In most companies, the accounts payable team is responsible for sending payments to vendors, customers, and other business partners. Opposite the AP team, the accounts receivable team is in charge of collecting outstanding payments from customers and business partners. These transactions – both incoming and outgoing payments – determine whether or not a business will continue to function. If an organization can’t make payments, vendors will stop working with them; If an organization can’t collect payments, its cash reserves will be put in danger, along with overall profitability.
Because these teams can fall into silos, many businesses miss out on netting payments. At its core, a netting payment is a way to simplify the number of transactions between your organization and an external business partner of some kind. This could be a vendor, lender, or even utility company.
If you can nail down a netting process that works for you and the entities you do business with, you’ll see monetary savings and a reduction in processing times, and your AP team will operate as efficiently as possible.
What is Netting?
If you find yourself asking, “What is netting?” you’re not alone. By definition, netting is the act of combining multiple financial obligations between two or more parties and paying a net payment amount. Netting in finance can work a few different ways, but no matter the netting process used, the goal is to reduce financial risks for all parties involved.
Netting becomes incredibly clear when it’s broken down in a simple example:
- Let’s say you borrow $20 from a friend to buy a t-shirt because you forgot your wallet at home. The next day, when you have your wallet, you offer to buy your friend’s $30 dinner.
- If you didn’t know about netting payments, you might Venmo your friend $20 to pay them back for the shirt, while they Venmo you $30 to pay you back for dinner.
- However, with a quick netting process in place, you can easily determine that if you net the $30 they owe you with the $20 you owe them, you can Venmo them $10 and everything will even.
The example above is how a netting payment is represented in our day-to-day lives, but it works the same way between businesses. If a vendor charges your company $100 for one line item, but you charge them $50 for a different line item, your AP team can work with their AP team to net those payments, resulting in a single $50 payment from your organization to theirs. All debts are ultimately cleared, but with fewer steps.
Types of Netting
There are multiple ways that companies can go about netting in finance, but the main methods are close-out netting, settlement netting, netting by novation, and multilateral netting. Different business scenarios will require a specific netting process. Here’s how to think about each of the 4 netting payment strategies:
In most cases, close-out netting is not ideal for either party involved. When one business defaults on the debts they owe another entity – meaning they are unable to pay principal or interest payments according to the agreed-upon payment schedule – close-out netting is the next step. In this netting process, all the debts between both entities are netted, creating a single payment amount for one business to pay the other. Once this route is chosen, all prior contracts are void and the remaining balance is paid.
A very common netting process is settlement netting. When netting in finance, your accounts payable team can look at all the incoming and outgoing invoices you have with a specific vendor or business. By netting payments together, when it comes time to pay these invoices, it can be done with one payment instead of multiple back-and-forth payments from each organization.
If, after netting payments, you are the organization with an outstanding balance, your AP team will send a wire transfer or physical check for the total balance. If you are the organization with a smaller balance, the other business will send a lump sum payment for the remaining amount you are owed.
Netting by Novation
Netting by novation is not all that different from settlement netting, but there are a few key variances that make both of these netting payment methods important. When netting by novation, all of the outstanding invoices between two parties are canceled and replaced by a new, single invoice for the final amount owed. This is commonly used in currency transactions; netting invoices that share currencies can simplify both the audit trail and payment process.
If your AP team is netting payments between more than two parties, multilateral netting can be used. Multilateral netting is the most complex method used for netting payments, and it often requires a central exchange or cutting-edge software solution to be executed properly. This netting process brings together all debts that exist between three or more entities, nets the amounts owed, and invokes a straightforward payment process. Multilateral netting can also be used in complex enterprises that may have transactions between their own subsidiaries or business entities.
How The Netting Process Works
Once the answer to “What is netting?” becomes clear, the netting process must be thoroughly thought through. It’s important to consider the overall invoice approval process and vendor payment completion when solidifying the netting process.
At a high level, the netting process will look something like this:
- Invoices are sent between both parties involved in the netting process. Your accounting team will send invoices to the vendor or business partner, and they’ll send invoices to your AP team when goods or services are administered.
- Your organization and the business that you will be netting payments with must review and approve all invoices before netting takes place. It’s important that the invoice approval process does not get overlooked because you could end up overpaying if a duplicate invoice is sent by accident.
- Once all invoices involved are approved by both parties, a netting center or AP software can aggregate the amounts and produce a final payment amount.
- After the final debt is figured out, your AP team will send a payment to the other entity, or their AP team will settle the balance. This could shift month to month, depending on which business has the larger debt at the end of the netting process.
Once you get familiar with finalizing a netting payment, the netting process becomes a simple component of the AP team’s monthly cycle. Netting payments is a great way to optimize the functionality of your accounts payable team, but the benefits don’t stop there.
Benefits of Netting
Netting payments should be a consistent part of your monthly finance cycle. Netting in finance comes with many benefits for you and the businesses you work with on a regular basis, such as:
When matching invoices on the AP and AR sides of your business, netting in finance can make it easier to resolve disputes between you and your preferred vendors. Software programs like Nanonets automatically match outgoing and incoming invoices with a single vendor, spit out a netted amount, and make it easy to reach a solution that works for everyone.
Reduced Financial Risk
By centralizing the financial transactions, they are easier to track and have less risk of getting caught up in the invoice approval flow. This means that you and your vendors get paid more quickly, avoiding potential late fees or contract breaches.
If an accounting error is made, say the wrong payment amount is sent for an invoice, it’s harder to dig through multiple invoices and payments instead of pinpointing one, larger payment made to a vendor. Netting payments makes it easier to highlight a discrepancy and get it rectified.
The month-end close process is hard enough for finance and accounting teams. When utilizing a netting payment solution, it’s easier to complete account reconciliations and monthly reporting processes.
Streamlined Cash Flow Processes
Cash flow management is one of the most complex finance processes. Finding any way to simplify it can help save your finance team time and boost their productivity overall. With fewer cash transactions – on the payment or AR side – it’s easier to manage cash flow.
Simplify Netting with Technology
If a netting payment had to be finalized by hand every time, the work might not be worth the hassle. However, with the use of technology and software solutions like Nanonets, netting payments is simple, fast, and accurate. These tools can match invoices between multiple vendors within a certain period, net the total amounts, and produce a final payment amount. Once you start employing AP technologies to optimize the supplier payment process, you’ll see a return on investment almost immediately. Don’t worry, these technologies are created to be simple to use and easy to implement.
Let Your AP Team Lead the Way
Accounts payable teams are stewards of funds; they know the ins and outs of your business and often play a major role in every business-related transaction. Let them finalize the process for a netting payment; they are the experts. When you give the experts the chance to architect a new and improved process with the help of technology, it’s more likely that the process will be adopted on a large scale.
What is netting, you ask? Make sure the AP team is on board with the answer. If you’re not netting payments, this is your chance to revolutionize how you manage funds in your business!