What it means
When a supplier ships goods with an invoice due in 30 days, it is lending the customer the value of those goods for a month without charge. Credit terms define that loan.
The most common elements are the payment period (net 30, net 60), the early-payment discount (2/10 means 2% off if paid within 10 days), the start date (from invoice date, from delivery, or from end of month), the late-payment consequences (interest, suspension of supply) and the credit limit (the maximum the customer may owe at any time). For the seller, credit terms are a commercial tool and a risk.
Longer terms win business, particularly from larger customers who expect them, but they tie up working capital in receivables and increase the exposure if the customer fails. Sellers therefore check creditworthiness before granting terms, set limits according to the customer's size and payment history, and price generosity into the deal.
An early-payment discount is a way to buy back some of the cash: 2/10 net 30 gives the customer a strong incentive to pay in 10 days, since the discount is worth about 37% a year in interest terms. For the buyer, terms are a source of free finance.
Paying on the last day allowed, taking discounts where the implied return exceeds the cost of capital, and negotiating longer terms with key suppliers are all standard working capital management. Paying late, by contrast, is borrowing without agreement: it damages the relationship, may trigger interest and, in many countries, statutory compensation, and can lead to supply being stopped.
Terms vary by industry and by power. Supermarkets impose 60 to 90-day terms on their suppliers; construction contractors are paid on certified milestones; professional services often ask for payment within 14 days; consumer businesses expect payment at the point of sale.
Governments in several jurisdictions have introduced prompt payment codes and reporting requirements to protect small suppliers from long terms imposed by large customers.
In practice
Real-world examples.
Example
A wholesaler's invoice states "Terms: 2/10, net 30, from invoice date. Interest at 1.5% per month on overdue balances. Credit limit $25,000."
Example
A software company offers annual subscriptions on net 30 terms but a 5% discount for payment in advance, effectively buying its customers' cash a year early.
Example
A small supplier to a supermarket accepts 75-day terms and uses invoice financing to bridge the gap, treating the finance cost as part of the price of the contract.
Think of it
“Credit terms are the payment rules you set-when customers must pay and what discounts they get for paying early.
Formula
Calculation
Annualised cost of forgoing an early-payment discount = [ Discount % / (100% minus Discount %) ] x [ 365 / (Full payment days minus Discount days) ]
Days Sales Outstanding = (Accounts Receivable / Credit Sales) x Days in period
Worked example 1, evaluating a discount. A supplier offers terms of 2/10 net 45.
- Discount rate = 2%; discount period = 10 days; full period = 45 days
- Annualised cost of not taking the discount = (2 / 98) x (365 / 35) = 0.0204 x 10.43 = 21.3% a year
A buyer that can borrow at 8% should pay on day 10 and take the discount; paying on day 45 is equivalent to borrowing at 21.3%. If the terms were 1/10 net 60, the annualised cost would be (1 / 99) x (365 / 50) = 7.4%, and a buyer borrowing at 8% would be marginally better off keeping the cash for 60 days.
Worked example 2, the seller's cost of terms. A manufacturer with $9,125,000 of annual credit sales moves its standard terms from net 30 to net 60 to win a large contract.
- Receivables at net 30 (assuming customers pay on time) = $9,125,000 x 30 / 365 = $750,000
- Receivables at net 60 = $9,125,000 x 60 / 365 = $1,500,000
- Additional working capital required = $750,000
- At a borrowing cost of 7%, the extended terms cost $52,500 a year in interest, plus the additional exposure if a customer fails. The contract needs to earn more than that to justify the terms.Case study
Seen in the real world.
A packaging manufacturer with 300 customers had let credit terms drift: sales staff granted whatever terms the customer asked for, credit limits were never reviewed, and the standard net 30 had become an average payment of 58 days. Receivables of $2.6 million against monthly sales of $1.35 million meant the company was financing nearly two months of its customers' purchases and running an overdraft to do it. A new credit manager tiered the customers: the 40 largest kept negotiated terms up to net 60 with formal credit limits based on credit reports; the rest went back to net 30 with 1.5/10 as an incentive; new customers got net 14 for the first three months.
Invoices began stating terms, due dates and interest on late payment. Within nine months average payment fell to 39 days, receivables fell by $850,000, and the overdraft was cleared. Two customers left over the tightening; both had been chronic late payers.
Watch out
Common mistakes.
- Granting terms without a credit check or limit. Terms are a loan and should be underwritten like one.
- Offering early-payment discounts without calculating their annualised cost. A 2% discount for 20 days is expensive money for the seller.
- Printing terms on the invoice but never enforcing them. Customers pay according to what happens when they pay late, not what the invoice says.
Questions
People also ask.
What does "net 30" mean?
Full payment is due within 30 days of the invoice date (or another agreed start point) with no discount.
What does "2/10 net 30" mean?
A 2% discount if paid within 10 days; otherwise the full amount within 30 days.
Can credit terms be changed?
Yes, by agreement or, for new orders, by notice. Changing terms for existing contracts usually requires the customer's consent.
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