Finally! You dreamed it, designed it, and manufactured it, now you’re ready to sell it. You made a sale and your customer can’t pay for it all at once. What do you do?
Cash is King
Almost 65% of small businesses have invoices that have gone at least 60 days past due.
Why does this happen?
- The customer is your friend- he/she will pay, right?
- You don’t want to blow the sale, so you say “pay when you can”
- You have no collections process
If you’re like most startups and small business owners, you haven’t thought much about financial policy, and being a lender. You make stuff…. You’re not a bank! Right? Wrong. Ever bought a car and didn’t have a check to write for the full value? How about needing a plumber but can’t pay for the full service all at once. They want their money, but they understand that sometimes making a sale means they have to be flexible before getting it.
Depending on your industry, this could be you. In other articles, we will discuss the opposite when dealing with accounts payable. In that arena, you want terms from your suppliers to help with cash flow, budgeting, and to afford that huge machine or even your office supplies.
Here, though, it’s about your risk tolerance and how extending terms affects cash flow, budgeting, estimating bad debt, collections strategy, and inventory.
Credit terms have several different codes with similar but independent meanings. Here are a few examples with their respective translations:
- Due upon receipt- Please pay immediately upon the invoice date
- Net 15- Please pay within 15 days of the invoice date
- Net 30- Please pay within 30 days of the invoice date
- 2/10 Net 30– Please pay within 30 days, but if you pay within 10 days of the invoice date, you get a 2% discount
There are many variations, but these are the most commonly used. So, as you can see, the other key component is when you make a sale send the invoice as soon as possible. Billing and Invoicing will be covered in further discussions.
How do you pick payment terms that work for your business?
It depends. Nice and vague, I know.
Here are some questions that help answer that question:
- How quickly do you need to pay your own bills?
- What is a typical sales cycle for your business?
- How long does it take to make your product, or deliver your service?
- Can you afford to wait for payment? (similar to bullet #1, but slightly different)
What happens when you issue terms?
On the Accounts Payable side, we discuss holding out payables as long as possible. This means to find the threshold tolerated by your suppliers to allow past due payments. There should be no surprise that your customers are enacting the same process.
Here’s an example:
- You set Net 15 day terms for your customers who request terms
- A sale was made for $2,500 on August 1st
- Invoice the sale immediately upon shipment on August 2nd
- Invoice is due August 17th
Guess when your customer is going to pay… September 15th.
Why?
Because most companies cut checks twice per month. In fact, when we discuss accounts payable in depth, we will discuss strategy to honor the time value of money- that is, keep your money as long as you can and make as much interest as possible before giving it to someone else. So, you asked for payment in 15 days and got paid in 45 days. In fact, expect this to be the reality. If there is an error on the invoice (ie. you applied sales tax when you shouldn’t have, you didn’t bill the right price on the sale), expect to be paid in 60 days. This will happen to you.
Exceptions
You will encounter examples of customers who are large enough to demand their own terms. For example, General Electric pays in 180 days without exception. Most hospitals pay at 120 days from the invoice date. If you choose to work in this space, you will not get them to pay sooner. How do you handle this this injustice? Plan ahead, ask for lesser terms, develop a relationship, and repeat. If you only do business with these companies, a strict accounts payable process is necessary to make sure you don’t run out of money before you get paid.
Now What?
Credit terms should be weighted when establishing your billing process, collections, and when developing your credit application. A method of assessing risk also should be used, along with developing a relationship with your customer to understand their business, and if credit terms are warranted. This should be in your business plan under the “Finance” section.
This information is based on the experience of Ryan Dietrich, consultant and principal at Finance Jack, LLC. Ryan has over 10 years of accounts receivable experience, and has led credit activities at Fortune 500 companies and small businesses alike. Ryan has developed policy, managed risk, and led teams in collections at all levels. Finance Jack focuses on strategic management in the accounting and finance areas of small business, startups, and scaleups. To contact Ryan Dietrich please email ryand@financejack.com.