For SME business owners the cash generation cycle is a key day-to-day challenge. At Crowe, we regularly assist business owners manage their working capital challenge of customers deferring or delaying payments (often using the delayed payments as a mechanism to improve the customer’s own working capital cycle).
Late payment of debt is significantly impacting many businesses already facing financial pressures. To address this, the government adopted The European Communities (Late Payment in Commercial Transactions) Regulations 2012. These regulations, which took effect from March 2013, give suppliers the right to apply interest on invoices due when payments fall outside of agreed terms and conditions.
Where interest is applied the rate can be matched to the ECB rate plus 8% (unless another arrangement is pre-defined in contract). Once payments fall outside of the contractual payment terms, interest is calculated at the equivalent daily rate. This legislation applies equally for both the public and private sector.
Late interest rate calculation
For illustrative purposes below is an example of how the late interest charge would be applied to an overdue supplier invoice of €100,000 collected on day 120 (90 days outside standard terms).
|A. Overdue creditor / supplier invoice||€100,000|
|B. Interest rate (ECB rate + penalty interest rate)||8%|
|C. Annualised penalty charge (A x B)||€8,000|
|D. Equivalent daily interest rate (B / 365 days)||0.022%|
|E. Equivalent daily interest charge (C / 365 days)||€21.92|
|F. Late interest penalty (E * 90 days)||€1,972.80|
The above calculation demonstrates an equivalent daily interest rate charge of €21.92. For example, if the €100,000 has a standard 30-day payment term and the invoice isn’t paid for 120 days, i.e. 90 days outside terms, additional penalty interest of €1,972.80 could be applied under the late payment legislation.
Many businesses may be willing to forgo the late interest penalty to maintain customer relations. Equally, they might wish to avoid the administrative burden in pursuing this approach, especially in light of the daily interest cost (€22) relative to the overdue invoice (€100,000).
Overdraft finance cost
Whilst the late penalty interest in the above example highlights potential recovery of €1,972.80 it does not fully articulate the cost of financing the gap between raising and collecting the invoice. The calculation below highlights the cost associated with a 120-day collection period assuming a standard business overdraft facility finances the €100,000 sum at 9.5%.
|A. Overdraft finance||€100,000|
|B. Interest rate||9.5%|
|C. Annualised overdraft interest||€9,500|
|D. Equivalent daily interest rate (B / 365 days)||0.026%|
|E. Equivalent daily interest charge (C / 365 days)||€26.03|
|F. Funding cost for 120-day collection (E * 120 days)||€3,123.60|
Penalty interest recovered versus overdraft costs
The above illustrates the potential recovery of penalty interest (€1,972.80) versus the cost associated with financing the late collection via an overdraft (€3,123.60). In summary, were the penalty interest to be applied and fully collected, a funding shortfall of €1,150.80 arises by virtue of the cost of financing an overdraft. If we scale the example up and assume a business with €10m turnover an equivalent shortfall of €115,080 arises.
An alternative mechanism
From our experience, Irish SMEs are often reluctant to apply penalty interest regardless of the cost of financing the period between the raising of invoices and their collection.
An alternative strategy may be to offer customers an early payment discount. For example, an early payment discount of 2% may sacrifice €2,000 of the total €100,000, but may provide an opportunity to reduce the burden of chasing the overdue debtors, improve customer relationships whilst also delivering a more efficient payment collection, saving potential overdraft interest costs and ultimately bolstering the working capital cycle.
Our corporate finance team advises clients who wish to raise funds or financially restructure at any stage of their business. We will help you find you the best terms in the market and advise you on how to structure your funding in the most efficient way.