For most small firms today, offering payment terms to customers is part of the cost of doing business.
This makes it imperative that companies account for the lag time between when they outlay cash to buy raw materials and manufacture and deliver goods (or simply provide a service for service-based companies) and when they receive payment from customers. Otherwise, they can run out of cash and go bankrupt, even if their financial statements show that they’re running a “profitable” operation.
One of the keys to avoiding this fate is diligence and persistence in collecting outstanding accounts receivable. But before things get this far, you can shorten the cash flow gap and significantly reduce your risk of running out of money by negotiating the most favorable payment terms possible with your customers.
The most common payment terms in most industries are “net 30 days,” which simply means that the customer’s payment is due within 30 days of the date that the product or service is delivered. Given the circumstances, though, this may be negotiable, even if it’s considered standard within your particular industry.
This negotiation should start at the beginning of a relationship with a new customer. Assuming that net 30 days is the industry standard, you could simply tell the customer upfront that you will require payment to be made in 10 or 15 days instead of 30 in order to do business together and see what the reaction is. The customer might simply say “That’s fine” with no questions or concerns, in which case you’ve gained some extra days of cash flow.
It’s likely, though, that the customer will balk and cite the industry standard of net 30 days, at which point the negotiation will begin. It’s important to remember the cardinal rule of any successful negotiation: Look for a win-win solution in which both sides feel like they achieved a meaningful outcome.
For example, the most meaningful outcome for you will be to narrow your cash flow gap by cutting the collection time in half. What can you offer your customer in return that they will perceive to be just as valuable? Things like “expedited order processing,” around-the-clock customer service, and free shipping are examples of services many businesses can offer that cost them little or nothing.
One of the best ways to speed up payment of accounts receivable is to offer customers a financial incentive for paying early, like a discount. The most common arrangement is what’s known as a “2/10, net 30” discount. Here, the customer receives a 2 percent invoice discount if they pay within 10 days instead of 30.
Taking a 2/10, net 30 discount usually makes financial sense if a company has the cash flow to do it, because it’s the equivalent of an effective annual return of more than 36 percent. You need to do the math on your end to determine whether you can afford to lose 2 percent of a sale in exchange for 20 days of cash flow.
Keep in mind that this works both ways: If you’re offered a 2/10, net 30 discount by your suppliers, crunch the numbers to see if you should take it. In a low-interest-rate environment, it often even makes sense to borrow from a line of credit in order to take the discount.