A strategic approach to payment terms remains crucial to cash management, and today’s economic climate continues to exacerbate the impact of extended payment terms on businesses across industries. Regardless of whether you are actively dealing with — or even aware of — the issue, you can still protect your cash and capital from an increasing threat.
Payment window expectations have dramatically evolved in a short period of time.
Years ago, sellers more commonly offered early payment terms to customers for a discount. While we still see these payment requirements, extended payment requirements are by far the more common arrangement seen today and much more widely accepted than 50 years ago.
Previously, businesses prided themselves on paying their suppliers quickly and efficiently. Now, the relationship between suppliers and vendors becomes more about companies finding ways to accelerate their flow of inbound cash and extend payables.
Today, businesses have normalized extended payment terms, often spanning from 60 to 90 days and with some terms even reaching up to 180 days.
Unfortunately, inaction ends up as the most common way to handle these arrangements due to uncertainty about approaching the topic with valued customers. If a company wants to improve a cash cycle by extending payables and collecting on receivables, the issue requires attention. Solving payment term problems and preventing them can be a competitive advantage.
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COMMON ISSUES
Businesses often struggle to push back on extension requests. Even if accepted, variable pricing and/or devotion of more resources to receivables collection might be employed to offset impacts. Regardless, the potential exists to create negative consequences well beyond payables and receivables, including:
- NEGATIVE BUSINESS IMPACT – Asking for longer payment terms can lead to lost clients and compromised relationships with suppliers. Accepting longer payment terms has a negative impact on cash flow, making it more difficult to invest back into a business.
- STRESS ON SUCCESS – The impact of extended payment terms can be felt most acutely when a company is doing well. Landing a new client is an achievement, but payment structure can jeopardize that relationship. The same is true when a business is struggling to stay afloat. A company might revise payment terms to gain some traction but might then find that cash flow issues make formerly productive relationships unsustainable.
- LACK OF REINVESTMENT – Cash flow is important but not the only important factor. When a company accepts longer payment terms, investment in areas such as research, development or hiring lags. Because innovation and talent are what ultimately determine success, this lack of reinvestment is particularly problematic.
- GROWTH LIMITATIONS – Working with progressively larger clients requires a lot of available cash flow. When high-value clients take longer to pay, serving needs becomes more difficult. A company might then struggle to pay the vendors, which then degrades their overall quality of service. Paradoxically, growth becomes the enemy of growth.
- STRAIN ON OPERATIONAL COSTS – There are certain bills that absolutely must be paid: utilities, rent, payroll, etc. If any one was neglected, operations could grind to a halt. When a company has to wait two or more months to be paid for completed work, it becomes harder to manage ongoing operational costs.
FIXING THE ISSUE
When extended payment terms can’t be avoided, negative impact can still be mitigated. Companies successfully addressing this threat take early action using these strategies.
1. ASSESS OPTIONS
A company should have a line of credit as backup liquidity in the event of a cash flow crunch. While not always viable, this credit can be a true lifeline. There are some very specific questions to consider in evaluating whether a line of credit makes sense. Consider the following questions about customers in regard to receivables mix:
1. How long have you been doing business with them?
2. Have you had to write off anything for them?
3. Do they have a history of disputing invoices?
4. How long have they been in business?
5. Are their financials sound?
Understanding the trends and data associated with receivables will not only help determine whether a line of credit is right but also help evaluate any risks in a business portfolio.
2. DIVERSE BUSINESS PORTFOLIOS
Trends in the market with business owners suggest large companies have natural inclinations to extend payment terms. For this reason, when companies work only with large clients, they contend with cash flow issues on a much more regular basis. Avoiding concentration in a narrow base of clients can help mitigate the risks extended payment terms may pose. That way, if one client extends payment terms, the impact is manageable rather than catastrophic.
Even if not currently impacted by payment terms today, if a payer extends or changes payment terms, it could be disastrous to a cash cycle. The broader the customer base, the more stable a company will be. Other considerations that can disrupt receivables include an overabundance of project-oriented work, concentration of revenue/large customers and narrowing margins.
A diverse business portfolio offers some insulation — as well as creative thinking.
For example, the possibility of negotiating agreements that include part direct sales and part intermediary sales. Direct sales represent a greater credit risk, but because the margins are higher with direct sales, it may be worthwhile to accept payment later. Conversely, selling to distributor networks creates a lower credit risk but also lower margins, making 30-day payment a priority. Diversifying a client portfolio can help accommodate a wide range of payment schedules with less risk.
3. MAINTAIN OPEN LINES OF COMMUNICATION
Companies often agree to terms because of a belief there are no other options. This is especially an issue when the payer is an industry-leading company. Many companies negotiate more advantageous payment terms just by having conversations with their clients or vendors.
If the goal is to secure speedy payment from clients and extend the time required to pay vendors, advance negotiation is required. Avoid the instinct to work with the most senior officer where a difficulty in bargaining leverage could be encountered. Instead, work with the person who can deliver the most value and wants to cultivate a long-term relationship.
Payment terms should be locked in at the same time as pricing agreements. If assistance is needed in dealing with shortened cash flows due to extended payment terms, be transparent with lenders about the sources of cash flow issues rather than repeatedly asking for additional funds, as this maintains transparency and trust.
Discuss impending issues well in advance and don’t hide challenges. This open, two-way communication flow can help build a level of trust that is often rare in business.
4. USE PURCHASING CARDS TO YOUR ADVANTAGE
Even for companies that strictly manage payment terms, cash flow issues can still inhibit operations. In these circumstances, a vendor payment program is a real asset. These programs turn purchasing cards and other lines of credit into cash flow tools instead of acting solely as instruments of debt. For example, if a company is required to pay in 30 days but must wait 60 or 90 days for payment, a vendor program uses credit to harmonize the schedules.
That way, even if payment is technically due in 30 days, the actual financial impact is not felt for 60 days or more.
With a corporate purchasing card program, the supplier gets paid immediately, but a business doesn’t have to pay the bank for potentially up to 60 days, all while earning cash rebates. This additional ‘float’ allows for payment to other vendors and suppliers while reducing the outstanding balance on a line of credit and providing the ability to potentially invest those funds in a sweep or other short-term vehicle.
5. EXPLORE ALTERNATIVE OPTIONS
Three primary strategies are used to address payment term issues: changing the pricing model, opening a new line of credit, and discounting prices for early payment. There are numerous options available that help solve the issues created due to extended payment terms, and there’s no one-size-fits-all approach. In determining the right solution, it’s important to understand how payment terms are really impacting a business.
Consider the following:
1. Do adequate margins exist to carry receivables should something change with a company’s largest customer?
2. What other levers can be pulled in a cash cycle to improve cash flow?
3. Are there opportunities to improve cash flow without borrowing?
MOVING FORWARD
The issue of extended payment terms continues to grow, and the largest and most influential companies will ask to extend payment terms even further, which only compounds cash flow issues. Business leaders must gain an understanding that extended payment terms are more than just an annoyance and should never be viewed as obligatory. Making sales is important, but being paid for those sales in a timely manner is what ultimately matters. If a company is serious about actively protecting interests, the payment window must be a constant source of focus.
Author: Karah Gagnon is Senior Vice President, Relationship Manager Team Lead at Enterprise Bank & Trust in Arizona. With more than two decades of commercial banking experience, Gagnon is a trusted expert and resource for her clients and team. She leads Enterprise’s commercial banking team in Arizona, focusing on strategy, lead generation, strengthening current client relationships and supporting the execution of clients’ financial success. Karah can be reached at kgagnon@enterprisebank.com.
