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How To Set Reasonable Payment Terms

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Posted by Brett Romero - 28 August, 2019

8 Hidden Costs of Extending Trade Credit

When you’re selling a large ticket item or service, a lot of your customers don’t have the cash available to purchase immediately. In a business to business transaction, paying a large lump sum at once can put businesses in a tough spot. When a business wants to make more sales, they’ll often allow businesses to pay within a certain time frame, usually 30, 60 or 90 days. In other words, they will extend trade credit.

While extending trade credit is a great way to make more sales, it brings with it a lot more costs, especially when you’re doing it by yourself in house. Here are just a few of the costs you can associate with offering financing, or in other words, extending trade credit.

1. Invoicing Software & Databases

When you’re thinking about the costs associated with extending capital to your clients, it’s easy to forget about the support system you need to setup so you can actually do it. Invoicing software has been a huge help to companies looking to offer net 30 or other forms of financing, but it still costs your company money, usually hundreds of dollars a month.

Trade Credit Software Cost-01
On top of that, you’ll often need additional software such as database software to support your invoicing software. These can add additional expense.

Experian trade credit Databases-02Experian Pricing

2. Accountants Salary

If you have invoices going out, it doesn’t matter how great your invoicing software is, you’ll still need someone to run it. Even if it’s combined with other accounting tasks, you’re still looking at thousands of dollars a month worth of manpower to deal with accounts receivable.

Screen Shot 2018-08-15 at 11.18.50 AM
Image Source: Glassdoor

3. Credit Insurance

Businesses that are looking to guard their accounts receivable against too many bad debts turn to insurance companies to help protect against these losses. This kind of insurance is called credit insurance and it can prove invaluable when trying to create a steady cash flow. Just like anything in business, it’s not free. Insurance companies will usually be paid based off a whole turnover basis. This can add up.  

Trade Credit Insurance Cost to SupplierSource

4. Uncollectable debt

Uncollectible credit in B2B ReceivablesA big obvious cost of extending trade credit to your customers is the uncollectible debt you’re going to have. It can be frustrating to provide a service or product to a customer and not receive payment for it.  

A lot of companies turn to collection agencies to help get their payments, but even then you’re going to be paying for their services. As seen to the left, uncollectable in some years has been on average 2.7% of all invoices.

5. Cost of capital

Another cost of capital is just not having that capital in your hand. When you extend $1000 worth of trade credit, that’s $1000 you don’t have to work with. One way to find out exactly how much this is costing is figuring out your weighted average cost of capital, or your WACC. When your business trade credit terms are net 60 or net 90, it can be easy to feel the cost of not having that cash on hand.

Average WACC by industry

6. Factoring

Often, companies that have a large number of accounts receivable, but need cash immediately will sell their accounts receivable to a financing company in a process that is called factoring. This can be a great way to boost your cash flow, but it doesn’t come cheap. 

factoring-rates-structureSource

Factoring can carry a high cost, largely because when you sell your accounts receivable, the risk goes along with it. While cash on hand can help you take advantage of opportunities that will help your company grow, you need to be careful to make sure your opportunity cost is greater than the cost of factoring.

7. Sales Department Salaries

A lot of companies will use their sales department to reach out to their clients in order to collect late payments. This makes perfect sense right? The salesperson already has a relationship with the client, and it would be a lot easier for them to negotiate the debt payment.

Here’s the issue.

Every hour your sales team spends chasing down debt is an hour spent not making a sale. IF you’re constantly chasing the money you’re already owed, you’re not chasing the money you have yet to make. While your immediate cash flow may improve, you're sacrificing your future cash flow.

Sales doing collections

8. Early Payment Discount 

One way companies incentivize customers to pay on time is with a discount, usually a 1/10 or 2/10 discount. What this means is if the customer pays in the discount period, which in the case of 1/10 or 2/20 is the first 10 days, they’ll get either a 1 percent discount or a 2 percent discount.

early payment discount for trade creditSource

While this is a great way to get paid quicker, and more consistently, you have to remember this is still a cost of extending trade credit. If you required people to pay up front, you would not have any early pay discount, and you would receive that money immediately.

Other Options

A lot of companies do in-house financing and succeed at it, generating sales while also collecting payments. Recently however, there has been a trend towards using 3rd parties to facilitate the financing. Companies like Apruve have developed platforms to manage credit while also managing invoicing and accounts receivable. 

When deciding which trade credit terms and processes are right for your business, make sure you take all the costs into account so you can make more sales, growing your company towards the future. 

Net terms accounts receivable

Topics: Finance, Management, Sales & Marketing

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