Supporting Extended Payment Terms: Techniques to Protect Your Cash Flow

Content

The Impact of Extended Payment Terms on Cash Flow
Encouraging Early Payments
The Need for Longer Payment Terms
Maintaining Cash Flow with Longer Payment Terms
Invoice Factoring
Early Payment Discounts
Example Scenario
Conclusion
View More

Last Modified : Oct 23, 2024

One of the most common concerns credit directors face is the need to support their customers’ demand for longer payment terms. There is a clear trend for longer payment terms across many industries, a trend which directly impacts sellers’ cash inflow. It’s not hard to understand why buyers want longer to pay. Every extra day of days payable outstanding (DPO) frees up working capital that can be put to use more profitably. Buyers use their sellers’ lines of credit to enable growth and improve liquidity.

Payment terms can make or break a sale. Consequently, businesses need to balance the cash flow and risk impact of higher days sales outstanding (DSO) with the ability to reach more customers and sell more goods or services. Here are some strategies to help your business navigate this delicate balance.

The Impact of Extended Payment Terms on Cash Flow

If you have had to extend payment terms to your customers, you are likely aware of the cash flow problems this can cause. If cash comes into the business later, liquidity is reduced and it becomes harder to meet liabilities. Cash flow management is crucial to effective business operations, allowing sufficient capital to invest in growth alongside day-to-day commitments to salaries, inventory, and other overheads. Late payments may already be testing your cash flow, so why would you allow longer payment terms to place even greater stress on cash flow management?

Encouraging Early Payments

To counter customers’ requests for extended payment terms, many businesses provide incentives for early payment, such as early payment discounts. Negotiating payment terms early in a customer relationship, as part of the sales process, can favor longer payment terms over early payment discounts to preserve sales revenue.

Aside from incentivizing early payments, businesses need to ensure invoices are generated and delivered quickly and accurately, and the payment process is as pain-free as possible. Consider sending electronic invoices that link directly to online payments via debit or credit card to streamline the process and remove barriers to early payment. If invoices are delivered electronically, open and click rates can be tracked, and automatic follow-up communications can be sent ahead of the invoice due date, encouraging early payment.

Customers may require invoices to be delivered directly to their accounts payable invoicing portals to automate the payment process. In some cases, this can require accounts receivable teams to log in to multiple portals and manually enter invoice details, risking human error and payment delays. Thankfully, there are now ways to streamline invoice delivery to these portals, as detailed in guides on streamlining invoice delivery to buyers’ AP portals.

The Need for Longer Payment Terms

As businesses recover from the impact of the COVID-19 pandemic and grapple with the supply chain crisis, financial leaders are inclined to prioritize liquidity to reduce the risk from future uncertainties. Small business owners are particularly sensitive to cash flow shocks and will take even longer than larger businesses to deprioritize liquidity. As a result, businesses may seek to increase DPO and benefit from the working capital this liberates. In some cases, this may be more than a customer’s attempt to improve liquidity but perhaps a necessity if their place in a supply chain is experiencing payment delays or extended payment terms.

Maintaining Cash Flow with Longer Payment Terms

Here is the crux of this article: how to meet customers’ demands for longer payment terms without suffering a hit to your cash inflow. There are two main ways this increase in the accounts receivable ledger can be converted into cash sooner, so let’s evaluate each in turn.

Invoice Factoring

Invoice factoring is a form of invoice finance where the seller sells their invoices to a third party (called a factor), who then owns the customer invoice and can collect the invoice amount directly from the customer. With customer payments going directly to the factoring company, it is immediately apparent to customers that the seller has employed an invoice factoring company to assist with the accounts receivable process. This can leave a negative impression, implying that the seller is either struggling with cash flow or needs to raise working capital.

Factoring liberates working capital from the accounts receivable ledger, removing the cash flow impact of longer payment timeframes – the cash is available from the moment the invoices are sold. However, a word of warning: factoring without a non-recourse agreement can leave you open to repaying the funds provided by the factor if your customers default on payments.

Early Payment Discounts

Early payment discounts are incentives offered by sellers to buyers to encourage prompt payment of invoices. Typically, these discounts are a small percentage reduction in the total invoice amount, provided the buyer pays within a specified shorter period, such as 10 days instead of the standard 30 days. For example, a common early payment discount might be 2% off the invoice total if paid within 10 days, often expressed as “2/10, net 30.” This strategy helps sellers improve cash flow and reduce the risk of late payments while offering buyers a financial incentive to pay sooner.

Example Scenario

Consider a mid-sized manufacturing company, XYZ Manufacturing, that produces custom machinery for various industries. Recently, several of their large clients have requested extended payment terms of 90 to 120 days due to their own cash flow management needs. While XYZ Manufacturing understands the importance of accommodating these requests to maintain good client relationships and secure large orders, they are concerned about the impact on their own cash flow.

To address this, XYZ Manufacturing decides to implement a combination of strategies:

1. Early Payment Discounts: They offer a 2% discount for payments made within 30 days. This encourages some clients to pay early, improving immediate cash flow.

2. Invoice Factoring: For clients who still prefer extended payment terms, XYZ Manufacturing sells their invoices to a factoring company. This provides them with immediate cash while the factoring company handles the collection process. XYZ Manufacturing ensures they choose a non-recourse agreement to avoid the risk of having to repay the factor if a client defaults.

By combining these approaches, XYZ Manufacturing successfully supports their clients’ demand for longer payment terms without compromising their own cash flow. They maintain strong client relationships, secure large orders, and ensure their operations run smoothly with adequate liquidity.

Conclusion

Supporting longer payment terms without losing cash flow requires a strategic approach and proactive financial management. By understanding the impact, negotiating favorable terms, leveraging financial tools like factoring, and maintaining efficient invoicing practices, your business can navigate the challenges and maintain healthy cash flow. The key is to strike a balance that satisfies your clients while safeguarding your financial stability.

ABOUT eCapital

Since 2006, eCapital has been on a mission to change the way small to medium sized businesses access the funding they need to reach their goals. We know that to survive and thrive, businesses need financial flexibility to quickly respond to challenges and take advantage of opportunities, all in real time. Companies today need innovation guided by experience to unlock the potential of their assets to give better, faster access to the capital they require.

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Kristine Darroch

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[/vc_column_text][vc_column_text css="" text_direction="default"]With over 15 years of experience spanning strategic marketing, business management, and commercial finance, Kristine has established herself as a trusted advisor for small to mid-market businesses seeking sustainable growth. Her unique blend of entrepreneurial experience and industry expertise sets her apart.

Having founded and led a successful small business herself, Kristine understands the challenges and opportunities entrepreneurs face. This firsthand knowledge, coupled with her proven track record in diverse industries, fuels her passion for empowering businesses to succeed.

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