B2B payment terms do not receive the attention they deserve. After all, trade credit is the most important form of short-term credit in the US. Estimates for US corporate receivables range from $3 trillion to $4.5 trillion at any given time. Trade credit, in turn, creates markets for short-term lending, factoring, supply chain finance, merchant cash advances, and all manner of ways to help suppliers cope with their need to provide financing to their customers. Those markets receive a lot of attention, but the underlying reason for their existence gets mainly academic attention.
What Are Payment Terms?
Payment terms are the time between when a supplier delivers goods (or an invoice) and the time that the supplier requires payment from the buyer.
Even this simple definition hides a little complexity. Suppliers define the term as beginning on the date of the invoice. Buyers often claim the term does not begin until they receive a compliant invoice. And the buyer defines what information is needed on a compliant invoice (e.g., requester, project number, case code, more line item detail, etc.)
Why Do Suppliers Offer Payment Terms?
There are many reasons suppliers don’t require buyers to pay on delivery:
- Cash-on-delivery (COD) is impractical for buyers. Imagine $3-$5 trillion more in petty cash laying around! Or requiring buyers to do continuous payment runs. Also, in many industries buyers need to compare the invoice to contracts, purchase orders, receipts, bills of lading, or other documents. Traditionally these documents have not been electronic, so buyers have traditionally needed time to approve the invoices before making payments. (This “excuse” is shrinking.)
- COD is unwise because the buyer needs time to inspect the goods/services. In some industries, the buyer must do a quality inspection or test on the products/services received and this takes time. Paying after acceptance makes sense.
- But most important in determining payment terms are the relationships between buyers and suppliers and the competitive dynamics of industries. For suppliers, extending credit is a calculated cost and risk for enticing new customers. An extended payment term is, in effect, a non-price discount. For buyers with leverage over suppliers, extended payment terms are another form of discount and a form of cheap financing. Simply put, like every other aspect of a relationship between a buyer and supplier, payment terms are a part of the negotiation.
How Are Payment Terms Determined?
In a few industries in the US, payment terms are regulated. This is true of payments made by the federal government, some construction projects, and many agricultural goods such as livestock, grains, and milk. (Most of the laws are state and local, and a few are federal.)
My favorite example of regulated payment terms comes from the alcoholic beverages industry. Payment terms for alcoholic beverages are governed, believe it or not, by a federal law dating from prohibition, as well as state laws. In some states, alcoholic beverages cannot be sold on credit, and in many, the terms depend on the type of beverage. Only in America!
(Of course, these crazy laws created a great business opportunity for Fintech, iControl, and others.)
In most industries, the payment terms are established by the competitive dynamics and practices of the participants, as well as the practical constraints mentioned above. As a result, terms differ by industry but tend to be stable within industries.
Sadly, there is not a lot of good public data on payment terms, and therein lies an opportunity! Most observers say “net 30” (meaning payment in full is due 30 days from the date of invoice) is the single most common payment term in the US. But that is just a rule of thumb. Anecdotally, some industries vary dramatically from this norm:
- Agricultural payments are generally very fast (under 7 days) due to regulation and the exigencies of perishability.
- Insurance terms seem to be immediate. (I don’t think your premium is in force until payment is received.)
- Rail networks seem to offer net 15-day terms, which makes sense given industry concentration. (There’s a reason Warren Buffett owns railroads.)
- Transportation used to be 30 days but has been stretching to 60 days.
- Many CPG and Retail companies have been aggressive adopters of supply chain finance which means net payment terms of 90-120 days.
- Construction payments, given all of the complexities (e.g., liens, etc.) are also often longer than 30 days.
- Many professional services, including oilfield services, have 45-90 day payment terms.
Payment terms are the results of a variety of industry and relationship-specific factors between buyers and suppliers. They are also quite opaque as they are buried in contracts and on invoices. They tend not to be disclosed for competitive reasons. Whoever does a great job of collecting this increasingly easy-to-extract data and aggregating it, will have a nice data asset to monetize. The AP automation vendors would seem to have a head start.
In the next post, I’m going to cover a highly-related topic. Rather than the payment terms themselves, I’ll focus on whether buyers adhere to the payment terms and pay on time or late. It will not surprise you to know that these payment habits or practices also vary by industry!