May 13, 2019
If your business can afford to offer net terms, it should. There are more potential customers who would rather pay on credit than not. However, not all businesses are in a place where they can extend credit to customers. At what point is it viable for a business to offer net terms financing?
Cash flow - the determining factor
Cash flow is certainly a determining factor in offering net terms. It isn’t the only factor, but it is one of the most important. A business that has sporadic cash flow and a difficult time keeping money in the bank is not a candidate for extending credit to customers. Extending credit means delaying payment. In other words, it means delaying additional cash flowing into the company. A business with no money in the bank doesn’t have the luxury of offering credit.
A business that does have steady cash flow and is able to pay its suppliers and employees may be able to extend credit. If there is enough cash left over after paying expenses, the company can finance its customers through net terms.
Cash flow that is just able to meet employee and supplier expenses doesn’t allow enough margin for extending credit. If the company is basically out of money once suppliers and employees are paid, it is dependent on an immediate injection of cash. That cash flow can’t be diverted to customer financing.
From the above, we can see that a company must be able to pay all of its immediate expenses and have enough cash left over to finance customers. The amount of cash left over will determine the net terms that the company is able to offer.
Implementing net terms financing
Once a company begins extending credit, its accounts receivable will become more complex. There is far more to track:
- Issuing invoices
- Collecting payment
- Sending reminders
- Sending overdue notices
- Writing off bad debts
Employees who are knowledgeable about A/R will be needed to ensure A/R is able to function, even when one of its employees calls in sick or quits. Software like Resolve's Net Terms product can greatly reduce the burden of accounts receivable management. Eventually, the company can automate most of its accounts receivable management. An advantage of using more sophisticated A/R software packages is that they allow you to perform analysis and constantly improve your A/R.
In addition to changes in A/R, the company will need to manage its cash flow so it doesn’t run out of cash and is able to continue paying its bills. Projections will have to take net terms into account as incoming money will be delayed. Projects will be affected as well; some may be delayed or scaled back. Most companies run on accrual accounting. If the business was one of those rare pure-cash accounting unicorns, it would need to migrate over to accrual accounting.
While the above may sound negative, there are plenty of advantages to offering net terms. The main advantage will be an increase in customers. It can also mean more stable customers because larger customers mostly work on net terms.
How to decide which net terms to offer?
There are many ways to offer net terms financing: 30 days, 60 days, 90 days, and even something in between are all viable. How do you know which to use? It will largely depend on your industry, which requires some researching. If the industry average is 60 days, starting there isn’t a bad idea. You’ll also need to determine how much your bank account can handle.
For customers who always pay on time, you may consider increasing their terms from 60 to 75 days. This will set you apart from the competition. After all, if a company can delay payment by an extra 15 days, it may choose a vendor that offers those terms over one that doesn’t. Discounts are another good idea and can speed up payments. For example, a 2% discount can be offered for customers who pay at 30 days and a 1% discount for those who pay at 45 days. You’ll increase cash flow by offering these discounts.
The flipside of discounts is that they compress margins. Rather than receiving 100% of an invoice’s value after 60 days, you instead receive 98% after 30 days. Small increases in product prices can cover this difference, assuming your pricing remains competitive. For a business that is moving to offer net terms financing, the changes required can be big. Payments no longer come in immediately and are instead delayed by weeks or even months. Accounts receivable becomes more complex and costly.
Despite the additional labor and cost, net terms financing opens the door to potentially far more customers. You’ll also attract larger customers, who bring with them stability. Overall, net terms financing is a positive for companies that are looking to grow.
