Late Payment and the Case for Legislation
Irrespective of the reasons we ascribe to a build-up of debtors and working capital investment in any economy, it seems reasonable to conclude that:
- Historically, creditor firms have set discounts to entice all customers to pay cash, including those with high opportunity rates.
Faced with cash shortage and ineffectual collection procedures:
- Many customers who forego the discount offset the resultant cost (or where discounts are not offered, increase the benefit of trade credit) by unilaterally extending the payment period.
Unfortunately, both strategies have two unfortunate effects.
- They perpetuate the myth that customers who do not take cash discounts, or pay late, are poor credit risks.
- Where collection policies are lax, this may be financially sub-optimal.
The consequential costs of credit mismanagement obviously represent a significant drain on working capital throughout the economy. But without detailed internal information on corporate cash flows and the firm's opportunity cost of capital this is impossible to quantify.
To resolve the dilemma, we can therefore make a strong case for government intervention and legislation to encourage a cultural change, so that paying late is unacceptable.
The UK first introduced late payment rules for charging interest on overdue company accounts into law, way back in 1998. This was reinforced in 2002 by a European Union (EU) Late Payment Directive, which created a statutory right to interest 30 days after the date of invoice. In 2011, the UK government also announced that in 2012 it would fast track the introduction of a revised EU Late Payment Directive, scheduled for implementation by other Member States in March 2013.
This new legislation not only increases the right to interest on overdue accounts, but also harmonizes standard payment terms throughout the EU for the first time. The Directive sets 30 days as standard terms for all public and private entities. These can be extended to 60 days when suppliers have specifically agreed to provide customers with this facility. The late payment rules now allow companies to charge 8 per cent interest on overdue accounts, as well as a minimum 40 euro administrative fee per invoice to recover bad debts. In the UK the government has been even more generous. It allows companies to add the Bank of England base rate to the late payment percentage (0.5% at the time of publication) plus an administrative cost ranging from £40 to £100 per invoice.
So, how will the new Directive work?
Before and after the introduction of UK legislation in 1998, CIMA and other professional bodies, such as the ACCA, the CBI and the Institute of Credit Management (ICM) were unanimous in their belief that it harms the very companies the law is designed to assist.
- Small firms are crippled by statutory interest.
- Large companies with a stronger network of trading relations and sophisticated computerized accounting systems have the resources to either take their custom elsewhere, or turn the law to their advantage.
If proof be needed, since 1998 UK legislation has been little used by those who need it most. The senior partner to any credit agreement can usually dictate whatever terms they want within the law. And even change them retrospectively, by moving supply elsewhere at little cost. Remember the 2011 reports by
the Forum of Private Business and Basware (op.cit) which revealed that large companies expect to pay late when times are tough.
The author's view is that standardizing payment terms to justify charging interest on overdue debtor accounts may also be a remedy worse than the original disease. Neither are substitutes for the derivation of optimum terms of sale and efficient working capital management.
Technotronic (a small company) currently requires payment from customers by the month end after the month of delivery (45 days). On average, it takes debtors 87 days to pay. Sales amount to £2 million per year and bad debts are £40,000 per year.
The company plans to offer customers a cash discount of 2 per cent for payment within 30 days. Management estimate that 50 per cent of customers will accept this facility. But the remainder will not pay until 80 days after the sale.
At present Technotronic has an overdraft facility costing 10 per cent per annum. However, if the plan goes ahead, bad debts will fall to £20,000 per annum. There will also be credit administration savings of £10,000 per annum.
Using all this information:
Advise Technotronic as to whether it should offer the new credit terms to customers.
Initial points to note
- Theoretically, the purpose of a credit period is to offer customers a source of finance at no explicit cost as an inducement to purchase, thereby increasing the demand for a supplier's goods and services (and hence profit).
- Alternatively, the customer may also be offered a cash discount for prompt payment.
- On the supply side, cash discounts mean the receipt of less money, but earlier. So, speedy payments should improve the creditor firm's net cash flow and hence liquidity.
Given Technotronic's revised terms of sale (2/30:80) there is a quantifiable benefit for those customers who opt for the discount. On a simple interest basis, this can be measured by the implicit annual cost of trade credit if they opt for the credit period. Recalling the cost of capital equation:
The annual cost of trade credit equals:
So, if customers can finance their purchases by borrowing funds at an interest rate lower than 14.6% they should take the 30 day discount. Customers with higher opportunity cost of capital rates should opt for the credit period.
Assuming a 50-50 split between discounting and non-discounting customers, the question management must now ask themselves is how do terms of (2/30:80) benefit Technotronic?
The effects of the revised credit terms can be summarized as follows (£000):
Thus, there is a potential £176,000 reduction in debtors and a cost saving (profit contribution) of £27,600 if Technotronic implements the new discount policy.