Estimated reading time: 7 minutes
In December 2021, the Financial Accounting Standards Board (FASB) updated its accounting standards to boost transparency around supply chain finance (SCF). SCF is also known as reverse factoring, payables finance, or supplier financing arrangements.
The new FASB requirements, which will begin to enter into effect in 2023, require buying organisations that use financing programs to disclose a more comprehensive array of information about their program.
Among other requirements, these disclosures must include:
- the key terms of the program,
- the buyer’s outstanding balance with suppliers in the program, and
- the location of that amount on the balance sheet at the end of the reporting period.
As the market adopts FASB directives, it raises an essential question for corporate treasury and procurement regarding how payment terms are determined from a financial asset perspective.
We should first look at the sophistication of capital markets when valuing and marking assets to market as the guiding principle.
Once this has been accomplished, we can follow the disciplined guidelines to adhere to the best practices adopted by companies. This approach is better than simply relying on increased disclosure.
Finally, we look at the broader corporate question of generally establishing a payment terms strategy.
Mark to market
Mark-to-market is an accounting practice that involves adjusting the value of an asset to reflect its importance as determined by current market conditions. In securities trading, mark-to-market consists of recording the value of a security, portfolio, or account to reflect the current market value rather than book value.
It is difficult to dispute that working capital is a precious asset and can be considered the lifeblood of a business. This raises the question of why working capital is not marked to market in the same way as other asset classes.
Companies can use three primary levers to manage working capital efficiency: inventory, receivables, and payables.
Inventory management is critical with companies relying on purchasing inventory and managing sufficient levels of goods in their warehouse.
Inventory has emerged as a key sticking point in the operating cash cycle of a business. Applying long inventory levels with inventory purchases strategically timed so that the materials arrive no earlier than necessary is critical and can improve working capital.
It is fair to say in the current supply chain backdrop that managing inventory availability is the primary matter.
Receivables are the easiest level to understand from the perspective of accelerating cash by rigorous management of the receivables book or collecting outstanding payments.
Nevertheless, collecting on receivables becomes much more difficult in times of economic turmoil: when clients struggle to pay their bills on time, but they would never admit to it.
Another strategy to reduce receivables levels—credit risk permitting—is to sell the receivables to a willing financier at a discounted price.
Payables are much more sensitive than receivables discounting.
Optimising payables and payment terms to suppliers can free up significant working capital, but it can also do irreparable damage to the supply chain if done improperly.
Marking to market
Reverting to the idea of marking to market your working capital: the key is to use an objective and universal data signal to benchmark working capital efficiency and performance.
This data point is payment terms applied and used by trading partners.
The advantages of incorporating market-derived data signals when setting and applying payment terms can be so powerful it is somewhat surprising it has yet to catch on in procurement and treasury.
FASB disclosure guidelines
When it comes to payment terms, there are questions abound.
What is a fair and reasonable payment term in the pharma industry versus the retail or mining sector?
Do my terms align with industry norms?
Do some suppliers need longer payment terms than the rest?
Should I give it to them?
Where is my bearing point?
What impact will sustainability and environmental, social, and governance (ESG) initiatives have on my working capital and my suppliers’ working capital?
There is no easily defined answer to any of these questions. Business leaders must examine market signals and conditions in conjunction with the current best practices in their space.
They can use any gathered insights to help them understand how best to ingest, absorb, and analyse the vast number of data signals required to give a corporate a defensible payment terms policy.
The volume, velocity, and variety of data have increased dramatically with the rise of technology.
As a result, we’ve seen spreadsheets in board rooms with vast amounts of data, formulas, and hundreds of sheets. Often, however, spreadsheets are unsuitable for such large and complex analyses, requiring businesses to turn to specialised programs and experts with the skill set to operate them.
One step at a time
While greater disclosure may be the gold standard for determining behaviour and transparency in payment terms, it may be a step too far—for now.
In the interim, the industry should establish a market-driven and data-signalling infrastructure that provides the framework to develop acceptable payment terms and working capital efficiency for all participants.
Returning to the FASB directives, transparent balance sheet disclosure is welcome; however, it does not solve the issue of determining acceptable payment terms in a given market, industry sector, commodity, or country.
By default, ‘disclosure’ is past tense.
This means it will not solve real-world challenges in real-time.
For example, take the forecasted demise in the just-in-time (JIT) inventory model due to the massive and ongoing supply chain disruptions.
Today, many corporates are trying to determine the optimal ratio of JIT Inventory versus just-in-case (JIC) inventory. Suppliers that are more discretionary are better prepared for the next external disruption.
Through these efforts, companies are looking to be better prepared not to be caught off-guard in the future by a lack of raw materials or port shutdowns.
According to the IHL Group, a global research and advisory firm for the retail and hospitality industries, the actual cost of inventory distortion—such as stockouts and overstocks—is expected to be over $1.9 trillion in the retail sector alone in 2022.
JIT is at the core of this inventory distortion alongside production located in just a small handful of countries. Nearly $1 trillion of the $1.9 trillion inventory distortion issue resulted from a JIT inventory system that relied too heavily on production in a small handful of countries.
If this is accurate, we have a significant change ahead in how global supply chains will work and be used as a competitive advantage in the coming years.
Part of that change will be establishing parallel supply chains in a wider geographic footprint.
System change means capital investment.
Capital investment requires working capital.
Working capital requires optimising inventory, receivables, and payables.
Reducing receivables and increasing payables requires optimising and aligning payment terms to the market.
This is all circular and requires real-time market-derived analytics as a necessity rather than a nice-to-have.
If the path to excellent supply chain resiliency requires more countries in the sourcing mix and parallel redundancy in supply chains, then part of the great analysis reset must include current working capital models and payment terms.
These must be considered across multiple jurisdictions, commodities, and sectors and look at how payment terms create maximum working capital efficiency for the corporate buyer and its supply chain.
Only the market can approximate the truth of the current situation upon which to base a future direction.
Spreadsheets and outdated payment terms trapped in contracts are not the paths through the current supply chain challenges regarding working capital conversations.
The solution is a universal, global payment terms market allowing corporates and their trading partners to mark themselves to their markets in real-time and gain a competitive advantage.
One example offering market data insights on payment terms is Miami-based Fintech company, Calculum. The company is deploying mark-to-market analytic capabilities for payment terms using the capital markets model as a guiding principle.
Treasurers and procurement leaders must own the agenda on payment terms from a market perspective rather than leave it in the hands of regulatory overseers to maintain flexibility in generating working capital for their business and supply chains.
The solution to optimising working capital—while adhering to market-accepted boundaries and market standards for any given industry or commodity—is a dedicated and purpose-built database fed by the market and leveraging AI to provide constantly updated data.
This database should provide insight to companies and their trading partners on the appropriate payment terms that reflect current market conditions.
The precedent already exists and has so for multiple decades.
That precedent is the capital markets that provide clear, reliable signals on multiple assets’ price, availability, and direction.