ComplianceLegalFinanceTax & AccountingJuly 21, 2020

Establishing credit terms for customers

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.

(A) (B) (C) (D) (E) (F)
Credit Terms % of Customers Taking Discounts Average Accounts Receivable (Note 1) 11% Annual Carrying Costs 
(C x 11%)
Cost of Trade Discounts
(Note 2)
Effect on the Bottom Line
(D + E)
no discount N/A $25,000 $2,750 ---- ($2,750)
1/10 Net 30 50% 16,666 1,833 1,500 (3,333)
2/10 Net 30 75% 8,333 917 4,500 (5,417)

Note 1: Average accounts receivable is computed as a weighted average of the accounts receivable for the month.

Note 2: Cost of the trade discount is computed as follows: ((percent of customers taking discount x monthly sales) x discount percentage) x 12

Determining whether or not to allow trade discounts requires Ms. Quick to look at the information from two different perspectives: the bottom line perspective, and the cash flow perspective. The option that strikes a balance between these two perspectives will help increase the company's cash flow without sacrificing the company's bottom line profits.

The bottom line perspective

Ms. Quick sees that offering no discounts has the smallest impact on the bottom line, reducing the company's profits by $2,750. Offering a 2 percent discount is the most costly, reducing the company's bottom line by $5,417.

Your cash flow perspective

From the cash flow perspective, a lower average investment in accounts receivable means a quicker inflow of cash for the company. Offering the 2 percent discount significantly reduces the companies average investment in accounts receivable. This option would have the most favorable impact on cash flow problems.

Reconciling cash flow and the bottom line

Combining the two different perspectives indicates that offering no discounts is the most profitable, but it does nothing to increase cash flow. Offering a 2 percent discount would significantly increase the company's cash flow, but at the expense of the company's bottom line profit. So which do you choose?

Ms. Quick determined that offering a 1 percent discount strikes a comfortable balance between the two perspectives. Offering a 1 percent discount reduces the company's bottom line by only $583: a small sacrifice for an increase in the company's cash flow. At the same time, this option increases the company's cash flow by $8,334.

Codifying your credit policy

A credit policy is the blueprint used by a business in making its decision to extend credit to a customer. The primary goal of a credit policy is to avoid extending credit to customers who are unable to pay their accounts. The credit policy for some larger businesses can be quite formal, involving things such as:

  • Specific documented guidelines
  • Customer credit applications
  • Credit checks

In contrast, the credit policy for most small businesses tends to be quite informal and lacks the items found in the formal credit policy of a larger business. Many small business owners rely on their instincts as their credit policy.

Your credit policy has a direct effect on the cash flow of your business. A credit policy that is too strict will turn away potential customers, retard sales and eventually lead to a decrease in the amount of cash inflows to your business.

On the other hand, a credit policy that is too liberal will attract slow-paying (even nonpaying) customers, increase your business's average collection period for accounts receivable and eventually lead to cash inflow problems.

A good credit policy should help you attract and retain good customers, without having a negative impact on your cash flow. Ms. Quick's policy does just that, building a credit policy that works.

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