Good Business, Bad Business: How Payment Terms reveal the Truth

Are you an aspiring Entrepreneur? searching for the perfect venture to launch. Or, are you an individual investor ? who is always looking for great businesses to invest in. In both scenarios, the goal is similar – How do I find a business that has compelling business economics? And in the journey of finding these opportunities, we often get caught up in flashy growth metrics, and trendy industry prospects that business would be in. However, there is one often overlooked factor, that can make or break company’s financial health, and therefore the life of the business: Payment Terms.

Payment Terms of business influence the timing of cash inflows, and cash outflows. Therefore, it impacts a business’s return on equity, working capital, and overall success. Yet many investors, and entrepreneurs overlook this critical aspect, focusing just on top-line growth, and margins. But what if you could uncover this hidden indicator of a business’s quality? Enter Payment Term analysis. By the end of reading this blog, you will be able to learn:

• What is Payment-Terms?
• Different types of payment terms, and their impact on Return on Equity, Working Capital, and overall financial strength.
• How companies get creative with their payment terms to improve their returns? (Case Study of Adobe)
• How to analyze a business or investment opportunity w.r.t Payment-Terms?

What is Payment-Terms?

Simply put, Payment-Term of a company defines why, how, and when does a company gets the actual cash for its products or service to customers.

WHY is easiest to answer. Why? Because the company sells the product or service. HOW & WHEN are a bit complex. Also, they have a tremendous impact on the business economics, and, the quality of the business.

How? Checks, credit cards, electronic transfer, or cash; One-time or installments; If in installments, will there be an interest charged or not.
When? Will the customer have to pre-pay – like tickets for Taylor swift’s concert, pay when the product or service is delivered – like haircut, or pay much latter, like car payments.

Types of payment-terms, it’s impact, and what does it imply about the company’s products/services.

1. Buy now, and pay in installments later:

This one is wide spread in the US, and slowly spreading through Asia. The idea is simple – let the customer take the product home, and hope that they will pay their dues regularly. And it usually comes in two flavors: Pay installments with interest or Pay installments without any additional interest. This payment term is generally great for the customers but one of the worst ones for the business. Usually, companies offer these kind of payment terms because they are selling a big ticket item in competitive industry, and customers have many options to choose from.

It results in lower ROE, lower return on total assets, high working capital, and also results in loss of revenue because many customers fail to pay their installments. Usually, you will see high amounts of Accounts Receivable (Amount of product sold but not received the payment for) on balance sheets of such company.

This type of payment plans imply that product value is higher, customers have other options to choose from, and the company would likely loose market share if they don’t offer easy installment plans.

Example: Auto Parts inc. manufactures engine components for various automobile companies. It requires capital to buy raw material, manufacture products, and hold inventory. And it needs to finance these expenses for several months before receiving payment from their customers, which is usually 30-90 days after product delivery. This results in high capital hold up, and therefore reduces the return on equity.

2. Buy now, Pay Now

As the name implies, customers pay the amount at the time of the purchase. Companies like these are better than the first category we learned about. The risk here is of loss of revenue is mitigated using this payment term. Therefore, impact on ROE is not as bad as “Buy Now, Pay later”. However, it still requires positive working capital, because these type of companies do need to finance their operations, pay their employees, keep inventory, etc. before the customer buys, and pays for the end product.

This type of payment plans are generally used in businesses where products are not expensive but need to be available for the customers for immediate purchase.

Example: A grocery store a lot of working capital w.r.t total revenue to fund all its operations, pay it employees, and maintain inventory before its customers pay for their product.

3. Pre-pay.

This is the best kind. In this model, customers need to pay before the company even manufactures the product or delivers the service. There is no risk of revenue loss, or large capital requirement to the main operation. In fact, many companies that use this payment term run on negative working capital. Not only these companies get the cash first, sometimes they also make extra interest before deploying the capital resulting in improved ROE.

But not all companies have the luxury to use these kinds of payment terms. Generally, companies with deep moat or unique market position enjoy this luxury.

Example: AirBnB enjoys negative working capital because it gets paid by the guests upfront but pays the host later. Earlier the customer pays, higher would be the ROE for Airbnb. It also doesn’t maintain any inventory as it doesn’t own any hotels or houses.

Note: In the real world, companies often use combination of the 3 above mentioned payment-terms or some tweaked version of it. But the idea is still the same. The payment term that helps reduce the working capital requirement, will improve cash flows, profitability, and Return on Equity. And a management with good operational and capital allocation skills should strive to do it.

How companies get creative with their payment terms to improve their returns? (Case Study of Adobe)

Adobe, company that creates a wide range of market products, increased its ROE from 15% to 40% by making a simple change in its Payment-terms & business model. It went from “Software License Model” to “Subscription Model”. Here is how it did it:

In the old “Software License Model”, Adobe used the “Buy Now, Pay Later” payment term. It would sell software license to customers, and allow them 60 days to pay for the software. It also practiced long software upgrade cycle of one year or more in which it would have the capital tied in developing software for an year before releasing the update. And many customers would choose not to buy the software update, resulting in losing the potential revenue and unpredictability. Adobe’s ROE while using this model was 15-20%.

However, in 2013 the management got creative. It decided to move to “Subscription” based mode. Under this model, the customer would “Pre-Pay” monthly to use the software and would regularly receive software updates without the choice to skip it. This model resulted in Adobe receiving upfront payments, thereby drastically reducing the working capital required, improved predictability, and also profitability, resulting in ROE to rise to 40%. And the company’s stock skyrocketed from $38 to $560 in a decade.

How to analyze a business or investment opportunity w.r.t Payment-Terms?

Now that you have a good idea about types of payment terms, its impact on cash flows, and profitability, let’s summarize the checklist that you should go through while analyzing the business:

• What is the current “Payment-Term” offered to customers?
• Does the company have a moat to improve the payment-term offered to customers?
• What is the current “Payment-Term” levied on the company from the suppliers? Does the company have buying power to renegotiate the terms?
• Does the company require high working capital?
• If the company uses “Buy Now-Pay Later” model, does it result in significant revenue loss due to customers defaulting?
• How else can the company improve or add smartness to its payment-terms?

Note that this is not an extensive list, but trying to answer these questions while analyzing a business will get the juices flowing. It will help you uncover deeper aspects of the company’s business model. Thereby, helping you with analyzing the long term prospects of the company.

Conclusion:

Having a good sense of the payment-terms of a business provides an edge. It will help you analyze the strength of the business model, understand the moat of the company better, its position in the market vs it’s competitors’, and help you calculate the potential cash-flows with higher probabilities.

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