Why would you pay early?

The Joy of Paying Early
Roy S. Ryniker

Traditional working capital management techniques state that a company can improve its cash flow by delaying paying its bills, allowing the company's creditors to in effect provide the required financing. However, for companies with the available liquidity, paying bills faster—and not just taking the discount, but making advance payments—can significantly improve profitability and ultimately cash flow.

An Advance Payment Plan creates value by allowing the company that makes the advance payment to capture some of the spread between their low borrowing costs and their vendors' higher cost of capital.

How does it work? To illustrate the advantages of the Advance Payment Plan, let's examine three alternative payment plans for acquiring a product with a $100,000 cost:

Case One: Take No Discount Plan—pay the $100,000 in 30 days after delivery.
Case Two: Discount Plan—Take a 2 percent discount and pay for the product in 10 days.
Case Three: Advance Payment Plan—Take a 5 percent discount by paying for the product when you order it, which is assumed to be 30 days before it is delivered.

Base assumptions for the comparisons of the three cases:

1. Your company's cost of borrowing is 4 percent annually.
2. Interest income is earned at the rate of 4 percent annually based on the assumption that available cash is used as a principal repayment on your company's line of credit.
3. That cash is available to make the payments under the three alternative payment plans.

Case One: Take No Discount
You pay for the product in 30 days at the full price of $100,000. You have the advantage of earning interest income on the $100,000 for the full days 30 days, plus the additional 30 days you have the funds compared to Case Three–Advanced Payment Plan. Total interest income for the 60 days is $658, so the effective cost of the product is $99,342 ($100,000 minus the $658 interest income).

Case Two: Discount Plan
Take standard vendor terms of 2 percent/10, net 30 days on a $100,000 purchase. That means the product costs $98,000 if you pay in 10 days. If you don't, the seller is charging you $2,000 interest for the additional 20 days that you're holding the payment. To make a valid comparison with Cases One and Three, from the $98,000 net cost you need to deduct the $443 interest income you would have earned (the total of the interest income on $100,000 for 40 days and on $2,000 for 20 days, assuming you paid for the product in 10 days, not 30 days). The effective cost of the product is $97,557.

However, if you can save the $2,000 by paying for the goods in 10 days, what would the savings be if you paid in advance for the goods? Let's assume that your vendor has a high cost of capital. By taking your advance payment and using it to take discounts offered by some of its suppliers, the vendor is able to lower the price of the goods sold to you. But how much are the lower costs to you?

Case Three: Advance Payment Plan
Suppose you went to the vendor and proposed paying 100 percent of the purchase price 30 days in advance. How much of a discount would you get? If the vendor were offering you a 2 percent discount for paying 20 days early, it would not seem unreasonable to assume a 5 percent discount for paying 40 days early. (You'd be paying 30 days in advance plus the 10 days normal pay-period allowance to get the discount total to 40 days.) The same $100,000 product now costs $95,000. To adjust for comparison with the other cases, you would have had interest income of $33 (that $5,000 for 60 days). Now the effective cost of the product is $94,967. If you think a 5 percent discount is too aggressive an assumption, try this: At only a 3 percent discount under an Advance Pay Plan, the effective cost of the product is $96,980, which still represents a savings from the 2 percent Discount Plan, even after adjusting for the cost of capital.

Case Comparisons
The effective cost of the $100,000 product under the three cases is:

Case One (No Discount) $99,342
Case Two (Discount Plan) $97,557
Case Three (Advance Payment Plan) $94,967

The earlier you pay for the product, the greater the cost savings, even adjusting for the cost of capital. Going from Case One to Case Three, the cost savings total is $4,375, which is 4.4 percent of the $100,000 stated product cost. Pay early and realize the largest savings.

If your company could lower its product costs by 4.4 percent, why not attempt to establish an Advance Payment Plan? One case where you want to be careful is if there is credit risk involved. However, that risk can be somewhat mitigated by only doing the Plan with vendors you are comfortable with as a credit risk. If vendors you offer the program to are not willing to offer the larger discount under the Advanced Payment Plan, your company can just continue under the current vendor payment terms. The challenge is not to change what is, but rather, to create what isn't. Proactively present the Advance Payment Plan to your vendors and see what develops.

The Advanced Payment Plan can be mutually beneficial, as the vendor benefits from an improved cash flow and your company benefits from reduced pricing. Adjusting your working capital management plans entails some inconvenience, but establishing an Advanced Payment Plan could significantly improve a company's profitability and ultimate cash flow.