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Trends & Insights
July 14, 2009
OPEN Insight: Managing Cash Flow With Trade Terms
Download the full PDF. Business owners who regularly need to purchase materials, supplies and other critical tools before receiving paym
Download the full PDF.
Business owners who regularly need to purchase materials, supplies and other critical tools before receiving payment from customers can often face cash flow issues. Many entrepreneurs in this situation use personal funds, tap credit sources with an associated fee, or require pre-payment from customers – but each of these options has a downside. As an alternative, trade terms offer business owners an opportunity to satisfy their customers and grow their businesses without the burden of having to pay immediately.
Trade terms — also called “terms,” “supplier terms,” “trade credit,” “net terms,” “purchase terms” and “payment terms” — are an agreement between a company and its supplier for the timing and amount of payments. Common business-to-business trade terms are “net 30” or “net 60,” meaning that a business has 30 or 60 days from the invoice date to pay in full for the purchase. To motivate early payment, suppliers will sometimes offer an incentive, such as a discount of 1% or 2%, for invoices that are paid within 10 days.
Trade terms can help you to manage your company’s cash flow by allowing you to:
Control cash: Cash flow is a perennial challenge due to the timing between when business expenses are incurred and payment is received. For example, a contractor might need to purchase building materials that a customer will not pay for until the job is done. Taking advantage of extended payment terms may allow the contractor to complete the job and receive payment from the customer before paying for the supplies.
Defer payments: In a cash crunch, you can use trade terms to defer payment until additional cash comes in. Think of a clothing boutique owner who needs additional products to stock her store, but lacks the money to buy them. Using trade terms, she can purchase $10,000 worth of inventory, with an agreement that, if partial payment is made in 30 days, she can defer paying the balance for another 30 days. She now has the inventory she needs but has to pay only $1,000 at 30 days, and she has 60 days to pay the balance.
Earn discounts: When your business is enjoying a strong cash position, you can use the early payment discount feature of trade terms to keep more of your hard-earned money. For example: A computer store spends $10,000 to agreement for a 1% discount if payment is made within 15 days. The store owner immediately sells the custom systems that it assembles from the hardware, allowing him to pay early, for which he receives a $100 discount. If his sales generated a 10% margin, he earned $1,000 in profit, in which case the $100 discount increases his profit by an additional 10%.
Keep working capital: Business owners often complain that purchasing expenses leave them little cash to make strategic investments. Deferred payment terms enable you to keep working capital on hand to purchase new equipment, hire additional staff, launch an advertising campaign or make other investments to grow your business.
Establish payment history: Trade terms can create a credit record that enables you to take advantage of future opportunities. Participating in a financial arrangement in which you commit to and then hold up your end of a financial deal sends a signal to the larger business world that your company is a responsible financial entity.
Trade terms can make sense for industries in which supplies, inventory or raw materials are typically purchased and paid for over time. The deferred payment option allows the purchasing business more time to generate revenue, which can help ease cash flow issues all around. Trade terms are also an important tool for suppliers who are continually seeking to find new customers and outlets for their goods.
When suppliers offer trade terms to customers, it becomes easier for companies to buy from them. At the same time, mutually agreed-upon terms that businesses can afford ensure that suppliers receive timely payments for their goods.
Ask your vendors and suppliers about trade terms, if you do not already have them. This OPEN Book guide and worksheet can help you determine how trade terms can benefit your business.