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Manage the Impact: How to prevent the negative effects of extended payment terms

 

by Joe Mark

Vice President, Relationship Manager Team Lead

Enterprise Bank & Trust, Member FDIC

You land a large, industry-leading company as a client that could have a significant impact on your bottom line – but they ask for 90 days to pay their invoices. How do you handle this issue?

Extended payment terms are a policy in which one company does business with another but uses leverage it has to pay invoices over a longer-than-normal period, which can exceed 90 days — and sometimes 120 days or more.

For example, a startup that sells a product to a large retailer, such as a big-box store, historically could have expected payment within the traditional 30 days. Under extended payment terms, the retailer might negotiate to push its payment window to the vendor out three to six months.

We began hearing about this from clients more than a decade ago, but extended payment terms are increasingly common now in the corporate sphere. Our 2018 Enterprise Think Tank survey, which had close to 100 small and midsize business leaders participate, reported 67% are impacted by extended payment terms, but most were simply not addressing it. This can be caused by uncertainty about how to approach the situation.

If your company is trying to improve its cash cycle by extending payables and collecting on receivables, it’s an issue demanding attention. Solving payment term problems and preventing them can be your competitive advantage.

Common Risks Associated With Extended Payment Terms With all the opportunities and obstacles you manage daily, it can be tempting to disregard the problem of extended payment terms, but the problem can create many potential negative consequences that reach well beyond payables and receivables, including:

  • Strain on Operational Costs When your company has to wait two or more months to be paid for completed work, it becomes harder for you to manage ongoing operational costs.
  • Lack of Reinvestment When your company accepts longer payment terms, it doesn’t invest as much in areas like research, innovation, development or hiring.
  • Growth Limitations When your high-value clients take longer to pay, you’ll likely find it more difficult to serve their needs. Your company might struggle to pay the vendors you rely on, which then degrades their overall quality of service.
  • Negative Business Impact Accepting longer payment terms has a negative impact on cash flow, making it more difficult for you to invest back into your business.
  • Fixing the Issue Even when you can’t avoid extended payment terms, you can mitigate their negative impact. Startups we see successfully addressing this challenge are taking action using these strategies:
  • Consider a Line of Credit According to the Think Tank survey, one of the most common actions taken to combat extended payment terms demanded by customers is securing a line of credit. There are some very specific questions to consider in evaluating whether a line of credit is a viable option for your business. Consider the following questions about your customers in regard to receivables mix:

1. How long have you been doing business with them? 2. Have you had to write anything off for them? 3. Do they have a history of disputing invoices? 4. How long have they been in business? 5. Are their financials sound?

Understanding the trends and data associated with receivables will not only help you understand whether a line of credit is right for you, but it will also help you evaluate any risks in your business portfolio.

  • Maintain Open Lines of Communication Startups often agree to terms because they believe they have no other option. This is especially an issue when the payer is an industry-leading company. We have seen many companies negotiate more advantageous payment terms just by having conversations with their clients or vendors. If the goal is to secure speedy payment from clients and extend the time required to pay vendors, advance negotiation is required. Avoid the instinct to work with the most senior officer. It may be difficult to find bargaining leverage with executives. Instead, work with the person who can deliver the most value and wants to cultivate a long-term relationship with you.

Payment terms should be locked in at the same time as pricing agreements. If you need assistance dealing with shortened cash flows due to extended payment terms, you should be transparent with lenders about the sources of cash flow issues rather than repeatedly asking for additional funds, as this maintains transparency and trust.

  • Utilize Purchase Cards to Your Advantage Even for companies that strictly manage payment terms, it’s possible for cash flow issues to inhibit operations. In these circumstances, a vendor payment program is a real asset. These programs turn purchasing cards and other lines of credit into cash flow tools instead of acting solely as instruments of debt. For example, if a company is required to pay in 30 days but must wait 60 or 90 days for payment, a vendor program uses credit to harmonize the schedules. That way, even if payment is technically due in 30 days, the actual financial impact is not felt for 60 days or more.
  • Diversify Your Business Portfolio Trends in the market we see with business owners suggest that large companies have natural inclinations to extend payment terms. For this reason, when startups work only with large clients, they contend with cash flow issues on a much more regular basis. Avoiding concentration in a narrow base of clients can help your company mitigate the risks extended payment terms may pose. That way, if one of your clients extends payment terms, the impact is manageable rather than catastrophic.

Even if you’re not impacted by payment terms today, if that payer extends or changes payment terms, it could be disastrous for your cash cycle. The broader your customer base is, the more stable your company will be. Other considerations that can disrupt your receivables include an overabundance of project oriented work, concentration of revenue/large customers and narrowing margins.

  • Explore Alternative Options Think Tank survey respondents reported three primary strategies to address payment term issues: changing the pricing model, opening a new line of credit and discounting prices for early payment.

There are numerous options available that help solve issues created due to extended payment terms, and there’s no one-size fits all approach. In determining the right solution, it’s important to understand how payment terms are really impacting your business. In determining the impact, consider the following:

1. Do you have adequate margins to carry your receivables should something change with your largest customer? 2. What other levers can you pull in your cash cycle to improve cash flow? 3. Are there opportunities to improve cash flow without borrowing?

Work with your banker to model the various scenarios relative to your cost of funds, your growth opportunities and your business plan. This will lead you to the right solution for your startup.

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