extended order" such a standard of behavior would have prevented the growth of the economic order itself. "For those now living within the extended order gain from not treating one another as neighbors and by applying, in their interactions, rules of the extended order—such as those of several property and contract instead of the rules of solidarity and altruism. An order in which everyone treated his neighbor as himself would be one where comparatively few could be fruitful and multiply." One of the more pervasive altruistic notions that frequently creeps into discussions of business ethics is that competition is a "necessary evil" and should be curbed by cooperative efforts whenever possible. "One revealing mark of how poorly the ordering principle of the market is understood is the common notion that cooperation is better than competition. But it is "through further competition, not through agreement, we gradually increase our efficiency." Hayek recognizes that making the distinction between personal ethics and abiding by the "rules of the extended order" is not always emotionally comfortable. "Part of our present difficulty is that we must constantly adjust our lives, our thoughts and our emotions, in order to live simultaneously within different kinds of orders according to different rules." An article in the December 24, 1991 Wall Street Journal made a similar point. In "The Munificent Ebenezer Scrooge' Kenneth Cowans points out that, given the economics of the early industrial revolution of England in the 1830s, Ebenezer Scrooge did far more for the Bob Cratchits of the world by behaving as a stingy miser than he ever could have done as a beneficent philanthropist. "It is difficult to appreciate just how powerful capital was in the early Industrial Revolution ... One or two pounds of sterling invested in an engine could thus produce 10 to 100 times that amount in usable goods the year after. Then the capital so generated could be reinvested to produce thousands the next year and so on." A basic principle of Finance is that efficient capital markets allow individual consumers to make personal choices concerning their consumption preferences over time. The decision to consume today necessarily means choosing not to have resources available for future consumption. In an economy (such as Scrooge's) in which real asset investments could produce huge increases in efficiency, the decision to consume today meant the decision to not have available for consumption 10 to 100 times as much tomorrow and 1000 times as much the day after tomorrow. "England was the birthplace of the Industrial Revolution from which all of us alive today benefit. The wealth generated by that revolution finances our contemporary welfare states. But we should remember that the Industrial Revolution was not the product only of scientists and engineers. The hardheaded businessmen like Ebenezer Scrooge who took this year's output and directed it to generating more the year after deserve no less credit. Ethical decisions in business are those that lead to wealth creation for our society. When an individual business owner tests to determine effective payment terms (such as is recommended in this article), that manager is operating competitively to maximize the wealth of the firm's shareholders. Wealth so accrued is available for reinvestment in the next cycle and produces in rum more wealth. Today's rates of return on real asset investment may rarely match those in Ebenezer's day, but that is no excuse for economically inefficient behavior. Personal ethics (altruism towards one's fellow man) and business ethics are frequently confused but the difference is easily understood. For some reason we seem to have no trouble recognizing, for instance, that a football player's "hard hit" bears no personal animosity toward the opposing player and enhances the game for all concerned. Those are the rules by which that game is played. Ever see a player turn around and offer a hand up to the opposing player he has just knocked down? Therein lies the difference between the rules of the extended order and personal altruism. "Hard hits" in business likewise enhance value for all concerned.
Developing a Vendor Classification System There are any number of factors that can be included in a Vendor Classification System, depending on the nature of your business and what you consider important about relationships with vendors. All, however, rest on a common assumption: Not All Vendors are Created Equal. Some vendors are more important than others. Now, just about anything that is said here about the relative importance of one type of vendor over another is likely to be offensive to someone. The reader is therefore warned that, if his or her business falls into a category about to be pronounced "less important," no offense is intended. The fact cannot be avoided, however, that some types of business are more susceptible to "substitution" than other types. Consider, for instance, the situation of a small manufacturing company known to your author here in central Nebraska. The company, PMZ, Inc., produces a short line of 14 consumer products that are assembled on piece rate and sold to women's fashion wholesalers and mass market retailers throughout North America. The firm manufactures for and ships from inventory (rather than to order) and competes with half a dozen other firms in the country offering similar merchandise. The products manufactured are themselves assembled from components made by other manufacturers throughout the United States. In fact, in order to produce the 14 products and two display groupings offered by the company, materials and components must be ordered from over 45 separate suppliers throughout the nation. In addition, the company has the usual array of professional and retail suppliers of services and materials in order to keep itself in business. These amount to an additional 30-plus accounts on the payables system and range from the corporate attorney to the local gas company to the suppliers of office equipment, pencils and paper clips. PMZ has assigned each of its suppliers to a category based on the relative indirect costs associated with late payment of their invoices. Why indirect costs only? Remember that we have already accounted for the direct costs of nonpayment. Indirect costs include only those items that tend to increase at an increasing, and frequently unpredictable, rate. But PMZ keeps it simple: there are really only two indirect cost categories: High and Low. The first category in the list is labeled Priority, and includes vendors for whom the "costs" (not all financial) associated with nonpayment are so extreme that no late payment can ever be tolerated. The last category is labeled No Effective Cost, which means that the costs are so low or inconsequential that they cannot be considered at all. We will need another means of determining optimal pay dates for these vendors. The two middle categories of Some Cost and High Cost are the two bins into which most vendors must be separated: A. Priority
Supplies critical components or materials or a quality of output that cannot be obtained from any other source: Irreplaceable. Holds a patent or special license that is required for the reproduction of our product. Maintains a unique or personal relationship with you (the business owner) that merits special consideration. B. High-Cost
Supplier is a member of a professional association or a major supplier in an industry and provides credit information to others. Finance charges and penalties for late payment are assessed and enforced. You depend on the good opinion of this vendor's accounting manager or owner to place your orders ahead of those of your competition. There are high transaction costs associated with switching to another supplier. C. Some Cost
Penalties or finance charges for late payment are assessed but enforced on an irregular basis. Receive reminder call before outer limit, but no finance charges or penalties imposed or enforced up to outer limit. Relatively low transactions costs associated with switching sources of supply, or this source of supply is assured to you for other legal or contractual reasons. The level of service you receive from this company will not vary with the opinions of the accounting managers. D. Low Cost
No finance charges or penalties are assessed for late payment. Never or rarely received a call or notice for late payment up to the outer limit. Many alternative sources of supply available with the same or similar quality, pricing and service. No or very low transactions costs associated with switching sources of supply. The products or services provided by this vendor are not of critical importance to the line operations of the company. Notice that the criteria for the four categories are largely subjective. Remember that this categorization process is a substitute for a strictly quantitative, statistical process to determine indirect costs rates used by large firms with more sophisticated resources in their accounting office. For the small firm, it is important to include indirect late-payment costs and this method of developing categories is a way to apply some consistency and rationality to the process. Categorization systems may, of course, be more complex and include several levels of costs rather than the two used here: High Cost and Some Cost. But the vendors placed in the cost categories must be assigned some (arbitrary) indirect cost rate to use in conjunction with the direct cost and opportunity rates for late payment. The arbitrary rates used by PMZ are: - .0000075 for Low Cost vendors,
- .0000085 for Moderate Cost vendors, and
- .0000095 for High Cost vendors.
PMZ places each of its vendors in one of the four categories. Category A companies ("Priority") are never paid late. Category B, C, and D companies ("High Cost," "Moderate Cost," and "Low Cost") are paid late according to the optimal timing formula, with subjective adjustments made according to the experimental method described in the article. Let's see how PMZ has categorized some of its suppliers. Remember, this is a subjective process based on your perception of costs and relative importance of different suppliers. Just because PMZ has placed one type of supplier in a particular category doesn't mean that you will do the same: - Mike's Metals Category A: Priority
Mike's is a metal fabricating company in Rhode Island that produces the basic "findings" that are central to the manufacture of most of the products assembled by PMZ. PMZ works with a second metal fabricating company for some minor components only to have a secondary source of supply should anything happen to Mike's, but Mike's company is critical to PMZ's central line manufacturing operation. Timing is critical as well, and Mike's is a small, family-run business where the owner's knowledge of PMZ's payment history affects his willingness to respond quickly in cases of special needs. Mike's is always paid on time.
- Ed's Electroplating Category C: Moderate Cost
A metals finishing company in New Jersey that electroplates gold and silver finishes on the metal work produced by Mike, this operation is easily replaced by other firms. Companies that do high-quality electroplating in precious metals are easily found and are looking for business, but there would be some significant transaction costs associated with switching. They do assess some finance charges, but PMZ ignores them and they are routinely written off. PMZ's jobs are just one more batch in line for processing and would only be affected in priority in the case of extreme nonpayment leading to order rejection.
- Pete's Plastics Category A: Priority
This is a packaging company in Lincoln, Nebraska, that produces thermoform plastic containers. They use all recycled plastics and certify their product as recycled, which meets the requirements of a major mass-market retailer that PMZ sells to. On all other counts Pete's would be category B, but the recycled plastic availability makes them a critical supplier. PMZ's largest customer demands such assurance and recycled plastic raw material is in short supply.
- Lisa's Letterpress Category D: Low Cost
This is a printing company in central Nebraska that produces PMZ's package "inserts," small instructions placed in the package along with the products. They assess no finance charges or penalties, send out no statements, and are one of a very large number of suppliers of such services in an industry with plenty of competition. They could be replaced tomorrow merely by taking the art work down the street.
- Ole's Office Products Category D: Low Cost
Athens accommodationA mail-order office supplies company that ships directly to PMZ such items as printer ribbons, paper clips and other office supplies.
- Tom's Telephone Category B: High Cost
black jack estrategiaIf you don't believe there really are such things as small, one-town telephone companies providing only local service to a community of 1,500 people, then you don't live in Nebraska. If a late bill goes past a certain date, phone service can be cut off, necessitating reconnection charges and resulting in lost business and customer service costs as well. In addition, increasingly late payments will be reflected in credit records that are reported to credit agencies, which means increasingly poor credit ratings for PMZ. Besides, Tom's is the only game in town. While they are not "priority" in the sense that the quality of their service will not vary according to PMZ's payment history, and service will be restored when a bill is paid, there are clearly increasing costs associated with late payment.
- Lea G. Elbeat, Attorney at Law Surprise! Category D: No Effective Cost
Lea assesses no penalties for late payment and appears to be blissfully unaware of when her clients pay their bills. Her office has never called about a late payment and never even sends out statements (only invoices). Although there is undoubtedly some point at which Lea would be less motivated by late payment, that point appears to be well beyond PMZ's "outer limit" (see below).
Since PMZ knows that all its bills must be paid eventually, what is really necessary is to decide which ones can be pushed maximally and which ones should be given immediate attention. Immediate attention (Priority) is clearly defined: pay according to terms (we have not yet addressed the question of "Pay Early?") But what does "Push to the limit" mean? In order to place these vendors along some relative scale, we must know the other end of the scale. In other words, what is the "outer limit" for payment? Ten days late? 20? 30? 60? That question cannot be answered except by yourself as you consider all the factors for categorizes vendors. PMZ has established its "outer limit" at 30 days late. In other words, regardless of the actual behavior, financing charges, penalties or lack thereof for any supplier, PMZ will never pay a bill more than 30 days late. How To Calculate the Cost of a Discount Step I - Pretend the invoice is for $100. If you applied the stated terms to the $100 invoice, how much would you owe if you paid the bill early? Example: If the terms are 5/10, NET 30, you would pay $95 if you paid the bill early (after 10 days). Step II - Subtract the amount in Step One from $100. The difference is the amount of interest you are paying to keep the money a few days longer. Example: $100 - $95 = $5. You are paying five dollars interest to keep the $95 for an extra 20 days Step III - Divide the interest paid by the amount due now to get the interest rate for the grace period. This is not the annual rate, only the rate for the short period of time you get to use the money. Example: Divide $5 by $95. 5/95 = .0526. That is the interest rate for the grace period only. If the terms are 2/10 NET 30, you are dividing $2 by $98 = .0204. Carry your calculation out four decimal places. Step IV - Determine the length of the grace period (how many "grace days" you are giving up by paying the bill early). Subtract the early payment date from the final due date. (Note: Calculate this based on the vendor's real terms, not the "stated" terms. If it says NET 30, but you know from past experience that they will allow 45 days with no penalty, then use 45 as the final due date). Example: Terms of 1/5 NET 30 provide 30 - 5 = 25 grace days. If you know that you can pay in 40 days with no penalty, then the grace days are 40 - 5 = 35. Step V - Divide the number of grace days into the number of days in a year to get the "annualization factor" to turn the interest into an annual rate (360 days is close enough and easy to divide into). Example: If you have 20 grace days (terms of 2/10 NET 30), then 360/20 = 18. The "annualization factor" is 18. Step VI - Multiply the interest rate you got in Step Three by the annualization factor from Step Five. Multiply that result by 100 to convert it to a percentage. The result is the annual rate of interest that you are paying (or receiving) to offer (or take advantage of) early payment terms. Example: For 2/10, NET 30, multiply .0204 by the annualization factor of 18 = .3673 = 36.73 percent. For 5/5 NET 30 with actual payment due in 45 days, multiply .0526 by the annualization factor of 9 (360 divided by 40 grace days) = .4734 = 47.34 percent. If you need help with financial management issues, contact your area Small Business Development Center. > See also: Capital, Credit & Dept Management | 
