If you are a new business owner, you need to learn about terms of sale so that you can forecast your cash flow. Small businesses frequently have limited financial resources. A failure to collect sales revenue can spell disaster for an under-capitalized company.
Terms of Sale
Terms of sale include expected time to receive payment, as well as any discounts or penalties for early or late payment and a provision for unpaid invoices. A company that sells a product or service does not generally expect customers or suppliers to pay on the date of sale. Rather, most firms extend credit terms through an asset account called accounts receivable (A/R). For instance, a term of 2/10 net 30 means that a customer or supplier will receive a two percent discount if they pay within ten days, and that in any event the full amount is due within 30 days.
Balances with an age over 30 days may be subject to interest charges to compensate the lender for the delay in collection. Lenders track A/R through aging reports, which categorize A/R by the length of time since the original sale. Accounts that are over 90 days delinquent may be turned over to collection agencies, and in the worst case for the seller (and the best case for the buyer), the invoices may be written-off entirely.
Collection costs are high. You might want to add a note to your invoices “buyer agrees to pay for collection expenses for invoices due over 90 days.”
Using the Float
Buyers maintain a liability account called accounts payable (A/P) to track the amount of receivable credit that they have been granted. Float is the term used for the interest a borrower can earn on A/P until a debt is retired. In the 2/10 net 30 example, the borrower can earn interest for 30 days before paying for a purchase. However, the latter 20 days have an implicit cost of two percent, because that is the amount foregone by not accepting the discount. Another way to look at it is that there are ten days of free float, followed by 20 days of float at a cost of two percent. Borrowers with tight cash flows may make the conscious decision to delay A/P payments to conserve cash, even if it means the payment of interest to the creditor.
Sometimes, creditors wish to monetize their A/R using factors – agents who buy A/R for cash. The cash paid is at some discount to the face value of the A/R account – this is the cost of factoring to the lender and the source of revenue to the factor. Factoring replaces the A/R balance sheet asset with cash, and the cost of factoring is treated as a sales expense.
A/R as Collateral
Businesses sometimes use A/R as collateral for short-term loans. Should a company default on a loan secured by A/R, the lender seizes the A/R account, who in turn must either collect it or factor it. Because of the expense and uncertainty of collecting the A/R, secured A/R loans must be over-collateralized, meaning that they use additional collateral to secure their loan by some appropriate percentage to protect the lender.