Part of the I don’t know what I don’t know series
This is seemingly a very simple topic, but it certainly can have a dramatic impact on the cash flow of your business, because it can impact both sides of your ledger – your Accounts Receivable and your Accounts Payable.
What does it actually mean to give someone Payment Terms? It is the period of time that you give your customers to pay their bills. But it can be more complex than just that. When someone sends you an invoice that gives 2/10N30 payment terms, do you really know what it means? Here’s the simple definition:
- They are willing to give you a 2% discount on the net invoice amount – before freight and tax.
- If you pay the invoice within 10 days of the invoice date, you can take the discount.
- If not, then you need to pay the full amount of the invoice in 30 days.
The discount is especially important if it’s your AR, you really need the money, and can’t wait the additional 20 days for it. In this case, you want to provide an incentive for your customers to pay early. Or, maybe it’s your AP and you want to take advantage of the discount your supplier is granting when paying your bills.
There was a time when discounts were given and taken on a regular basis. But that was when interest rates were high, and you were paying 10% or 15% to the bank for the money that you borrowed when you used your credit line. What does that 2% discount give you? It’s actually a 2% discount for sending your money 20 days earlier than you would normally. Well, 2% doesn’t sound like much, and remember that you’re only sending that money 20 days early. To really understand if that is a good deal or not, you need to annualize the interest.
When you calculate it, paying that invoice 20 days earlier for a 2% discount means that you earned annualized interest of a bit over 36%. Who wouldn’t like to get 36 percent interest on their money? If you are paying your bills 20 days early and getting a 2% discount, then you are earning 36% on the money that you’re paying on that invoice. This is an example, but you certainly understand the benefit now. Realize, though, that no one is giving 2% discounts for early payment anymore.
If you are giving someone a 2% discount, then you are actually paying them 36% interest to get their money early and use it in your business. How badly do you need/want the money? If your cash flow forecast shows that you are badly in need of cash, and you can’t borrow it from the bank, then you may have no choice but to grant your customer a discount. But remember that you are actually getting the money only 20 days early.
There is truly one more aspect to this. You may grant your customer terms, but what are the terms that are used? It’s simple enough. If you give your clients Net 15 day payment terms, but they always pay you on Net 30, then their terms are actually Net 30. So how effectively you police the terms that you are giving is probably more important than the terms that you actually give someone. How aggressively do you collect the money that is owed to you? Do you call the customer when they are late to see where your money is?
Collections is the key, because that is what drives Cash Flow. What do you need to do to provide an incentive to your customers to pay you what they owe you? Maybe a discount for prompt payment is worthwhile. But it also cuts into your margins. The important thing is that you evaluate the costs and benefit of what you’re doing with your collections policy. It could pay off for you handsomely. Or, it could become a drag on your cash flow and your profitability.