The Role of Payment Terms in Cash Velocity
To reduce the time it takes to collect payment from our customers we offer a 1%/10 option, but none of our customers use this option and many of them pay late which is why we have an average of 42 days. So we remain at 55 days.
Thus far we have gone from receiving a net of $300 every 134 days to receiving that same $300 every 55 days. If we were to pay out a 10% sales commission (on selling price) once the customer pays, the net receipt would be $260 every 55 days (assuming continuous sales). More than double the velocity.
Our cash velocity has gone from 1.94 ($260/134 days) to 4.73 ($260/55 days)!
This increase in cash velocity can help you to grow your business. The difference in velocity is 4.73 – 1.94 = 2.79. This means we are getting our cash back more than two times faster than before. We can use this cash to fund additional raw materials and grow our sales and profits.
However, if you reduce your cash-to-cash cycle time but do not have the opportunity to increase your sales, what have you gained? The only bottom-line impact you would have is the reduction of carrying cost and the interest you would now be earning on the cash you are accumulating.
In addition, if you have a cash reserve, you are now in a position to take the discount your vendors are offering. If terms are 2% discount if paid within 10 days or full payment in 30 days, what return would you earn? A 2% return on 20 days is equivalent to 36.5% return over a year. That is a good return, but taking the discount depends on what else you could do with the extra 20 days of money. If your company is growing, and you can use the cash to grow, then you may be able to produce and sell another product in that time. The answer then, depends on your cash position and your goals.
Here’s to maximizing YOUR profits!
“Dr Lisa” Lang