Cash flow management is a critical aspect of any business, and credit terms play a crucial role in shaping the financial health of an organization. Understanding credit terms, their impact on cash flow, and implementing effective credit strategies is vital during uncertain economic times.
This article will delve into what credit terms are, explore their impact on cash flow, discuss the cash flow challenges that businesses are likely to face during a recession, and outline strategies that cash managers should adopt to adjust credit terms and prevent cash flow issues.
Understanding Credit Terms
Most business in the United States is done on credit. Credit terms refer to the agreed-upon conditions between a buyer and a seller regarding the extension of credit for the purchase of goods or services. These terms typically include payment due dates, discounts for early payment, interest charges for late payment, and any other conditions related to the credit agreement.
Credit terms can have a big impact on a company’s cash flow.
- Delayed cash inflows. When businesses offer credit terms, it essentially means they are deferring cash inflows. Instead of receiving immediate payment, they allow customers to pay later, affecting the cash flow cycle.
- Potential cash flow constraints. Extending credit terms can lead to cash flow constraints, especially if a company has more cash going out than coming in. This scenario can strain liquidity and hinder a company’s ability to meet immediate financial obligations.
According to a study by the National Retail Federation, the average company that sells on credit experiences a 10 percent increase in sales. But these sales come at a cost. The study found that the average company that sells on credit also experiences a 5 percent decrease in cash flow.
Cash Flow Challenges during a Recession
Businesses of all sizes face several cash management challenges during a recession, a study by the National Association of Certified Public Accountants (AICPA) found:
- Reduced sales and revenue. A downturn in the economy typically results in reduced business and consumer spending, leading to lower sales and revenue for businesses. This decline can strain cash flow, making it challenging to meet payment obligations.
- Increased credit risk. Economic downturns often result in higher credit risk, as customers may face financial difficulties and delay or default on payments. A customer’s credit worthiness can change fast. This further intensifies cash flow issues for businesses.
- Tighter credit availability. Financial institutions tend to become more cautious during a recession, reducing credit availability. Small and mid-sized businesses typically find it hard to access necessary funding. In short order, tight credit can affect a company’s cash flow.
These financial challenges can exacerbate the impact of credit terms.
Credit Strategies for Cash Managers during a Recession
To mitigate the risk of cash flow issues during a recession, cash managers should take a hard look at their company’s credit policies. Here are some strategies for adjusting credit policies to reduce risk.
- Review and revise credit policies. Assess the creditworthiness of customers and adjust credit policies accordingly. Implement stricter criteria for extending credit, conduct more thorough credit checks, and consider reducing credit limits or requiring shorter payment terms. According to a study by the Federal Reserve Bank of New York, businesses tend to tighten their credit terms during recessions to protect their cash flow. This can include things like increasing interest rates and requiring larger down payments for purchases. In the 2008 recession, the average length of credit terms for businesses decreased by 10 days, the Federal Reserve Bank of New York found. The average interest rate on business loans increased by 1 percentage point during the 2008 recession. The average down payment required for business loans increased by 10 percent during the 2008 recession.
- Communicate and negotiate. Encourage your AR team to openly communicate with customers experiencing financial difficulties. Engage in negotiations to find mutually beneficial solutions, such as revised payment plans or discounts for early settlements.
- Diversify your customer base. There’s truth to that old phrase about putting all your eggs in one basket. During a recession, diversifying the customer base can help mitigate risk. To maintain cash flow stability, suggest that your sales team target industries or regions that are less impacted by the downturn and cross-sell to customers that reliably pay on time.
- Strengthen collections and receivables management. Now is the time for companies to implement proactive collections strategies to minimize late payments and delinquencies. Suggest that your AR team delivers invoices electronically, monitors customer payment behavior closely, sends timely reminders, and considers incentivizing prompt payment.
- Collaborate with suppliers. Work closely with your procurement team to negotiate extended payment terms with suppliers or explore discounts for early payments. This collaborative approach can alleviate immediate cash flow pressures and free up working capital.
- Explore alternative financing options. In situations where credit availability is limited, cash managers should explore alternative financing options such as invoice financing, supply chain finance, or short-term loans to improve liquidity and bridge cash flow gaps.
These strategies can help cash managers avoid a cash crunch when their business sells on credit.
Avoid a Cash Crunch
Cash managers play a vital role in maintaining a healthy cash flow, especially during challenging times such as a recession. Understanding credit terms and their impact on a company’s cash flow and implementing appropriate credit strategies is crucial for navigating economic uncertainty.