Payment Term Selections

Payment terms are often an afterthought when setting up an agreement with a vendor or large customer. We tend to think that everyone will pay their debts so there is little emphasis placed on choosing an optimal payment term. This overlooks a key piece of your business as payment terms can be leveraged to build long term relationships with other parties as well as protect your firm from more risky ventures.

There are four main buckets of how payment can be rendered, and we wanted to share our thoughts option for your business. Not all of these will work in all situations but knowing when to use which terms can greatly improve the chances of success for your business dealings. We will view this primarily in a business to business sales environment, but some principles can be applied to business to consumer sales as well.

Cash in Advance

Cash in Advance is a payment method that transfers all risk of the transaction onto the other party where the price of the goods is paid in full, in advance of delivery. There are some major advantages with this method for both the buyer and seller. For starters, this method allows certainty to the seller that the goods they are selling will be paid for in full before they lose possession of the items or render the service.

Every firm likes certainty in payment, and nothing can beat the certainty of being paid in advance of delivery. This act can even allow smaller firms a chance to deliver large orders by getting the cash prior to manufacture, funding the production of goods for the specific order. Cashflow management with this payment method should be highly valued.

Another benefit is that buyers who may not have access to credit, or who have poor credit, can still purchase goods. While many consumers have credit cards to pay for the goods or services, credit may be a challenge when selling to another business. This can be especially useful when a firm has gone bankrupt but is trying to rebuild after implementing a restructuring plan. A downside of this method is that all risks are shifted to the buyer, so if the seller fails to properly deliver the goods or service (or they are of poor quality) the buyer must go through lengthy legal (or return) processes to recover their cash.

When selling internationally, this method could be valuable in developing countries, where access to traditional capital institutions is scarce. While it may be difficult for firms in developing nations to pay cash in advance of delivery it allows the ability to import goods that would otherwise be inaccessible. Another way this method could be beneficial is if your two firms have a long history together and paying cash in advance allows for the avoidance of financing fees, therefore saving costs for both of you.

Letter of Credit

A letter of credit is a note issued by the buyer’s bank which is in favor of the seller. The main point of the letter is to be a statement that the bank will provide funds once certain criteria for delivery are met. The letter has an expiration date and cannot be revoked by the buyer once it is issued.

An advantage of this method is that it gives the seller near certainty that the bill will be paid while also giving the buyer a way to withhold the cash until the goods or services are fully delivered or rendered. While it may be only a small amount of security for the buyer, having the bank release the funds once the transaction is complete guarantees the buyer delivery of product.

This method is also beneficial for the seller because if the buyer fails to pay, the buyer’s bank would then peruse payment against the non-paying firm while the buyer receives payment from the bank, allowing their firm to continue to operate and not have a long gap without payment. A disadvantage of this method is that since the letter of credit is irrevocable there is the risk that by the time the seller sends the material the buyer may no longer need it and can’t cancel the order. While this may be an uncommon issue, it can happen when a highly anticipated product is ordered in bulk but then fails to sell in the intended final market. They may wish to cancel the order but are unable to pull the letter of credit so the seller may ship regardless and collect payment.

Another risk here is that since the letter has an expiration date if the seller fails to cash in the letter quickly, for any reason (such as bank closures from a pandemic) they may no longer have a means to collect payment for delivery of goods. Additionally, if the goods are of poor quality the money will be sent by the bank regardless as long as the delivery criteria has been met, which is an obvious disadvantage for the buyer.

This method could prove to be a valuable option when selling to high risk firms that have access to credit but do not have a long track record or reputation for paying debts yet. This gives them the ability to import goods with the backing of a local financial institution, so they can begin building a reputation within the business community.

Documents Against Payment

Documents against payable sight draft is where an agreed upon price is recorded in the document by the selling firms’ bank and the buyer will pay the amount of the draft to receive the documents (often a Bill of Lading) required to obtain the goods from the shipping company. An advantage of this method is that the banks are facilitating the transaction, giving the buyer a sense of security and that they will pay for the goods only after it has arrived at the final destination and have been inspected. The advantage here is that the buyer can decide when to collect the Bill of Lading and transfer the funds after the product arrives, giving them lots of flexibility if they no longer need the shipment once it has arrived. Once it has arrived, the buyer can then pay the bank to obtain the bill of lading to claim the goods.

Funds are transferred between the trading firms’ banks and are deposited in their respective accounts once all paperwork has been completed. A major disadvantage for the seller with this method is that if the buyer changes their mind while the goods are in transit or the service is being completed the seller can end up with their finished product sitting around without a customer.

This method could be well suited for when a purchasing firm is bringing in goods from a new supplier and they want to have certainty they will receive the goods prior to surrendering their funds. While this is a big risk for the seller it may make sense in the short term to do this method, so they can build a relationship with the buyer and show good will towards their new trading partner.

Open Account

The open account method of payment is where there is a standing account open between the buyer and seller that can be transacted on throughout the business relationship. With this method, the invoice is shipped at the same time as the product or service to the buyer. We find that this method is by far the most common method used between large firms within the same country or region. The big advantage here is for the buyer who doesn’t pay for the goods until the goods are fully received and are in-shop. This allows the buyer to hold on to cash longer and delay payment until it is convenient from a cash flow perspective. Especially for start-ups, having plentiful cash on hand is a critical need for day to day survival.

Another advantage is that the seller doesn’t have to deal with the complications of a financial institution to receive payment in a more secure manner. The buying firm, if trustworthy, pays the invoice before the agreed upon date and there is no need for any further action. However, this comes at the risk of the seller not receiving payment. If a previously trustworthy firm suddenly fails to make payments the selling firm will need to go to great legal lengths, especially if dealing with an international customer, to attempt retrieval of its assets or compensation for spent time on the service. This method is likely used between firms who know and trust one another greatly. Once trust has been built between two firms this method can lead to smoother transfers of goods and capital around the globe.

Another possibility could be between a large firm who is buying and a small firm who is selling. Due to the size of the large buyer they may force the smaller firm to accept payment terms that disadvantage the seller by giving longer terms of payment (i.e. forcing a net 90-day payment term as opposed to a net 30-day payment term).

Overall, choosing the optimal payment terms when dealing with other businesses (or large customers for that matter) can help build competitive advantage. We often spend the majority of our days thinking about the customer facing issues to build competitive advantage, leading to far too little time being spent on the operational excellence tactics that have made other firms so successful. These high value background activities are becoming increasingly important in todays competitive, and uncertain, world.