Suppliers Paid in Advance
This is a general guide to post-pandemic business management.
Suppliers paid in advance (SPIA) are sometimes referred to as prepayments. Most operating expenses are prepaid (rent, insurance, subscriptions, etc), thus the term prepayments is typically used in reference to operating expense items.
For trade businesses, ‘suppliers’ is a term typically used in reference to those businesses that sell items that are typically classified under Cost of Sales for the business, and some items that go to the balance sheet as assets.
The meaning of Suppliers Paid in Advance adopts the COS and Assets connotation to the meaning of suppliers. The discussion excludes operating expense items.
Suppliers paid in advance are just like debtors. They are affected by changes in risk profile. They are a dimensional opposite of income received in advance; thus they are affected by the inverted dynamics of income received in advance.
Suppliers paid in advance are a common occurrence in the following industries:
- Travel and tourism
- International trade (product import-export)
- Business services
- Mining (especially procurement)
The business manager in the post-pandemic era should practice an active approach to risk management. As pointed out previously, the risk profile of debtors is undergoing rapid changes. A supplier paid in advance is a debtor up to the point that products or services are delivered. The business manager should assess risks before making advance payments.
There is a risk that you pay the supplier in advance, and you never get to receive the products or services that you paid for. The supplier could be experiencing going concern issues. A lot of businesses would be facing going concern issues in the post-pandemic world. You will eventually have to write off a portion of the advance payments.
Regarding the post-pandemic upheavals, it is worth mentioning the winner-takes-all types of outcomes again. The relentless advancement of technology is forcing smaller businesses out of some markets and establishing a few giants that control entire industries.
An example is advertising. As of 2020, the internet accounted for 51% of all advertising (from Statista). This share is growing every year. It can easily grow to 80% within the next decade as digital natives (those born after the internet age) enter into adulthood. The share of online advertising that goes to Google and Facebook is 80%.
Thus, you can easily have two giants firms that control 64 to 70% of the advertising market. The question is, what happens to other advertising media, agencies et cetera. Some will survive and take their small share of the market. However, many will struggle to sustain operations.
The above example is extreme but illustrates the dynamic very well. In many other industries, there will be consolidations, buyouts, and outright business failures. Many travel agencies will be eaten by Airbnb, at the same time, supersized hotel groups are consolidating and buying out small lodges. Uber is eating taxis.
Tesla is eating other car manufactures, who might then be forced to consolidate. One or two giants will emerge to grab the market for the 3D printing of buildings. 3D printing is poised to eat the traditional construction of buildings; thus, you will have a winner-take-all type of outcome there as well.
Globalization and technological advancement will be the major forces behind the post-pandemic upheavals that elbow out small and medium enterprises in favor of giant global players. That is the general environment. It will evolve over time.
The business manager must take this environment as a given, and then proceed to actively monitor the suppliers that he pays in advance. Sooner or later, one of those suppliers is bound to go down. This is an eventuality rather than a matter of probabilities.
The goal is not to go down when one of the suppliers that we pay in advance goes down. The general idea is not to tie the fate of the company to the fate of the suppliers we pay in advance.
This then leads us to the point of managing the exposure. There should be a limit dictated by the balance sheet size, the size of the supplier, and our risk appetite.
Before you make a payment to a supplier, consider the size of that payment in relation to the annual business of that supplier. If you are the biggest customer for that supplier, and your payment constitutes a very significant amount on the supplier’s balance sheet, then you are exposing yourself to so much risk.
Ideally, you would not want to pay $100,000 in advance to a supplier whose annual turnover is half a million dollars. Business managers always make these types of mistakes and only realize later that they were buying from a small guy who had no capacity to deliver, in the first place.
If your balance sheet size (measured by total assets) is $1.5m, you should be worried if the ‘Suppliers paid in Advance” line item on your balance sheet is half a million dollars. Of course, this is industry dependant, but in general, your exposure should not overwhelm your balance sheet size.
Again, when monitoring, for businesses that receive income in advance, your Suppliers Paid in Advance should not be higher than your Income Received in Advance. This applies to travel agencies, event planners, and the likes.
If your suppliers paid in advance is larger than your income received in advance, it means you have effectively financed the client. If the client cancels, you are exposed. You are taking a risk that you are not supposed to take.
If your business routinely makes very large payments to suppliers in advance, you might want to purchase an insurance contract that specifically insures the suppliers paid in an advance line item on your balance sheet. This is over and above the normal business insurance that you have in place.
The reason you might want to have this in place all goes down to how standard insurance contracts are structured. They are usually not explicitly structured to cover suppliers paid in advance. Whilst some contracts make use of terms such as clients, customers, business partners, and debtors, they typically don't include prepayments and SPIA.
If you pay a supplier in advance and he fails to deliver, good luck trying to claim that loss from your insurer using the standard business insurance. If your business routinely makes large payments to suppliers in advance, you have a unique risk. It is only fair that the insurer should isolate this risk, assess it, and price it accordingly.
The accounting for suppliers paid in advance should follow the same pattern discussed for income received in advance where the figure is a separate balance sheet item that can be easily monitored instead of being a debit balance in the supplier control account, where it dilutes the real figure of outstanding suppliers. In short, suppliers paid in advance should be a line item under the asset side of the balance sheet.
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