Moving to Open Account Payments: Managing Shareholder Value

In the last blog posting I cited three factors that a company considers in moving to open account payments. The last point, on the view of the market on moving to open account payments, is not so obvious a consideration until one understands that once a company pays on open account, it requires much lower lines of credit to sustain an important payment program. If the company is viewed as proactively managing the reduced credit, it can be rewarded by investors; however, if the move is forced on the company, its shares can take a big hit.

This was illustrated back on April 16, 2008, when stock price of Talbots fell 32 percent after it announced that two lenders, HSBC and Bank of America, would not renew lines of credit totaling USD 265 million. The credit lines were used to support import letter of credit payments to its suppliers. On the same day Talbots issued a press release commenting on the “financial arrangements” with its banks and suppliers. Portions of the release read as follows:

“As reported in the Form 8-K, the Company’s major vendors, which represent approximately 75% of Talbots offshore merchandise purchases, have agreed to “open account” terms with payment in 45 days. The revised terms extend the settlement period to 45 days from approximately 22 days on letter of credit purchases, which the Company expects will effectively add approximately $40 million to the Company’s 2008 operating cash flow.

Due to the revised payment terms with its major vendors, the Company believes that its financing needs with respect to the remaining smaller vendors, representing a minority of its purchases, have been substantially reduced and can be accommodated with a letter of credit line of approximately $50 million. In recent years the Company had letter of credit facilities aggregating approximately $300 million; however, by going to “open account” for the majority of merchandise purchases, the need for credit should significantly decrease. The Company believes that approximately $50 million will be sufficient to satisfy the financing needs in purchasing from its smaller vendors. Talbots is in discussion with several financial institutions to supply the $50 million letter of credit and expects resolution of these discussions in the next few weeks. “

Talbots most likely made the change in payment terms in response to earlier notice from its lenders that its lines of credit would not be renewed. But, what if a company were to proactively move to open account payments with extended terms? Talbots was able to improve its working capital, freeing up USD 40 million in cash flow. Even for a company not at risk of its lenders reducing their credit lines, if a company can renegotiate its payment terms to free up working capital it should do so.

In fact many companies have already done so. They are moving to open account payment terms and extending payment terms. But, many are still keen to retain lines of credit even if they are not fully utilized. Perhaps as a lesson learned from Talbots, some treasurers have been keen to retain lines of credit, or at least reduce the lines in small increments, in order to ensure that reducing letters of credit payments is not perceived by market analysts or shareholders as a symptom of underlying financial weakness. In the process of improving its working capital, management will not do its shareholders any favor if a reduction in credit lines is perceived as a weakness in the company’s financial position with a corresponding drop in share value. Thus, when moving to open account payments, companies are moving cautiously to ensure that the reasons for doing so are not misinterpreted, reducing shareholder value.

Moving to Open Account Payments

I was talking to a banker colleague who informed me that over the past two years the move from documentary credit to open account payments has been dramatic.  Certainly, companies I have spoken to all have plans to move to open account payments as fast and as completely as possible. Most of the motivation to move to open account payments is driven by the desire to reduce ongoing operating expense for its own benefits and that of its more financially sound suppliers, improve working capital through an extension in payment terms accompanying a move to open account payments and a reducing in credit expense.

So, how does a company move from payment on documentary credit terms to open account? Typically, there are three factors the company considers: (1) does the company have the technology and operating process in place to move payment processing from the bank to the company, (2) are their suppliers willing to move from documentary credit to open account payment terms, and (3) does the move to open account payment term have an inadvertent impact on the company by financial market.

Welcome to Supply Chain Finance

This year marks the twentieth anniversary of the publication of six documentary credit message standards by the then-named UN/EDIFACT organization.  These messages provide the framework for electronic exchange of documentary credit[1] messages between the importer and importer bank, and exporter and exporter bank.  They were designed by a small group of trade specialists from banks and corporations who met for the first time three years earlier in San Francisco.  Departing from current standards for documentary credits, this group developed the new standards to integrate documentary credit instruments into the order management operations of importers and exporters.  Thus began the journey to integrate, electronically and seamlessly, the financial and physical supply chains.

Since this seminal work, various industry initiatives, banks and companies—startup and established–have endeavored to take the electronic documentary credit from concept to profit.  Most of these efforts met with limited success or outright failure.  Instead of embracing the electronic documentary credit, the market has moved to another form of payment—the open account payment—to automate payments in the global supply chain.

The documentary credit—the traditional paper instrument—not only facilitates a guaranteed payment between importer and exporter—but also the transfer of credit and liquidity from importer, through banks, to the exporter.  This credit transfer mechanism has evolved over decades to provide exporters access to funds from their banks before shipping goods and to accelerate collection of funds after shipment and bank payment approved.  As payments move to open account payments, providers of trade financing services are developing solutions for pre- and post-shipment financing that work for open account payments as well as financing supported through documentary credits.  This new open account supply chain financing is still evolving.

The journey that began twenty years ago to integrate electronic documentary credits into the supply chain has taken many turns in the road, some into dead ends.  The glimmer on the horizon is a process revolving around the payment on open account terms wrapped in new supply chain financing programs that continue to get credit to the exporter.  But we are still on the journey to get to this new trade paradigm.

Welcome to “Supply Chain Finance: Perspective on Physical and Financial Global Supply Chain Convergence,” a new blog chronicling the journey to the new financial supply chain.  In the coming weeks we will cover past, present and, with some verve, the future of the global financial supply chain. 

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[1] Documentary credit is also known as a commercial letter of credit.