Most commercial sales typically have payment terms that give clients 30 to 60 days to pay an invoice. Offering payment terms is a way of extending credit to your customers and must be done carefully to avoid problems. In this article, we cover:
- What are payment terms?
- Why do companies ask for terms?
- Financial risks
- How to offer net-30 terms
- Handle cash flow issues
1. What are payment terms?
Payment terms are sales conditions that determine how long a client has to pay your invoice. In most commercial sales, companies are expected to deliver their products or services. Companies also give clients 30 to 60 days to pay their invoices. This practice is also known as offering trade credit.
Payment terms are usually displayed on the invoice using the word “Net” followed by the number of days the client has to make the payment. Typical payment terms include:
- Net 30
- Net 45
- Net 60
2. Why do clients ask for terms?
Clients ask for payment terms for a simple reason: it’s to their advantage. They get the benefits of your product or service for up to 60 days before having to pay you. Arguably, offering terms is similar to giving your client a short-term, interest-free loan.
Larger companies usually work only with vendors who offer payment terms. Consequently, small companies must be prepared to offer terms to remain competitive.
3. Financial risks of net-30 accounts (or longer)
Offering terms increases the risk of cash flow problems or bad debt. Typically, most financial problems related to offering terms result from one of the following situations.
a) Can’t wait for payment
When you offer net-30 payment terms, your company must cover all the expenses of delivering the product or service. It must also use its cash reserve to cover internal costs while it waits for payment. Companies that offer terms and whose cash flow is thin run the risk of getting into financial problems. This situation could leave them unable to make vendor payments or, worse, payroll.
b) Client pays late
Offering trade credit also increases the time and effort you spend collecting invoices. Some clients will take longer than their negotiated terms to pay an invoice. This delay creates a problem because late payments affect your working capital.
c) Client doesn’t pay
The main challenge of offering trade credit is that the client won’t pay at all. This situation creates bad debt since your company has already incurred the expense of delivering the goods or services.
4. How to offer payment terms effectively
The best way to offer payment terms is by following a strategy that minimizes financial risk. Before offering 30- or 60-day payment terms to any client, examine your company’s financial situation and determine if your company can wait for payments. If your company can offer trade credit, follow this process.
Step 1 – Use commercial credit reports
The most effective way to determine if a customer will be a reliable payer is to check their credit report. These reports show a customer’s payment profile and often suggest a credit limit. Two well-known providers are Dun and Bradstreet and Equifax. Consider getting credit reports from two providers when working on a large project. This step provides a complete view of your client’s commercial credit.
Step 2 – Get a credit application
While credit reports are good, they are not perfect. You may find situations where the credit bureau has limited information about your client. Consider asking the client to fill out a credit application in these cases.
Credit applications ask for basic information, such as company name, address, and trade references. Contact the trade references and ask them about your client’s payment record. Always be polite and professional. Also, remember that credit applications can be biased since customers will always provide their best references.
Step 3 – Make a decision
Make a credit decision once you have all the required information. The answer will be clear cut in some cases. Other times, you will need to make a judgment call. Ask yourself, “Given what I know, do I trust this client to pay me in full after 30 (or 60) days?” Your answer to this question will determine the credit line.
5. Avoid cash flow issues
Ideally, companies should be able to manage potential challenges using their cash reserve. Unfortunately, companies aren’t always in the financial position to do so. Here are the three ways to avoid potential cash flow issues.
a) Build a cash reserve
Every company should have a cash reserve to help manage cash flow shortfalls. While building a reserve is simple, the process takes discipline. Consider building a reserve that enables you to offer terms while minimizing cash flow concerns.
b) Discounts for early payment
An effective way to accelerate payments is to offer an early payment discount to select clients. As the name suggests, your client gets a discount if they pay early. Discounts are negotiable, but the typical discount is 2% if they pay in ten days.
c) Invoice factoring
Consider invoice factoring if your company needs reliable cash flow or is growing. Factoring is a form of financing that provides an advance for slow-paying invoices from creditworthy customers. It offers immediate funds that can be used to handle expenses and grow the company. This solution has several advantages over conventional financing and can be deployed quickly. To learn more, read “What is Factoring?” and “How Does Invoice Factoring Work?”
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Disclaimer: This article is provided for information purposes only and is not intended as legal/financial advice. Consult a professional if you need advice.