Updated: Sep 23, 2022
Negotiating payment terms usually fall under the responsibility of the purchasing department as it is part of what is called the Procure-to-Pay (P2P) process. A payment term determines when the buyer will reimburse the seller for goods or services sold. Typically, the buyer wants to pay as late as possible and the seller wants to be paid as early as possible. This is because there is an opportunity cost to having funds, meaning that the funds could be alternatively invested in other assets for a return. The Weighted Average Cost of Capital (WACC) is the estimated annual percentage return the company could earn with funds. The higher the company's WACC, the greater the opportunity cost of funds.
Cash Conversion Cycle is another financial metric that drives payment terms goals for a company. The lower the CCC, the faster a company can produce cash. The more efficient the company is in generating cash and the lower the risk profile the company has. Here is the equation for cash conversion cycle:
Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding.
Days Payables Outstanding is what payment terms can improve. Longer payment terms increases days payables outstanding thereby decreasing cash conversion cycle of the company
Payment terms are structured by days from the invoice date. For example, Net 30 means that payment will be made 30 days from the invoice date. This has historically been a common standard, but Net 45, Net 60, or even greater can be negotiated to add value to the buyer. Alternatively, a vendor can offer the buyer a discount to encourage early payment. For example, 2% 15 Net 60 means that payment is due 60 days from the invoice but the buyer can receive a 2% discount on the price if the invoice is paid within 15 days. Some other payment terms include PIA – Payment in Advance; EOM – End of Month; and, COD – Cash on Delivery.
It is important to define payment terms for smooth business transactions. It also helps the finance department with financial planning and helps the credit department determine a schedule for escalating actions for payments in arrears.