The impact of deferred payment terms on cash flow

The need for Deferred Payment Terms

Most suppliers allow their credit-worthy customers to defer payment for their purchase. It is commonplace to extend 30-, 60- or even 120-day (in recent years) payment terms. Such terms often cover the full value of the invoice, although the seller may also demand part of the goods to be paid in advance or on delivery. Deferred payment terms exist to allow buyers to store, process, and eventually sell the purchased items before having to pay off the amount due: without them, most companies would be unable to operate without relying on expensive, constant lines of credit.

Deferred payment terms always need to be agreed on between the seller and the buyer and should always be clearly explained in any agreement, contract and invoice. Both parties should clearly know what is expected in order to avoid costly misunderstandings later in the relationship.

Net D

Net 10, 30, 60, etc. are forms of trade credit that should always be included in the invoices presented to customers when deferred payment terms are agreed upon. These specify that the invoiced amount is expected to be paid in full by the buyer within the indicated number of days.

Example: If a $2,500 invoice has the terms “net 60”, the buyer must pay the full $2,500 within 60 days.

x %, Net D

Companies often attempt to incentivize earlier payments by offering a percentage discount on the invoiced amount if paid before the end of credit terms.

Example: If a $2,500 invoice has the terms “5% 30, net 60”, the buyer must pay the full $2,500 within 60 days but could take a 5% discount and make a $2 375 payment within 30 days.

Accounts Receivable

Receivables are claims held against customers for money, goods, or services. If collection is expected in one year or less, they are classified as current assets. If not, they are to be presented as noncurrent assets.

Trade receivables are due from customers for goods sold or services performed in the ordinary course of business. Trade receivables may either be accounts receivable or notes receivable. Nontrade receivables come into being from other types of transactions and may be written promises to pay monies or deliver services.

Late Fees

Contracts and invoices should always include late payment fees and penalties if the seller decides to extend credit to a customer. However, in some jurisdictions, a business can always charge interest for late payments if the invoice is overdue. 

Cash is King

As a business owner, operations manager or CEO, there are many steps you can take to improve your company’s cash flow while simultaneously extend credit terms to your customers.

The goal is to optimize your Cash to Cash (C2C) conversion cycle. To calculate it, you can use this simple formula:

C2C = IDS + ARDS – APDS

Where:

IDS = Inventory Days

ARDS = Accounts Receivable/Revenue per Day

APDS = Accounts Payable/Revenues per Day

In this article, we’ll only be discussing what you can do to optimize your accounts receivable while also granting payment terms. You can head to our articles on IDS and ARDS.

How to Optimize your Accounts Receivable

1. Always check the creditworthiness of your customers before granting credit. Ask yourself the following questions to start

   1. Have you ever worked with this customer in the past? Did anything go wrong at some point in the relationship?
   2. If you’ve never supplied goods or services to this customer, has any of your competitors, or anyone from your network?
   3. Can you afford to lose this customer?
   4. Is the contract large enough to justify hiring a credit reporting agency?

2. Ask your customer to sign a credit application, which usually includes:

   1. Contact information of the customer company
   2. Detailed information of the customer company directors, officers or principal
   3. A personal guarantee if a business exists for less than five years, ideally
   4. Banking details
   5. References from at least other 3 vendors with whom the client has worked in the past 3 years, including at least one contact person (A sales manager or a financial director)

3. Have a solid, tested credit management process in place before you agree on any payment term structure.

   1. Does your finance and accounting team have enough manpower and training to handle debt collection?
   2. Do you already know a commercial debt collection agency to hire in case of nonpayment?

4. Don’t wait until you have a problem to hire an agency, always have someone in place before

   1. Time is extremely valuable: if your customer does not respond to your final collection demand, you will know you’ve used all the hostile tools at your disposal
   2. If professional collection is initiated in a timely manner, the odds of success can greatly increase.

5. Offer discounts for earlier payments

   1. Do not underestimate the power that discounts can have on your cash cycle. Your customers are also trying to constantly balance their cash flow and a few hundred or thousand dollars can make the difference. Make sure they understand a discount is an option.