While shortening the collection period can be a helpful strategy, managing your cash outlays represents the other half of optimizing your cash flow. See how you can hang on to your money for longer periods of time without incurring
While cash inflows are all about you getting money into your business, cash outflows are all about money leaving your business. A few examples of cash outflows are paying expenses, purchasing property or equipment, or paying back a bank loan.
The key to improving your cash flow with regard to cash outflows is to delay all outflows of cash as long as you possibly can while still meeting all your outflow obligations on time. Delaying cash outflows makes it possible for you to maximize the benefits of each dollar in your own cash flow. Seeing the benefit of delaying your cash outflows is the first step in managing them.
The proper management of cash outflows requires you to track and manage your business liabilities. Managing your cash outflows also requires that you follow one simple, but basic rule: Pay your bills on time, but never pay your bills before they are due.
As you work to improve your cash outflows, you'll want to focus on a few key areas:
- Trade credit. This allows you to defer cash payments to suppliers until a later date, without calling credit card interest and limits into play
- Trade discounts. This actually requires you to pa your bills quickly, but by doing so you can take advantage of a discount.
- Negotiating payment terms. This, along with deferring expenses, can give you a with your suppliers and vendors, or deferring expenses, are two more methods of delaying your cash outflows.
- Avoiding "using the float." This common, but somewhat risky, practice of using the float between when your check is written and when it is cashed isn't a smart way to handle temporary cash flow problems.
Using trade credit
Your suppliers are extending you trade credit whenever they allow you to purchase their goods or services without making you pay for them at the time of purchase. Trade credit allows you to defer your cash payments to your suppliers in exchange for your promise to pay them in the future, according to their credit terms. Using your trade credit to purchase goods or services from your suppliers creates an account payable for your business and an account receivable for their business.
In essence, trade credit is actually a short-term loan with interest-free financing. The amount of the loan is equal to the purchase price of the goods or services you've purchased. The loan's due date is the date you're required to pay the supplier's bill. As an added benefit, no interest is charged on this short-term loan, as long as you pay the bill off according to the supplier's terms.
Just like a loan, using your trade credit creates additional cash resources by delaying cash outflows that would otherwise occur at the time of purchase. For this reason, taking full advantage of your trade credit is an important step in managing your payables and improving your cash flow. The average payable period indicates how well you're using your trade credit. It does this by measuring how long you use your trade credit before paying your obligations to those who extend you trade credit.
How trade credit works
Most of your suppliers will determine in advance the maximum amount of trade credit they are willing to extend to you. The decision to extend trade credit to your business is generally based on the supplier's credit policy. The amount of trade credit extended to you is based on each supplier's estimate of your creditworthiness, and your capacity to pay for your purchases.
If you're a new customer to the supplier, you may have to:
- Fill out a credit application
- Give some credit references
- Provide other financial information about your business
If you're an existing customer to the supplier, the supplier's credit decision is based primarily on your past payment history. And if your payment history with your suppliers shows a long history of prompt payments, you can expect the supplier to extend to you a realistic amount of trade credit. On the other hand, if your payment history isn't so good, then you might find your suppliers a little less generous when extending their trade credit
In short, use your trade credit, but don't abuse it. Paying your suppliers in a timely fashion, and according to their credit terms, goes a long way in helping your suppliers make favorable credit decisions about your business.
Maintaining your trade credit and taking trade discounts
The first, and most important, step in maintaining your trade credit is to make sure you establish a dependable and consistent payment history with your suppliers. Your past payment history is probably the biggest factor your suppliers will consider when making their credit decisions.
With this in mind, maintaining your trade credit could be quite difficult if your past payment history makes it impossible for your suppliers to predict the dependability of your future payments. A consistent payment history with your suppliers, even if consistently late, goes a long way in helping your suppliers feel safe in extending you their trade credit. Don't beat yourself up over past payment mistakes—just start paying on time.
Keeping in contact with your trade creditors also helps solidify your stands as a worthy creditee. The more your suppliers know about you and your business, the more likely they will want to continue to extend you trade credit. Communicating with your suppliers may help you get through periods when your cash flow is less than overflowing. During these situations you may find it necessary to pay one or more of your suppliers later than they allow.
If you find yourself in this situation, call and inform your suppliers in advance, before they pick your name off their list of overdue accounts. Be prepared to explain your circumstances for not being able to pay your account on time. It's also a good idea to be reassuring, and offer your honest estimate of when you expect to be able to pay your account.
When notified in advance, you'll find that most suppliers are willing to extend their credit terms and carry an account past its due date. In the long run, your suppliers will view these situations as exceptions to your payment history, rather than your normal payment practice.
Taking trade discounts
Some suppliers may allow you a trade discount off the total amount of their invoice if you pay within a specified period of time. The amount of the trade discount is typically 1 percent or 2 percent if you make payment within 10 days.
Full payment is normally due within 30 days if you don't take advantage of the trade discount. The amount of the discount and the time in which you have to take advantage of the trade discount can vary from business to business. To a large extent, a supplier's trade discount is based on what is common for the supplier's line of business. Don't be surprised if some of your suppliers offer generous trade discounts, while other offer no trade discounts at all.
The supplier's trade discount, if offered, will be shown as part of the credit terms on your invoice. Trade discounts are generally listed on an invoice in the following format: "1/10, Net 30" or "2/10, Net 30." "1/10" or "2/10"—all indicating the amount of the discount offered and the number of days you have to take advantage of the discount. In these examples, a one percent or two percent discount is being offered if the payment is made within 10 days of the invoice's date.
"Net 30" indicates when the full amount of the invoice (without the discount) is due if the trade discount is not taken. In both examples, the net amount of the invoice is due within 30 days of the invoice's date. In most cases you are better off to pay the bill early and take advantage of the trade discount.
Tip
As a rule, you should always take advantage of trade discounts of 1 percent or more if your suppliers require full payment within 30 days. If your suppliers offer payment terms extending beyond 30 days, it may be more advantageous to skip the trade discount and delay payment until the full amount is due.
In order to decide more precisely when to take a trade discount, you must compare what you earn by taking the discount, to what it costs you to borrow money in order to have funds available to make an early payment to a supplier.
Taking trade discounts
Perhaps the best method of explaining trade discounts is through a familiar example:
Meet Frank, owner of a print shop that produces a wide variety of items (flyers, calendars, catalogs, etc.) for all sorts of different customers. Frank regularly purchases paper and ink from one supplier. This particular supplier offers a 1 percent trade discount if Frank pays the supplier within 10 days of the invoice's date for the paper and ink purchased.
If Frank does not pay the invoice within the 10-day period, the full amount of the invoice is due within 30 days. Looking at one invoice in particular, it lists the following information:
Invoice date: May 1, 2013
Terms: 1/10 Net 30
Cost of merchandise: $4,565.31
For this invoice, Frank can take a discount of $45.65 if he pays the supplier not later than May 11, 2013. Therefore, instead of paying the full amount of the invoice ($4,565.31), Frank can subtract the discount and pay only $4519.66. Of course, if Frank does not take advantage of the trade discount, the full amount of the invoice is due no later than May 31, 2013.
Looking back through his invoices, Frank determined that he has purchased a total of $34,950.23 from this particular supplier throughout the year. Frank has taken advantage of the trade discount on each invoice. Therefore, his total savings for the year have been $349.50 ($34,950.23 x 1 percent).
Assuming this doesn't present any cash difficulties, Frank has saved a nice bit of cash. Of course, taking trade discounts isn't always as advantageous as paying a bill on its due date.
When to take a trade discount
First, the general rule on trade discounts: You should always take advantage of trade discounts of 1 percent or more if your suppliers require full payment within 30 days. If your suppliers offer payment terms beyond 30 days, it may be more advantageous to skip the trade discount and delay paying the supplier until the full payment is due.
For situations outside the scope of the general rule, or if you just want to test the general rule, you can determine for yourself if taking a trade discount is advantageous. The following will help you make that determination:
In order to determine if a trade discount is advantageous, you need to consider the annualized interest rate you earn by taking the trade discount. If this annualized interest rate is greater than the interest rate charged to borrow the money from a bank, for example, then the discount is definitely worth taking. On the other hand, if the interest rate charged to borrow the money from a bank is greater than the annualized interest rate earned by taking the discount, then you shouldn't take the trade discount.
Deciding when to take a trade discount
When taking a trade discount, you need to consider the early payment of a loan to your supplier.
Take, for example, a supplier offering a discount if their invoice is paid within 10 days, or accepts full payment within 30 days. When you pay this supplier in 10 days, instead of waiting the full 30 days, this supplier is actually borrowing money from you for 20 days.
The amount of the discount is the interest you earn on the loan to the supplier. If you view your early payment as a loan to your suppliers, you can then determine the annualized interest rate you're actually earning. Once you know the annualized interest rate, you can then compare it to your cost of borrowing money and determine if taking the discount is worth while.
The annualized interest rate is calculated as follows: