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- Payment terms: Definition, types, and what you need to know
Payment terms: Definition, types, and what you need to know
It does not matter whether you own a business or work as a freelancer; having a structured invoice helps maintain cash flow and streamline the payment process. If you are someone who manages finances, it is important for you to know how to create invoices that clearly define payment terms. Incorporating payment terms into your invoices encourages customers to make payments on time. The better you understand the payment terms, the better you can craft your invoices.
This guide will discuss what payment terms are and how important it is to include them in your invoices.
What are payment terms?
Payment terms are agreements between buyers and sellers on how and when a company should be paid for the goods and services they provide. These terms are specified in invoices and can vary based on the requirements and nature of each client. Generally, payment terms are negotiable, but the seller determines what should be incorporated to set payment standards and ensure prompt payment.
Why are payment terms important?
Payment terms are a vital part of invoices and positively impact cash flow, revenue recognition, and financial reporting. Here's a list of benefits gained by including payment terms to your invoices:
Having clear payment terms ensures financial stability and helps businesses maintain a precise understanding of their finances.
Payment terms are clear and open-ended, promoting transparency and reducing the risk of delayed payments.
Setting the right payment terms helps maintain a steady cash flow, ensuring the business has the necessary liquidity to operate efficiently.
How to choose the right payment terms for your business
Payment terms can be determined by a variety of factors. You can decide which payment terms to include depending either on the nature of your business or the flexibility and experience you have with your clients. Below is a list of factors that influence the payment term for your business.
Type of industry
The nature of the business is one of the key factors that influence the payment terms. For instance, a construction company might require customers to pay in installments depending on the different stages of the project completion. On the other hand, a retail store might want the customer to pay immediately for the purchase
Cash flow requirement of the business
Businesses have ongoing expenses, including resources, suppliers, and other investments supporting the expansion of the business. For instance, a manufacturing company might offer short-term payment options like net 15 or 30 days as they need to invest in raw materials while ensuring steady cash flow. On the other hand, a service-based business can offer flexibility in the payment like net 60 to accommodate the client's budget and also maintain a long-term relationship.
Changes in the economy
Economic fluctuations play a crucial role in choosing the payment terms. Businesses need to adjust the payment terms according to the rise and fall of the economy. For instance, when the economy is booming, you can be lenient by providing flexible payment options or giving discounts. On the other hand, when there is a fall in the economy, you have to be strict with the payment terms to reduce the risk of delayed payments. Businesses need to know how to place these payment terms effectively for long-term benefits.
Client relationship
Payment terms can be included based on the relationship you have with the clients. For instance, you can make payment terms flexible for the clients who have been a part of your business for a long time, and for the new ones, you can validate their credit report and plan your invoice accordingly. Understanding the financial health of the buyer and framing your payment terms accordingly will help you maintain a long-term relationship with them.
Geographical considerations
International transactions often involve greater risks compared to domestic sales. For instance, a product purchased from a foreign country can have payment options such as net 30 or 60 due to the currency exchange, changing regulations, and the payment infrastructure, while a local store might not require that much payment flexibility.
What are different types of payment terms?
Every business is different based on the number of clients they have, the type of payment method they choose, the relationship they have with the buyers, and the like. Based on your business requirements, you can choose the payment terms that fit best. Listed below are the common payment terms used.
PAYMENT TERMS | DEFINITION | EXAMPLE |
|---|---|---|
| Cash in Advance (CIA) | Buyer pays the full amount of the goods or services before shipment. | Subscription-based platforms require customers to prepay monthly or yearly. |
| Payment in Advance (PIA) | Buyer is required to pay before a project starts. This can be the full payment or a partial one, such as a down payment. | Booking a hall or photographer for an event requires the client to make an advance payment to reserve the service. |
| Cash with Order (CWO) | Buyer pays the full amount at the time of placing the order. | Online retail stores require customers to pay upfront while placing the order. |
| Cash on Delivery (COD) | Buyer makes the payment upon delivery of the goods or services. | Online electronic stores allow customers to examine the product before making the payment. |
| Contra payment | Businesses offset the money they owe each other using goods or services. | When a furniture manufacturer supplies office desks to its raw material supplier, instead of exchanging payments, both the businesses agree to deduct the cost of the desks from the supplier's balance. |
| End of Month | Payment is due on the last day of the month of which the invoice is issued. | A supplier delivers raw material on January 5 and issues an invoice on the same day with EOM terms. This means the buyer must pay by January 31. |
| Due upon receipt | The buyer must pay after receiving the invoice. Preferably the next day at the latest. | Advertising firms send invoices to clients along with the campaign budgets, expecting prompt payment for their creative services. |
| 1/10 NET 30 | The supplier offers the buyer a discount if the payment is made early. The discount percentage and timeframe can be adjusted based on business needs. | If a supplier issues a $1,000 invoice under 1/10 NET 30 terms: If the buyer pays within 10 days, they will receive a 1% discount, reducing the payment to $990. If the buyer pays after 10 days, they must pay the full $1,000 amount. |
| Month Following Invoice (MFI) | The supplier uses MFI to indicate that payment is due on a specified date in the following month. | If you receive an invoice on May 1 with 20 MFI terms, then the payment is due on June 20. |
| Installment agreements | The buyer can make the payment over time instead of paying the full amount upfront. | When you sell an electronic item worth $10,000, you allow the buyer to pay $1,000 per month rather than making a single lump-sum payment. |
| Lines of Credit (LOC) | Buyers can make purchases on credit and repay over time. | A small business experiencing cash flow constraints may use a $10,000 credit line from the supplier to purchase goods worth $2,500. The buyer only repays the $2,500 used, keeping the remaining credit available for future transactions. |
| Interest invoice | Issued for late payments with interest charges. | A supplier issued an invoice for $5,000 with net 30 terms; if the buyer fails to pay the amount within 30 days, the supplier applies interest to the overdue amount. |
How to set payment terms in your invoices
Managing payment terms manually can be a time-consuming task. Zoho Books simplifies the process by allowing you to customize payments based on your business type or customer preferences. This results in a streamlined and efficient payment process that helps maintain a steady cash flow.
While there are many payment terms available, it is crucial for businesses to read and understand each one to select the most suitable option. Understanding your business needs and choosing the right payment terms will ensure timely payments. With the right accounting software, you can effectively manage your payment terms without hassle.
