Effective cash flow management is crucial to the financial health of any business — and it starts with clear payment terms. Payment terms are more than just details on an invoice; used skillfully, they can be a vital part of a business’s financial strategy. From billing methods to acceptable forms of payment and potential early payment discounts, these terms set the stage for your company’s financial interactions. By understanding the potential effects of different payment terms and then employing the most suitable terms, businesses communicate their expectations clearly to customers, which should increase their percentage of on-time payments and, in turn, improve their cash flow.
What Are Payment Terms?
Payment terms are the conditions agreed upon by buyers and sellers that document how and when a company gets paid for the goods or services it provides. They should be clear and precise so as to set expectations for the business and its customers. Payment terms may include the method of billing, such as billing in advance, billing in arrears or progress billing; how much time a customer has to make a payment, such as 30 or 60 days; what forms of payment are accepted (and the currency to use in international sales); discounts offered; late fees; and any special treatment for a particular customer.
For example, a company might choose to bill using “2/10 net 30” terms, where the customer can take a 2% discount if they pay within 10 days. Otherwise, the full amount is due within 30 days. Another example is cash In advance, where payment is required before any goods or services are provided.
Key Takeaways
- Businesses can set payment terms that work best for both their cash flow and risk tolerance.
- Payment terms should be clear and transparent, and established at the beginning of a customer relationship.
- Different industries have different standard expectations of payment terms.
Payment Terms Explained
Payment terms include a stipulation about when a business gets paid. Customers may not always follow payment terms to the letter, but having such terms in place creates a clear path toward payment and dispute resolution, if needed. So, when a company establishes payment terms, it is essentially creating its cash flow cycle. Payment terms determine when and how accounts receivable come in and accounts payable go out.
Payment terms can vary, depending on the nature of the business relationship; so, they are sometimes negotiated from one client to the next, although the seller typically sets the conditions for routine sales transactions. So, for example, a construction contractor may be willing to accept payments that are spread out over six months after completing a job for a trusted, longtime client — but if that contractor purchased the materials for the job from a retailer with which it had no prior established relationship, it likely paid at the point of purchase.
Keeping payment terms clear and transparent means clients should know what to expect and can be prepared when payment is due. When customers are billed, the agreed-to payment terms should be included on the invoice. In addition to the amount due, invoices may include late-fee penalties, method of payment, when payment is expected, and any additional stipulations specific to that client. In this way, payment terms help businesses get reimbursed and provide a structure through which they can consistently monitor transactions and take action if any issues or disputes arise. As a result, payment terms are more than mere transactional instructions; rather, they’re an important framework for improving cash flow and business-client relationships.
Different Types of Payment Terms
When a business develops its payment terms, it can choose from a multitude of options representing different approaches to how the business will get paid. Which type of terms a business uses may depend upon factors ranging from industry standards to the customer’s credit, but selecting and communicating appropriate payment terms can help businesses manage their cash flow, improve customer relationships, and mitigate the late or non-payments. Here are explanations of 10 of the most commonly used payment terms.
Advance Payment
When a business stipulates payment in advance, the customer must pay for goods or services before they are delivered or performed. Often, it is partial payment covering a predetermined percentage of the total cost. Advance payment is sometimes required by manufacturing companies if goods are made to order or customized, or by services companies that will be doing a significant amount of work before the job is completed.
Net D (e.g., Net 30, Net 60)
“Net” means the amount the client owes after any discounts, markdowns or credits are applied. The “D” is short for days, and it refers to the number of days until a payment is due after the invoice date. Either buyer or seller may stipulate a Net D based on their cash flow requirements. Large organizations usually set a Net D that favors their cash flow — for example, proposing payment of invoices in 60 days or more, as opposed to the more traditional Net 30 — giving their suppliers little choice in the matter, if they wish to do business with that company.
Cash on Delivery (COD)
Payment is provided immediately upon receipt of goods delivered. It also is referred to as “due upon receipt.” COD is often used to mitigate the risk of nonpayment when a business begins servicing a new customer or one that has been delinquent in the past.
End of Month (EOM)
With this payment term, the money owed is due at the end of the month in which the invoice was issued. Businesses may require EOM if they’re trying to synchronize payments with their monthly financial cycle.
2/10 Net 30 (Cash Discount)
This type of early cash discount, often referred to as an ECD, explains how much a client can take off the invoice if they pay within the time frame listed. ECDs are used to accelerate the seller’s cash flow by providing an incentive for the buyer to pay more quickly — and they can be highly effective. With 2/10 net 30, for example, a client would save 2% if they paid in full within 10 days; otherwise, they have 30 days to pay the total amount. This means a client could save $20 on a $1,000 invoice issued on Dec. 1, if they paid in full by Dec. 10.
Letter of Credit
Letters of credit have been in use for centuries, holdovers from a bygone era when transportation of goods took months and communications of all kinds were equally slow. They survive today as a payment term used almost exclusively for international transactions, though there’s no reason they couldn’t still be used domestically. A letter of credit is a contract from the buyer’s bank in which the bank guarantees payment once goods are shipped and the necessary documents are provided to the bank. Nowadays, the buyer is almost always an importer, which secures the letter of credit from its bank to reduce the seller/exporter’s risk of nonpayment. Letters of credit can help a business expand into global markets, since they guarantee payment.
Consignment Sale
This is a trade agreement where a supplier, or consignor, provides goods to be sold to customers by another party, or consignee. The consignee can return unsold goods to the consignor, paying only for the items sold to end customers. Consignment relationships are often considered old-fashioned — you might picture a thrift shop or an art gallery. But consignment is finding use at organizations of all sizes. Consigning stock helps retailers lower their risk as they generate sales from new, untested products. It adds titles to bookstores’ shelves, with low cost to the publisher and the consignee retailer. Consignment can be a flexible and innovative tool to better manage inventory investment and capture additional sales. On the flip side, it can raise risk for the seller, which must have sufficient cash flow to cover costs until end customers buy, and which must deal with the challenges of managing inventory across a network of consignors.
Open Account With Revolving Credit
Just as consumers have credit cards and home equity lines of credit, businesses buy from other businesses on credit via an “open account.” But, in many circumstances, the seller will choose to lower its risk of nonpayment by applying a credit limit to all or to only unproven buyers. An open account with revolving credit means a customer can access its line of credit repeatedly, up to the limit set by the provider. As payments are made to reduce the outstanding balance, that money again becomes available to borrow in the form of purchased products or services.
Payment in Arrears
Most people think “arrears” means “overdue,” but that’s not true. It means being “behind,” which, in the case of this payment term, simply means that a business will bill its customer after completing the agreed-upon work or delivering the goods. Billing in arrears is the most trusted method of billing for business customers that want the peace of mind that comes with being able to inspect the work before paying.
Installment Payments
The client is billed in regular intervals and pays the total amount for the product or service over a period of time. Installment payments typically are used on larger purchases or capital expenditures. They may also be used for service contracts and projects that span many months.
Importance of Establishing Clear Payment Terms
Establishing clear payment terms isn’t just a matter of settling day-to-day finance operations or determining the deadline for entering invoices into an enterprise resource planning (ERP) system’s accounting module. Because they help a business forecast how much money will be available to fund its immediate cash flow needs, such as payroll, rent, utilities and paying suppliers, payment terms can be a proactive method of defining payment administration operations to support day-to-day and long-term financial requirements. Defining when and why customers should pay their bills is one of the best ways to avoid the potential chaos and uncertainty of running a business and to ensure that the business’s best interests are respected by its customers.
Making sure the payment terms on a contract and invoice are clear and easily understandable for the client creates the following advantages.
Ensuring Financial Stability for the Seller
Clear payment terms support greater predictability of business operations. Knowing how much money is expected to come in, and when, is essential to the accuracy of a company’s cash flow projections. Having clear payment terms makes it easier for a company to forecast its financials to keep the business running smoothly and to manage growth.
Building and Maintaining Healthy Business Relationships
In business terms, trust is predicated, in part, on reliability. Clear payment terms give buyers and sellers a set of agreed-upon expectations to work with, minimizing the potential for confusion or conflict. Establishing such expectations is usually necessary for customers to be satisfied — and a happy and satisfied customer is almost always a repeat customer. Keeping a customer relationship strong takes effort. Understanding the customer better is a good way to maintain your customer base and, more important, grow the business. Software can help to manage the customer relationship via data collection, aggregation and analysis.
Mitigating Risks Associated With Nonpayment
Clear payment terms help manage and mitigate the risk of nonpayment. Customer incentives, such as early payment discounts and late fees, lessen the chances of customers not paying their bills. In addition, when negotiating payment terms with a client, a business can ask for partial payment up front. All such terms should be stated clearly at the outset of a customer relationship — and documented on contracts, statements of work and invoices — so that there are no surprises when the client receives the invoice.
Enhancing Cash Flow Management
Payment terms are key variables for businesses when it comes to managing cash flow. Setting appropriate terms will ensure that a business has the necessary liquidity to meet expenses and drive planned growth. So, understanding the company’s cash flow requirements should be one of the main factors that determine the company’s payment terms. For example, offering an early payment discount can help get money into company accounts in a timelier manner. Same with asking for up-front payment in full or in part, depending on the nature of the industry and the client relationship. Payment terms’ due dates can help a business balance the flow of its receivables and payables. If a furniture maker pays for lumber COD but uses 90-day payment terms when it sells to customers, the business will find itself experiencing a cash flow imbalance that will have to be managed.
Factors Influencing the Selection of Payment Terms
Payment terms can be broadly influenced by various elements. For example, the nature of a business’s work might determine whether payment is due in advance, when goods or services are delivered, or in arrears. The experience and stability of the relationship between buyer and supplier might dictate whether flexibility is warranted, while financial conditions may make it necessary for a business to be more stringent — or more lenient. The following six factors are the ones customarily considered when crafting payment terms that align with a company’s operational needs.
Nature of the Business
The type of business and customers’ expectations for that business often dictate payment terms. For example, wedding venues, which provide a (theoretically) once-in-a-lifetime service, typically invoice in installments, whereas retail stores usually insist on cash at the point of sale. Services-based businesses with ongoing client relationships might sell on credit, opting for net 30 or net 60 terms, while a wholesale business might require COD.
Relationship With the Buyer
Is the buyer a longtime customer that has given the company plenty of business over the years and paid on time? If so, that can be taken into consideration when setting terms, such as by extending the length of the payment period or even waiving late fees. With newer customers, businesses can obtain a credit report to get a sense of their recent track record. Focusing on customer-preferred methods of payment can be another way to establish a good relationship with clients and can be a bargaining chip to receive payments sooner.
Economic Conditions
Changes in the economy can also influence payment terms. For instance, when the economy is booming, a business may be able to be more generous with payment terms than it would be during a downturn — it might offer a longer payment period or discounts for prompt payment. Conversely, in an economic recession, the business might be more likely to adopt stringent payment terms as a way to mitigate the risk of its customers making late payments or defaulting. Rising inflation can also be a driver of new, less flexible payment terms that allow the retailer to recoup as much as possible of its invoiced amount in more valuable dollars. It can be a delicate balance at times, but the right adjustment may yield bigger benefits in both the short and long terms. For example, a company that doesn’t pass on credit card fees to its customers during hard times could actually increase its sales, as buyers may appreciate that and develop stronger loyalty as their financial picture improves. And, if a seller with a strong financial position is able to maintain its payment terms during tighter economic times — or even extend them for loyal customers — it could, again, reap long-term benefit in the form of increased customer loyalty, albeit at the cost of increased risk. Regardless of the strategy, companies should adjust their payment terms on the fly to ensure that they continue to align with the economy at any given time and to help the business react swiftly as the economic climate evolves.
Industry Standards
The payment terms that become standard in any industry are influenced by the operational tempo, the nature of the goods or services provided, the typical sales and delivery cycles, and the standard practices that have evolved over time within that industry. What’s common in the food and beverage industry, which sells perishable goods and has a high volume of transactions, doesn’t necessarily correspond with accepted standard payment terms in professional services or construction, the latter of which often uses progress billing tied to milestones due to the nature of long-term projects. In the auto repair business, payment terms can range from immediate to net 30 or even net 90 days because repair shops may have to wait for insurance payments. One way to stand out in an industry is to give longer payment terms or slightly higher discounts than competitors offer — but be mindful of your company’s cash flow when using such enticements.
Financial Health of the Buyer
Consider stricter terms — such as up-front payments, either in part or in full, or COD — for clients that frequently pay late or may not have the strongest credit or track record, to lessen the chances of not getting paid at all. If the buyer has a positive history with the company, offering more convenient payment terms is an option, such as a longer time period to pay or early payment discounts. Most companies will run a credit check on new customers before allowing them to buy on credit. Some businesses also may stratify their payment terms based on the customer’s credit score.
Geographical and Cross-Border Considerations
When it comes to payment terms for international sales, there are more risks to evaluate than for domestic transactions. To mitigate those risks, international transactions may involve letters of credit or advance payments. The type of order also plays a part — for example, does it involve stock goods or a custom-made product? — as do the political and economic climates of the buyer’s area and the delivery destination. In certain markets, foreign currency controls may limit options for payment terms. Consider how unstable political and economic situations can affect short-term price changes and currency exchange rates. With longer payment terms, that could prove costly to your cash flow. Every company has a preferred approach to risk management, so consider those guidelines as well when establishing payment terms for international dealings.
Negotiating Payment Terms
Certain businesses, such as credit card companies, have set payment terms in place, with no room for negotiation. In others, such as professional services, there are opportunities for supplier and customer to work together to devise a payment plan. Whether you are the seller or the buyer, negotiating favorable payment terms can improve your cash flow. The longer a business holds on to cash, the more liquid it is. And, better cash flow and greater liquidity can also lead to an improved credit rating.
So, when working with clients to negotiate payment terms, remember that the ideal terms for a business are those that optimize its cash flow. The more lenient the terms, the more a business might struggle to pay its bills while it awaits receivables. Two integral steps at the outset: understanding your company’s risk management levels and analyzing its working capital requirements . The company’s positions in these areas can help determine how strict or lenient you can be with a client at the time of negotiations.
Learning the credit history and business reputation of a potential client also can provide leverage in negotiating terms. A positive and nearly spotless track record may earn a client more favorable terms, since the risk level of nonpayment is lower. Conversely, a client with a spotty record and questionable credit worthiness could find itself facing more stringent terms, such as full payment in advance of delivery.
However, delinquencies are part of doing business — and another point at which a business may find itself negotiating payment terms with a customer. Depending on the length of nonpayment, a company may want to recoup as much money as possible for goods or services it has already delivered. But, whatever the number of days sales outstanding, there are a few things you can do to manage both payment terms and the client relationship:
- Listen to the client’s situation and hear out their issues.
- Offer a restructured payment plan that helps manage the debt and ease their stress.
- Compromise where possible, such as on due dates.
Legal Considerations for Payment Terms
Payment terms should always be established in compliance with the relevant laws of the jurisdictions of both the buyer and seller. In the United States, that usually means the Uniform Commercial Code(opens in a new tab) (UCC), a standard set of laws that has been adopted by all 50 states. The UCC provides a common legal framework for commercial transactions, including payment terms. Its provisions set forth a clear understanding of when payment is expected and what happens in the event of nonpayment. For example, even if a contract contains no payment terms, the UCC establishes a default expectation that payment is due upon delivery of the goods. It’s important for businesses to be aware of UCC stipulations and ensure that their contracts and payment terms comply.
To be clear, complying with the law is about more than simply meeting regulations; it’s about establishing the strongest legal framework around payments to make sure that your business gets paid. Different international regions have different criteria, and what’s allowed in one location may be unacceptable in another. Clear payment terms can help a business protect itself from a legal dispute, giving a company cover if a customer doesn’t adhere to the terms or requests a refund.
Under the UCC, businesses are legally allowed to add late fees to overdue invoices, but they may only do so in a way that’s clear when the contract is signed and that is considered fair and appropriate. These requirements make the addition of late fees valid and act as a deterrent for late payers.
Should an invoice not be paid, a business can opt to sue the defaulting customer to seek payment. Companies considering legal action must be prepared to show they have tried to collect payment for the unpaid invoice. Otherwise, if the dispute is brought before a judge, the company could face an even tougher time collecting.
Technologies for Payment Term Management
Various technology solutions can significantly help businesses manage their payment terms. Accounting software can automate the creation and delivery of invoices according to specified payment terms — for example, as soon as a job is completed or goods are delivered. Such systems can also generate reminders that give customers a nudge, automatically, when a payment deadline is approaching, which boosts customer compliance.
Digital payment systems, meanwhile, can simplify the actual payment process and give customers maximum flexibility in how they pay. They can also feed automated payment-processing systems for one-click payments, minimizing the time it takes to invoice and receive payment. This can improve a business’s liquidity. It is also a selling point for customers that appreciate having different payment options.
ERP systems with integrated accounting software can analyze historical payment data to help businesses understand how much cash they’ll have on hand in a week, a month or a quarter, so they can set payment terms that truly reflect the business’s financial requirements for that period. Such systems can further analyze payment data to detect trends and help the business adjust terms strategically. For example, if recent payment data shows that an increasing number of customers are paying within a shorter time span, you may choose to temper the agreed-upon payment terms accordingly.
Manage Payment Terms for Faster, Easier Invoicing With NetSuite
The more payment options you offer a customer, the more complex it can be to manually manage accounts receivable. It eats up time and increases the risk of human errors. One accident with a decimal point when calculating an early payment discount, or one number transposed with another on an installment invoice, can wreak havoc with payments. NetSuite cloud accounting software eliminates such errors by automating many accounting processes, including payment management. NetSuite’s cloud-based software can automatically send invoices and process payments, making it feasible for businesses to deliver accurate invoicing quickly and, in turn, gain prompt payment — a clear win-win. Furthermore, it can provide real-time data insights no matter how many payment methods you use. Companies can use NetSuite’s payment processing solutions to process payments via credit card, direct debit, ACH and many other digital options. With NetSuite’s real-time financial reporting, your business can know exactly where its liquidity stands, boosting confidence in financial decisions. Meanwhile, built-in financial controls provide assurance that payment terms are being honored — while safeguarding the business against fraud.
Payment terms should be easy to understand, agreed to up front and always clearly listed on invoices. The terms you put on those invoices, however, should be the ones that make the most sense for your business model — in other words, the terms that best maximize cash flow. There are times, though, when businesses must balance their cash flow requirements with effectively managing client relationships. Payment terms may change from one client to the next, but most businesses will start with a basic framework and proceed from there as needed. Automated accounting software can help businesses choose the right payment terms and then adhere to them well over time.
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Payment Terms FAQs
What are standard payment terms?
There are many different types of payment terms a company can use when invoicing clients. Some standard or common terms include:
Payment in advance: This can be a partial deposit or complete payment before a project is begun or a product is delivered.
Cash on Delivery (COD): The seller pays for the goods or services at the time they are delivered.
Due upon receipt: Payment is expected at the time the customer receives the invoice.
Net 30 days: The client has 30 days from the date it receives the invoice to pay the bill. Other common net-days numbers include net 7, 15, 60 and 90.
End of the month: Payment is due by the last day of the month in which the invoice was received. For example, under these payment terms, whether you received the invoice on May 4 or May 22, it’s due by May 31.
What is a payment terms example?
Early payment discounts are a familiar method companies use to incentivize a client to pay promptly. It will look something like this on an invoice: “4/10 net 21.” In this example, that means a client can save 4% if the bill is paid in full within 10 days. If that doesn’t occur, the client has 21 days to submit the full payment. Early discount terms are up to the parties involved.
What are payment terms options?
Payment terms options refer to the number of ways a business can charge clients for its goods and services. The parameters are set for when payment is due, whether partial payments are required in advance, whether an installment structure is in place and any late penalties that may be assessed for delinquent accounts.
What is the most common payment term?
Best practices for choosing payment terms will differ across industries. What’s common in manufacturing may be the complete reverse of what’s typical for a marketing firm or food services company. Nevertheless, perhaps the most common payment term is “net 30 days.” That gives the client up to 30 days from receiving the invoice to make the payment.