Working Capital Optimization: Understanding Your Options

Scott Pezza

Part 2 in a 3-part series. Read Part 1 and Part 3.

This series focuses on how to get started on an effective working-capital optimization initiative. 

Our last blog concluded with an example of how you can harmonize the goals of procurement, finance, and treasury to pay suppliers early with an efficient invoice-approval process – and a supply chain–finance relationship to hold onto your cash, as well. Even in that simple example, there are multiple types of functionality at play that may exist in several different interconnected systems. In this blog, we’ll look at all the pieces that can be brought together to effectively manage your working capital and achieve your desired goals.

Your options

Net-payment term management. Net-payment terms are typically housed right within your ERP system. Your standard terms live in supplier master data and are included in contracts and on your outgoing purchase orders. Extending net terms is your main way to hold onto cash longer and improve your days payable outstanding (DPO). Doing so requires accurate supplier contact data, clear messaging, and a clear analysis of industry and peer comparisons to find the right number for various supplier groups.

Static early-payment discounts. Another piece of information typically housed in your ERP system, these discount terms apply to every payment to a particular supplier and take a standard form – for example, 2/10 Net 30. Because they apply to every supplier payment, they can have a significant negative impact on your DPO. That said, by working with treasury to ensure that the discounts’ APR is higher than your WACC, you can make sure the use of cash is a net positive. The drawback of ERP-managed static terms is that they are inflexible. Paying beyond day 10 in a 2/10 Net 30 scenario yields no discount, and paying on day 1 yields the same discount as on day 10.

Sliding-scale discounts. An advance on the typical ERP approach, this discount option is typically managed via an add-on solution. Sliding-scale discounts calculate a decreasing face-value discount for each day beyond the initial discount period. For example, 2/10 Net 30 provides a 2% face-value discount on Days 1 through 10, 1.9% on Day 11, 1.8% on Day 12, etc. In some scenarios, you can also have higher discounts on earlier days, such as 2.5% on Day 5. These terms are still static in nature, as they apply to every payment, but they are flexible enough to ensure that you always derive some benefit from earlier payment.

Dynamic discounts. This option gives your suppliers a choice to accept a discount for earlier payment on a transaction-by-transaction basis. They can be integrated with your ERP and use a series of automated supplier communications, responses, and ERP integrations to execute. Dynamic discounts come in two main varieties:

  • Buyer-initiated discounts: For suppliers that do not wish to accelerate every payment, this allows you to automatically offer early payment upon approval of an individual invoice. The supplier can then choose whether or not to seek acceleration.
  • Supplier-initiated discounts: Mirroring the buyer-initiated option above, this allows suppliers to solicit early payment at terms they suggest without your having to make an initial offer. When combined with a buyer-initiated program, this functionality allows suppliers to make counter offers if they are interested but found the initial terms undesirable.

Supply chain finance (SCF). This is another option that can be integrated with your ERP system. Like buyer-initiated discounts, an SCF platform shows suppliers which invoices have been approved and lets them elect to be paid early at a discount. The distinction is that the supplier would be paid early by a third-party financial institution (FI), and you would update their payment records to pay that FI (rather than the supplier) at the original net-term maturity date. These programs offer suppliers cash at very attractive interest rates because the FI sets terms based on your creditworthiness, which is typically superior to that of your smaller suppliers.

Supplier finance. Like SCF, supplier finance allows suppliers to borrow against approved invoices (or executed purchase orders). It is different in that you do not select the FI to do the funding, and the supplier may – depending on the platform used – be able to access funding from multiple sources. Because these options are based on their ability to repay, the effective rates suppliers incur are far less favorable than with SCF programs.

Card-based payments. For the long tail of your suppliers that are too small or infrequent to justify addressing with the options above, card-based payments can be a great option. They bring three big benefits:

  • Your supplier is paid on time.
  • You hold onto your cash until you settle your monthly card statement.
  • This option can yield rebate income similar to what you would achieve through a discount.

Suppliers will incur interchange fees so they won’t receive the full value of their invoice, but they do get the benefit of prompt payment.

Quick summary: Buyer and supplier impact of functionality options

Functionality DPO Impact Discount Savings Impact Supplier Impact
ERP Net-Term Management ↑↑↑
ERP Discount-Term Management ↓↓ ↑↑
Sliding-Scale Discounting
Dynamic Discounting ↑↑
Supply Chain Finance ↑↑↑ ↑↑↑
Supplier Finance
Card-Based Payments

Wrapping it up

When looking to optimize your working capital and keep procurement, finance, and treasury aligned, you have a whole host of options at your disposal. By combining different approaches to best address different segments of your supplier base, you can craft a comprehensive strategy to keep suppliers paid on time (or early). At the same time, you can optimize your cash on hand and hit your discount-based savings goals.

But technology alone isn’t enough. Stay tuned for our third and final installment in this blog series to learn some tips and tricks to effectively implement and execute on your working-capital optimization program.

Get more information on optimizing working capital through payables, receivables, and inventory management.

Get more information on aligning procurement, finance, and treasury teams to optimize working capital management.

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Scott Pezza

About Scott Pezza

As part of SAP Ariba's Digital Transformation Organization's Center of Excellence, Scott researches, compiles, and shares best-practice information to help SAP Ariba's customers get the most out of their investments. He has a dual focus on the emerging technologies (AI/ML, IoT, Blockchain, etc.) across the source-to-settle cycle, as well as a specific interest in the financial supply chain (invoice management, payments, discounting, and supply chain finance). His research helps inform strategic planning, performance measurement, and program execution. He has spent the past 17 years in the B2B technology space, in roles ranging from software development and support to research and consulting. Scott earned his BA in English and Philosophy from Clark University, his MBA from Boston University Graduate School of Management, and his JD from Boston University School of Law, where he served on the Executive Board of the Annual Review of Banking and Financial Law.