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Navigating a New Normal: How Businesses Have Adapted Their A/R Practices in a Pandemic

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Posted by Matt Osborn - 17 September, 2020

Understanding Credit Terms and the Cost of Early Payment Discounts

Extending credit is increasingly being adopted as a business strategy to acquire more customers. In certain industries, it’s standard practice. While it’s admittedly a tactic that can generate more revenues for your business in the long run, before you jump on the bandwagon, understand that there are inherent risks, costs, and consequences associated with extending credit to your customers.

Credit terms – a definition

Credit terms, according to BusinessDictionary.com, are standard or negotiated terms offered to a buyer by the seller. Specified in the credit terms are:

  • the monthly and total credit amount
  • maximum time allowed for repayment
  • applicable discounts for cash or early payment
  • the rate or amount of penalty for late payment

Just so everything is crystal clear, with absolutely no room for guesswork that can become grounds for a dispute later, aside from a credit agreement that you and the customer signed off on, credit terms should be explicitly stated in the invoice.

When to offer early payment discounts

Companies offer discounts for early payment to encourage buyers to settle their payables early. On one hand, this ensures you have a consistent flow of cash to keep the business running smoothly. On the other, you lower your profit margins.

The question then remains: Should you offer early payment discounts to your customers?

The quick answer: It depends.

First off, do you immediately need the money? If yes, then go ahead and offer the discount. But if you have enough cash reserves to financially see your company through the next 30 to 60 days, for example, allow the customer to pay on their normal terms.

Second, can you afford to lower your profit margins? If your profit margins are already low to begin with, think twice about any early payment discount offers.

The cost of credit

Let’s say you offer a customer credit terms of 1/10 net 30 days, which means the customer only pays 99% of the amount owed when paid in full within 10 days. To calculate the effective interest rate granted to customers through early payment discount terms (also referred to as the cost of credit), use the following formula:

Discount % ÷ (100% - discount %) x (360 ÷ (allowed payment days – discount days))

For our example, we have:

  • Discount % = 1%
  • Allowed payment days = 30 days
  • Discount days = 10 days

Discount % ÷ (100% - discount %) x (360 ÷ (allowed payment days – discount days))

1% ÷ (100% - 1%) x (360 ÷ (30 – 10))

1% ÷ (99%) x (360 ÷ 20)

0.0101 x 18

18.18%

From the customer’s point of view, if the cost of credit is higher than the incremental cost of capital (“costs associated with acquiring more debt or equity” to finance a future project, according to Investopedia.com), then it would be wise to take the discount.

B2B Credit DSO payment How Apruve can help

Apruve is an end-to-end credit management service. From evaluating the credit-worthiness of your customers to granting them revolving lines of credit, to making sure you get paid on time, Apruve takes on much of the work tied with extending credit to your customers. It absorbs the risks that would otherwise keep you up at night, such as defaults, late payments, difficult customers, and a consistent, steady stream of cash to fund your operations.

With Apruve, you need not even think about offering early payment discounts or charging late payment penalties because the moment you issue an invoice to a customer, you promptly get paid within 24 hours.

Final word

Extending credit to customers is an exercise that must be approached with caution. And because credit management is a tedious process that requires considerable man-hours, partnering with credit management services minimizes the risks you have to carry, while allowing you to focus on growing your business. 

Net terms accounts receivable

Topics: Finance, Credit, Management


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