What it means
When a business sells on credit, the invoice carries a set of terms, usually written in shorthand. "Net 30" means the full amount is due 30 days after the invoice date, while "2/10 net 30" means the buyer can take a 2% discount by paying within 10 days, but otherwise must pay in full within 30 days.
For the seller, terms are a balancing act. Generous terms can win customers and increase sales, but they tie up cash in receivables and raise the risk of bad debts.
Tight terms protect cash but may send buyers to competitors who are more flexible. For the buyer, terms are a form of short-term financing at no stated interest.
Paying later keeps cash in the business for longer, which is why many buyers push for 60 or 90 days. The cost is hidden in the price, because a supplier who waits longer for cash may charge more.
Early payment discounts deserve careful thought. A 2% discount for paying 20 days early looks small, but expressed as an annual rate it is often far higher than the cost of borrowing, so taking the discount can be a good use of cash.
Sellers should check that they are not giving away more than the benefit of faster cash. Credit terms usually also cover late payment penalties, interest on overdue amounts and the process for disputes.
These should be stated clearly in the contract or on the invoice, so that both sides know what to expect. Terms are set by customer risk.
New or weaker customers may be asked to pay in advance or on delivery, while established, reliable customers receive longer terms. Finance teams monitor the effect through metrics such as days sales outstanding, and they review the terms whenever a customer's payment record changes.
In practice
Real-world examples
Example 1
A packaging manufacturer invoices a large retailer on net 60 terms. The retailer pays on day 58 every time, so the manufacturer budgets for a two-month wait and finances it with an overdraft. The cost of that overdraft is built into the price quoted to the retailer.
Example 2
A wholesaler of building supplies offers 1/10 net 30 to contractors. A contractor with spare cash pays within 10 days and saves 1% on a $40,000 order, which is $400.
Example 3
A start-up software vendor asks a new customer to pay the first invoice in advance because it has no credit history. After six months of on-time payments, the vendor moves the customer to net 30 terms. The change rewards good behaviour and keeps the customer loyal.
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 a discount = (discount % / (100% - discount %)) x (365 / (credit period - discount period))
A supplier offers terms of 2/10 net 30. The buyer pays $50,000 for goods, so taking the discount saves 2% x $50,000 = $1,000, and the buyer pays $49,000 within 10 days. Forgoing the discount means paying 20 days later (30 - 10), so the cost is (2 / 98) x (365 / 20) = 0.0204 x 18.25 = 0.372, or about 37.2% a year. If the buyer can borrow at less than that, it should take the discount.Case study
Seen in the real world
Foxglove Electronics is an illustrative, fictional distributor with annual sales of $9,000,000. Its customers were on net 45 terms, but a review showed that many took over 70 days to pay, leaving about $1,750,000 outstanding in receivables.
The finance director introduced 2/10 net 30 terms and a late fee on overdue balances. Around 30% of customers began paying within 10 days, the average collection period fell to 48 days, and receivables dropped by roughly $550,000.
The discounts cost about $54,000 a year, which was less than the roughly $66,000 of overdraft interest saved at a 12% borrowing rate. In this illustrative case, clearer terms improved cash flow and customers understood exactly what was expected.
Watch out
Common mistakes
- Offering an early payment discount without calculating its annualised cost, and so giving away more than the faster cash is worth.
- Allowing customers to ignore the terms with no consequences, which turns agreed terms into suggestions and slows collections.
- Giving the same terms to every customer regardless of risk, which exposes the business to its weakest payers.
Questions
People also ask
What does net 30 mean?
The full invoice amount is due within 30 days of the invoice date, with no discount for early payment.
Are credit terms negotiable?
Yes, they are often a key part of the deal, and larger buyers frequently negotiate longer terms, but suppliers should price the cost of the extra time. A 30-day extension on a $1,000,000 annual account ties up about $82,000 of the seller's cash.
How do credit terms affect cash flow?
Longer terms delay cash coming in for the seller and help the buyer, so each side tries to balance the benefit of the sale against the cost of waiting.
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