Briefly put:
- Small businesses have struggled with cash flow issues, and customers who consistently fail to meet credit terms are a significant factor contributing to the problem.
- To encourage timely payments from clients, companies can implement various measures, such as offering discounts, imposing penalties, reporting payment history to creditors, and more.
- Additionally, businesses can explore different funding options, including credit cards, lines of credit, accounts receivable factoring or financing, among others, to obtain the necessary cash when accounts receivable fall behind.
Many small business leaders face the persistent and distressing concern of cash flow. Capital deficiency is a significant obstacle for them: according to the Federal Reserve’s Small Business Credit Survey, conducted in late 2019, 43% of small business owners reported covering operating expenses as their most pressing financial challenge, and 86% stated that they would need to find additional funding or reduce costs if revenue ceased for two months.
However, not all cash flow issues are the fault of small business owners. It often arises from increasing accounts receivable (AR) balances and late payments from customers that many owners or leaders regard as an unavoidable problem they must deal with.
Late payments are particularly problematic in the B2B world, where trade credit is common, and payment is not typically due at the time of purchase. According to a report from PYMNTS and Fundbox, U.S. businesses have a total of $3 trillion in unpaid invoices at any given time. And 68% of companies that receive more than half of their payments late report that cash flow is a concern.
The coronavirus has exacerbated the situation: Experian reports that the number of small businesses with bills overdue by 31-90 days increased slightly in the second quarter of 2020, and the credit bureau anticipates that trend will persist in the coming months.
Small business owners are well aware of the challenges associated with collecting accounts receivable (AR). When businesses are unable to collect payments from their buyers, it can become a problem as they struggle to pay their own bills. Some organizations have different schedules for AR and accounts payable (AP), such as net 30 vs. net 60, which can make the situation particularly difficult.
We believe there are two ways to address this issue: encourage more customers to pay on time or secure access to capital to bridge the gap when funds are low.
The first option is proactive and the preferred solution, but it is not always easy to achieve and may not be feasible for all businesses, particularly when dealing with larger companies that hold the power to pay on their own terms. Nonetheless, both options can provide small business owners with the necessary cash injection to prevent them from worrying about their sinking credit or sweating out the next payroll period as AP payments fall behind.
Option 1: Encouraging Timely Customer Payments to Improve Cash Flow
Small businesses that struggle to collect payments from their customers and experience delays of days or weeks after the due date can utilize the following strategies to encourage faster settlement:
Offering incentives for early payments and imposing penalties for late payers
A common approach is to provide a small discount, typically around 5%, to customers who pay on or before the due date. According to Paul Miller, a CPA and founder of the accounting firm Miller & Company, LLP, this is one of the initial steps small businesses should take when they see their accounts receivable balance increasing. By providing a direct financial incentive for timely payments, the buyer is encouraged to stay on top of their payments. Although offering a discount may result in a loss of revenue, the business can benefit from immediate cash that can be allocated towards projects that support the company’s growth.
Similarly, businesses should not hesitate to charge late fees, interest, and/or finance charges for overdue bills. Unfortunately, many customers require an incentive to make timely payments. For instance, Lindemann Chimney Supply, a supplier of chimney tools and supplies, often imposes finance charges when the payment is overdue by 15-30 days. This approach has proven to be effective in prompting a response from the customer.
Thoroughly research potential customers
Before signing any contracts or onboarding customers, make sure to conduct comprehensive research on them. This includes checking their credit reports and requesting references to get a better understanding of what you can expect from the customer. Doing so will help you avoid problematic clients who may be slow to pay.
According to Gerri Detweiler, education director for Nav, a financial services provider for small businesses, it’s important to manage risk when providing any services without receiving full payment upfront. This makes it essential to check the credit of prospective customers, just as lenders do.
Some companies may not have a credit history, either because their current vendors don’t report them or they haven’t been in business for long. In such cases, references become even more important. Although business credit reports are more expensive than consumer ones, some services offer packages to check the credit of multiple prospective clients.
Report customer payment history to credit bureaus
Credit is crucial for companies, as it affects their ability to secure loans, lines of credit, and even potential partnerships (if partners check credit reports). Reporting customer payment history to credit bureaus such as Dun & Bradstreet, Experian, and Equifax provides additional motivation for customers to pay on time.
If you plan to report customer payment history, be sure to inform them upfront and make it clear that it is part of your company policy. If a customer is consistently late with payments, it may be worth issuing a second warning that you will be reporting their history, which could negatively impact their credit rating. According to Gerri Detweiler, this can be a powerful incentive for customers to pay on time because they know that failing to meet your terms could have consequences elsewhere.
Implement Immediate Payment Requirement
When the COVID-19 pandemic caused an economic upheaval in March, Lindemann Chimney Supply had to take drastic measures to stay afloat. They opted to require credit card payments for all purchases from about 95% of their customers, and removed the sales reps’ authority to grant trade credit.
The company had to focus on collecting cash flow and tightening their processes during the uncertainty of March and April. Michael Schaefer, the director of operations, said they had to throw out their original plans for the year.
Fortunately, most of their customers, including chimney installers, sweepers, masons and roofers, understood the situation. They only allowed net 30 terms for the small group of customers with impeccable payment histories. Previously, a few buyers had 60- or 90-day terms.
By implementing these changes, Lindemann Chimney’s days sales outstanding have decreased from 40-plus days to 27 days, and their total outstanding accounts receivable balance has dropped as well. In September, they eased up slightly by increasing the credit limit for some customers who frequently hit their limit and kept up with payments.
While this strategy may not be suitable for every organization, it’s a powerful way to grab customers’ attention and eliminate payment risks. Small business leaders should analyze payment trends and consider requiring immediate payment from the slowest payers.
Schaefer acknowledges that some customers may take this personally, but it’s essential to communicate that it’s data-driven and not personal. He emphasized the need for clear communication and strong internal and external processes and rules.
Option 2: Bridging the Cash Flow Gap with Capital
If your business has enterprise clients or faces strong competition, it may be difficult to change customer behavior with the previously mentioned strategies. In this case, boosting capital may be the best approach. Here are some options to consider:
Utilize a business credit card
Business credit cards function similarly to personal credit cards and can help business owners manage expenses and provide a cushion when accounts receivable is slow. According to Miller, business credit cards can provide a full month of cushion if the owner pays an invoice on the day the cycle resets. For example, if a statement closes on Oct. 28, a payment made on Oct. 29 can be paid off without interest until as late as Nov. 28.
Small business credit cards usually have higher credit limits than personal cards, but the limit is based on the owner’s personal credit, income, and the company’s revenue. These credit cards are generally not difficult to qualify for, and consistent on-time payments can help businesses build credit.
Secure a Line of Credit for Improving Cash Flow
A revolving line of credit from a bank is a common tool businesses use to manage cash flow issues. Similar to a credit card, the limit is determined by the financial standing of the business. For instance, a business may secure a line of credit for $40,000 and withdraw funds as needed up to that limit. Unlike credit cards, interest is charged right away; however, the interest rate at most large banks starts around 4.5-7%, which is lower than most credit cards.
Securing a line of credit can be more challenging than getting a credit card, and a company’s age, revenue, balance sheet, credit rating, and customer base are all factors that banks consider. A company’s primary bank usually offers the best interest rate, but younger businesses or those in high-risk industries may need to turn to alternative lenders, who may charge less favorable rates. It is essential to fully understand the total cost of interest and fees associated with a line of credit before utilizing it.
Use AR Factoring or Financing
If you need cash quickly, another option to consider is AR factoring or financing. This involves selling your outstanding accounts receivable (AR) to a factoring company, which pays your business a percentage of the total value of those invoices, usually between 70-90%. The factoring company then collects payments from your customers and takes a “factoring fee” of 1-5% before returning the remaining balance to your business.
While factoring companies have traditionally worked with larger enterprises, some have recently expanded their services to smaller businesses due to the economic impact of the COVID-19 pandemic. However, using factoring or financing services could damage your customer relationships since the factoring company collects payments directly from them.
To protect your business against the risk of never receiving the full amount of money owed, you can pair AR factoring with credit insurance, which typically costs between 0.25-0.5% of the total amount covered. This combination allows your business to access the capital it needs while eliminating the risk of non-payment.
In addition to traditional factoring, some companies offer accounts receivable loans, which allow businesses to take out short-term loans based on the value of their invoices without selling them to a third party. These loans come with varying interest rates, from about 5-6% at banks to 10-20% with other firms.
For example, Fundbox offers AR loans of up to $150,000 based on a company’s transactions, including both AR and accounts payable (AP), as well as other credit factors. The seller makes weekly payments, with interest rates starting at 4.66% for 12-week loans and 8.99% for 24-week terms, though rates may be higher depending on the company’s credit standing.
Another option is BlueVine, an invoice factoring company that provides upfront payments of up to 90% of your AR balance. BlueVine offers loans of up to $5 million, with weekly interest rates starting at 0.25%. However, your business must pay a factoring fee and may receive the remaining balance of the invoice only if customers pay their invoices.
Implement a Deposit Policy for Improving Cash Flow
Another way to improve cash flow is to require customers to pay a deposit before they receive the goods or services. This upfront payment can help cover the costs of materials and labor, especially for businesses that have long payment terms.
Miller recommends that businesses collect a deposit, even if it’s a small amount. This practice ensures that you receive some payment in advance, which can help you manage your cash flow.
In addition, you could consider requesting a second installment when a certain amount of work is completed, and the final payment upon completion. This policy ensures that you receive regular payments as the project progresses.
However, it’s important to apply the same deposit policy to all customers, regardless of their size or status. This consistency shows that you treat all clients fairly, which helps build trust and credibility. Otherwise, you risk damaging your reputation and losing customers.
Open up negotiations with your suppliers
One way for companies to improve their cash flow is by aligning their accounts payable (AP) terms with their accounts receivable (AR) terms. If your AP terms are shorter than your AR terms, it can create cash flow issues that may hurt your business.
To better align your AP and AR terms, consider negotiating with your suppliers. You may be able to persuade some suppliers to give you longer payment terms by explaining that you need to provide more time for your customers to pay, based on industry standards or other factors.
If you have a good payment history and strong business credit, negotiating longer payment terms may be easier. However, it’s important to ensure that any changes to payment terms are reported to credit bureaus. If not, it could negatively impact your credit rating, even if you are making payments on time under the new agreement.
Firms’ received payment termsShare that receive payment select terms durations, by persona
| LOW-MARGIN | HIGH-MARGIN | |||||
|---|---|---|---|---|---|---|
| Early-stage | Intermediate | Established | Early-stage | Intermediate | Established | |
| 0 days | 4.2% | 7.6% | 8.2% | 4.2% | 3.9% | 3.7% |
| 1-15 days | 30.4% | 23.9% | 20.0% | 18.5% | 9.4% | 19.8% |
| 16-30 days | 42.9% | 40.8% | 38.8% | 33.6% | 35.6% | 37.7% |
| 31-60 days | 18.3% | 23.4% | 25.3% | 34.5% | 40.6% | 23.5% |
| 61-90 days | 3.1% | 3.3% | 6.5% | 8.4% | 9.4% | 11.7% |
| More than 90 days | 1.0% | 1.1% | 1.2% | 0.8% | 1.1% | 3.1% |
Data: “SMB Receivables Gap Playbook,” from PYMTS and Fundbox, based on 2019 survey of 1,000 businessowners and execs
Summary
Small businesses should not rely on hoping their customers will change their payment behavior, nor should they be too lenient in collecting past-due invoices. Instead, companies must take charge of the situation by conducting proper research on potential clients, offering incentives for early payment, and imposing penalties for late payment. Additionally, businesses should make it clear to customers that their payment history will affect their credit score and use accounting automation software to aid in reporting delinquent payments.
If a company is struggling with cash flow due to unpaid invoices, they can consider using credit cards, lines of credit, factoring/financing of accounts receivable, customer deposits, or adjusting accounts payable terms to inject capital into their business.
In some industries, extending trade credit is necessary, but it’s crucial to persuade customers to stay on top of their payments. Instead of considering late payments as a “cost of doing business,” companies should take action to ensure prompt payment and see positive results reflected in their bank account balances.
