Your credit terms set the time limits for your customers' payment on the merchandise or services received. Learn how to create a clear policy delineating when to extend credit to a customer and, if so, how much and for how long.
Credit terms are simply the time limits you set for your customers' promise to pay for their merchandise or services received. But for many small business owners, establishing credit terms can be cumbersome.
When customers purchase your merchandise or services, you expect them to pay within a specific period of time (generally, 30 days). As a result of this promise, you agree to give up an immediate cash inflow until a later date. The credit terms of most businesses are either 30, 60, or 90 days. However, some businesses may have credit terms as short as 7 or 10 days. Often a business's credit terms are dictated by an industry standard, or by its competition.
While building a credit policy that works is a very important topic, creating the credit terms for your business has a direct influence on your cash flow. Longer credit terms mean your business will have to wait longer for the cash inflows from the collection of accounts receivable. In the meantime, your business may experience a cash flow shortage.
- Offering trade discounts may help speed up your cash inflows from accounts receivable, and help reduce a cash flow shortage created by extended credit terms.
- Our case study on trade discounts shows you how to decide what kind of trade discount to offer.
Offering trade discounts
The credit terms of your business should be designed to improve your cash flow. Some businesses allow customers to take a trade discount off the original sales price if the customer pays within a specified period of time, thus providing the customer an incentive to pay quickly and you a way to improve your cash flow.
The amount of the trade discount is typically 1 percent or 2 percent if the customer pays within 10 days. Full payment is normally due within 30 days if the customer doesn't take advantage of the trade discount. Some service-oriented businesses, like doctors or dentists, offer a trade discount of sorts for immediate payment upon completion of their services. Offering trade discounts has both advantages and disadvantages.
Considering the advantages
The main advantage of offering trade discounts is that it shortens the average collection period. Shortening the average collection period for accounts receivable is one of the biggest hurdles in accelerating your cash inflows.
Weighing the disadvantages
The primary disadvantage of offering trade discounts is the cost to your bottom line profit associated with the lost revenues. The cost of trade discounts must be weighed against the improved cash flow expected. Another possible disadvantage is the increase in time necessary for billing and accounts receivable processing.
In order to take full advantage of trade discounts, billing should take place as early as possible, which is generally the shipping date. For some small businesses, this may require outsourcing some of your billing work.
The cost of trade discounts illustrated
The primary disadvantage of offering trade discounts is the cost to your bottom-line profits associated with the loss of revenues. The following example looks at the bottom line effect of offering trade discounts:
Quick Computer Supply has been experiencing a steady build up in accounts receivable over the last six months (!). This build up in accounts receivable, however, comes with a downside: It has put a slight strain on the company's cash flow because collections are often lagging behind.
The company has decided to look at the possibility of changing its credit terms by offering a trade discount to its customers if their payments are received 10 days after shipment. The company's current credit terms call for full payment within 30 days of shipment. Sarah Quick, founder and CEO, has provided the following information:
- Sales have been averaging about $25,000 per month.
- Ms. Quick estimates that about 50 percent of the company's customers will take advantage of a 1 percent discount. She expects 75 percent of the company's customers will take advantage of a 2 percent discount. For analysis purposes, she assumes all customers not taking advantage of the trade discounts will pay within 30 days.
- The company's annual carrying costs for its investment in accounts receivable is 11 percent.
With this information, the following analysis is prepared for the company showing the effect on the company's bottom line for each of the possible options.
