There's Nothing Good about Extended Payment Terms
Protecting Your Cash Flow Requires Relentless Vigilance
Payment Terms define when a customer is supposed to pay your invoice for the products and/or services your firm provided . . . at your expense, using your cash. For many industries the “norm” is 30 days from invoice date (Net 30), but there are many variations. Some, such as food distributors, may offer as few as 7 days (Net 7), while other industries require payment on a specific day of the month for all purchases made anytime during the previous month (e.g., Net 10th Prox). Problems arise when customers try to extend payment terms by another 15 to 30 days or even more.
Trade credit terms are intended to provide a convenience for the customer and unlike most loans are generally unsecured, in large part because they have a short term. Outside the USA, and in export markets, payment terms typically range from 60 to 120 days. For a foreign buyer, it is a lot easier to convert a purchase to cash in 90 days than in just 30 days. Besides offering convenience, payment terms represent an accommodation between your cash flow and that of your customer. It is not surprising then that longer credit terms, such as Net 90 and above, are more likely to be secured or backed up by some other sort of credit enhancement.
Problems Associated with Extended Terms
Extending payment terms delays your incoming cash flow. If too many customers request and are granted extended terms, it will cause a substantial strain on your cash flow. To compensate, you may have to borrow funds, pay interest and submit to the lender’s conditions and covenants.
In addition, extended terms increase your exposure to customer bankruptcies and the resulting non-payment. If a customer has 60 day payment terms, and pays 30 days late, you will have three months of sales dollars at risk versus one if the customer had 30 day payment terms. Also, once granted, extended payment terms are very difficult to rescind.
If other accounts learn of your granting extended payment terms to one customer, it is likely they will demand the same, further increasing your investment in Accounts Receivable (AR) and straining your cash flow. Actually, this is a reasonable request on their part because the Robinson-Patman Act (which deals with anti-price discrimination) stipulates that competing customers be treated predominately the same because terms are considered part of the price.
As we say in the title, there’s nothing good about extended payment terms . . . except if they enable you to secure an additional customer whose business is contributes significant profits, and whose credit risk is low.
During the pandemic induced economic slump, many companies reported requests for extended payment terms from their customers. The smart ones extended them for a limited defined period (e.g. 3 to 6 months), at which time they automatically reverted back to the original shorter terms.
In our current elevated interest rate environment, cash flow has taken on added importance. This is because the cost of money (borrowing to be specific) is significantly higher than it was before the pandemic. That creates a powerful incentive for buyers to find ways to delay payments to their vendors. Some will just pay late, but your more honest customers will request extended terms.
Unilaterally Imposed Extended Payment Terms
Unfortunately, many large companies impose extended payment terms as a condition of doing business, and offer their suppliers no opportunity to negotiate. Their value as a large customer enables them to do this. Some implement this with a formal change to any sales agreement and reflect it in their purchase orders. Others do not. They just take the extra time to pay your invoices.
Unfortunately, there’s not a lot that can be done other than choosing not to sell to the customer. You can try to resist, but unless you are a providing a unique product or service (have market power), your chances of success are slim.
To continue reading and learn 6 things to consider when confronted with a request for extended payment terms, as well as how to combat Payment Timing Optimization, you need to be a paid subscriber to Your Virtual Credit Manager. The good news is that until Wednesday May 1, 2024, annual subscriptions are only $29.40 . . . forever . . . that’s 40% off the standard price.
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How to Handle Extended Payment Term Requests
The same disadvantages exist no matter the status of the customers requesting extended terms. Your negotiation objectives should be to either retain the shorter payment terms or increase the price to cover your cost of borrowing money to compensate for the lack of cash flow. Achieving these objectives are difficult unless you’re willing to walk away.
Here are six alternatives you should consider when confronted with a request for extended payment terms:
Conduct a credit check to determine if the customer’s financial condition is deteriorating and their request is driven by the realization that they cannot pay on time with the existing, shorter payment terms. This is a red flag and you should revisit ways to reduce your exposure to this company (lower credit limit, shorter payment terms, strict order holds).
If you are willing to lose the customer, simply say no in a professional manner. If you also sell through a distributor channel, you may want to refer them to one of your distributors instead of selling then directly.
Attempt to increase your price to compensate for the increased borrowing cost and increased credit risk you will bear.
Your credit agreement should include the assessment of late charges on past due balances. While these can be hard to collect in the normal course of business, they can be a useful negotiating tool when a customer tells you they will be extending your terms (and it is always worthwhile to add in late charges whenever you are forced to place an account with a collection agency).
Arrange trade financing, which involves selling a customer’s receivables to a third party that will pay you at a specified number of days after invoicing (typically 3 to 10 days) and collect from your customer at a later date (typically 60 to 120 days. There are a growing number of Buy Now Pay Later (BNPL) products that provide these types of options for commercial transactions, but that’s a discussion for another day.
If a customer is facing a short term cash crunch, as many companies did at the onset of the Covid-19 pandemic, extending terms for a limited period will help you cement your relationship, and should be granted serious consideration when the customer is important to your business.
Beware Payment Timing Optimization
In order to improve their cash flow and working capital position, some companies have subscribed to Payment Timing Optimization. PTO seeks to extend the timing of payments to suppliers without arousing the ire of the suppliers. In effect, they are trying to extend their supplier’s terms without their suppliers even realizing it.
In practice, the customer’s AP department will gradually increase the number of days before remitting payment, and continue doing so until they get push back from their supplier. Assuming 30 day terms, most practitioners of PTO typically find they can easily extend terms to most suppliers beyond 45 and even 60 days from the date of the invoice.
The idea is to find out how many days past due a supplier will tolerate, and then pay just before that date. Companies utilizing a PTO strategy like to differentiate between your stated or published terms and the actual terms your company will tolerate.
Combating PTO is fairly simple if your actual terms conform to your published terms. Make sure your past due collection efforts commence as soon as an invoice goes past due. Automating dunning notices should be sent within 3-5 days of an invoice going past due and followed up by calls. Better yet, send a reminder — along with an invoice copy — that payment is due 5-7 days before the due date.
You should also monitor the average number of days it takes your customers to pay. Customers who consistently pay slow should be asked why and efforts made to change their payment behaviors. Customers whose payments are trending slower and slower need immediate attention. Either they are practicing PTO or they are facing cash flow issues and possibly financial distress.
Some Final Thoughts . . .
When possible, extended payment terms are to be avoided. Inevitably, however, you will be forced to accept some extended payment terms, but each request should be evaluated both in respect to it’s own merits and the impact on your company’s cash flow and capital structure. When granting extended terms always look for a concession of some sort in exchange. The goal is to minimize the negative impact on your company, and if possible solidify your relationship with the customer.