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Many business owners don’t give too much thought to their invoice payment terms, choosing instead to follow industry standards or to do things “the way they’ve always been done.”
This can be deadly for your business.
Choosing the right invoice payment terms is essential for your business accounting processes, as it can be the difference between positive cash flow and a cash flow crisis. Many businesses that are profitable on paper fail due to inadequate cash flow. Invoice payment terms not only regulate your business’s cash flow, but they can also impact your customers’ payment habits, including whether or not payment will be collectible at all.
Let’s start with a quick look at what invoice payment terms actually are.
Invoice payment terms are the conditions you set forth when you invoice a customer for products you have sold them or services you have rendered. These terms dictate the due date for the payment, as well as any discounts that might be applied for timely payment (more on this later). They should also include any payment plan details, interest and penalties for past due payments, and the payment methods you accept.
All payment terms should be included on each invoice you send to your customers. This makes it easy for the customer to know exactly when and how you expect to be paid, as well as the consequences for late payments.
As a business owner, you want to be fair to your customers. You also want to encourage your customers to purchase large amounts of products or services from you, and to do so frequently. Because of this, many business owners choose to give extremely generous payment terms to their customers—sometimes at the expense of the health of their own businesses.
For example, let’s say you are a clothing manufacturer. One of your customers purchases $50,000 worth of clothing from you—one of your biggest orders ever. The customer knows it will take them a couple of months to sell the merchandise, so they ask if you will give them 90 days to pay the invoice.
You’re concerned if you say no, the customer might reduce the size of their order. You don’t want that to happen, so you agree to the payment terms.
A few things could happen next:
Conversely, maybe you have a marketing agency, and you require a deposit upfront for work you will do for the customer. This protects your cash flow—giving you working capital at the beginning of the engagement to pay your staff—but it also creates a liability for your company. If something happens and you aren’t able to deliver on your service agreement, or if the customer cancels the contract within your cancellation guidelines, you will have to refund the money to the customer. This can be problematic if you have already used the deposit money to pre-fund the work for the client.
The “days to pay” stipulation is only one component of your invoice payment terms. Your terms should also include what payment methods you will accept. There is an element of expense and risk to any payment method you accept. Credit card and PayPal payments come with service fees and can be recouped by the customer if they submit a successful dispute with the payment service provider, whereas payments by check require handling by yourself or a staff member and the risk of the payment not clearing.
Some business owners decide it’s too expensive to accept credit card or PayPal payments, but this can be short-sighted. Often, customers will pay sooner if they can pay with a credit card or with a few clicks into their PayPal account. On the other hand, many large businesses won’t pay invoices electronically, instead opting to mail checks to their vendors.
Use caution when determining your accepted payment methods, keeping in mind cost, risk, and customer expectations.
Now that we’ve discussed how payment terms can impact your cash flow and some of the risks inherent to the common payment methods, let’s take a look at the most common invoice payment terms and the pros and cons of each.
Many businesses have started collecting all or part of the payment due from the customer at the beginning of the business relationship. This can be done in one of two ways.
Getting paid in full before delivering a product or service removes the risk of the customer defaulting on the payment. It also provides your business with the capital necessary to deliver the product or service. However, collecting payment in full upfront puts the onus on you to deliver as promised or to refund the money if you fail to do so.
Some customers are hesitant to pay in full prior to the delivery of a product or service, though. This is especially true if they are purchasing from a new business or if they are purchasing from an industry with a track record of problems with delivering as promised. Requiring payment in full upfront can cause tension between you and your customer, and it could result in the customer choosing to purchase elsewhere.
You can make these payment terms a win-win for you and the customer by providing satisfaction guarantees. You can also allow the customer to pay with a credit card or some other method that will allow them to recoup their money if you fail to deliver, but be careful to only accept payment methods that will hear your side of the dispute should one arise.
A deposit works much like payment in full upfront, except only a portion of the total amount is collected from the customer in advance. Like getting paid in full upfront, getting a deposit from a customer provides your business with the money needed to deliver the product or service. Customers might feel more comfortable with a deposit than payment in full upfront because a smaller amount of money is at risk.
Either party can sever the sales agreement early in the relationship, and the deposit money can be refunded if the business relationship doesn’t work out. This eliminates much of the risk associated with payment in full upfront for both parties.
A lot of businesses still invoice in arrears (after the product or service is delivered). This is the arrangement most customers are accustomed to. Billing in arrears puts more risk on the vendor because the customer has received the product or service promised, but it can increase the customer’s comfort level with the transaction.
Some of the most common payment terms for billing after delivery are:
The due date on an invoice that is due upon receipt will be the same as the date of the invoice itself. Some businesses use due-upon-receipt payment terms because they think this will speed up the collection of the payment due. However, many customers will enter a due-upon-receipt bill as due in 30 days, which can actually slow down the payment. For this reason, we don’t recommend due upon receipt payment terms.
An invoice with net 10 or net 15 payment terms will likely arrive at the customer’s office a few days before it is due. You still might not collect the payment right on the due date, but invoices with net 10 or net 15 terms may actually be paid faster than those with due-upon-receipt terms because they outline a specific timeframe. If you need to collect quickly, use either net 10 or net 15 payment terms.
Net 30 payment terms are pretty standard across industries. As mentioned above, many customers will default to net 30 if they receive a bill that states it is due upon receipt. If you have healthy cash flow—and if your industry dictates it—there’s nothing wrong with net 30 payment terms. Just know that not every client will honor this deadline.
Some businesses allow customers to pay for large purchases in multiple installments. The most common installment arrangement is a 30/60/90 day payment arrangement. A 30/60/90 payment arrangement means you will receive part of the amount due every 30 days—making it preferable to net 60 or net 90—and it also encourages your customers to purchase more from you since they will have longer to make their payments. These are generous payment terms, and you should look at your overall projected cash flow before offering it to your customers.
In addition to the invoice payment terms outlined above, here are some additional considerations to keep in mind when billing your clients.
Sometimes a business will extend a discount to a customer who pays their bill early. A common example of this is “2/10 net 30.” This sort of payment term indicates payment is due in 30 days, but the vendor will extend a 2% discount on the total of the invoice if it is paid within 10 days.
Early payment discounts can speed up your receipt of payment and reward customers for good payment behavior. However, not all customers will take advantage of these discounts, so you shouldn’t count on receiving payment in 10 days from most customers. Also, you must make sure your overall pricing strategy can support a 2% reduction in the total for invoices with early payment discounts. Many businesses won’t accept a credit card for early payment discounts, as skipping the credit card processing fee can help offset the discount you’re giving your client.
If you assess interest, late fees, or penalties on past due invoices, you need to spell this out on your invoice terms and conditions and also follow through on collecting these additional payments. Interest, late fees, and penalties can encourage customers to pay on time, but they will not typically speed up your collections as early payment discounts can.
In addition to choosing the right invoice payment terms for your business, there are a few additional ways you can use invoice payment terms to collect payment from your customers quickly:
Although you have to keep customer expectations and industry standards in mind when setting invoice payment terms for your business, your primary consideration must be your company’s cash flow needs. The best invoice payment terms are the ones that provide enough cash to keep your business running while still satisfying your customers’ needs and expectations. Your accountant or bookkeeper can help you run some scenarios to determine how different payment terms will impact your cash flow, which in turn will allow you to choose the best terms for your business.