What are credit terms and how should they be determined?

Extending credit to your customers can be a way of attracting new business and building loyalty amongst existing customers.

The terms under which you agree to extend this credit are set out in the invoice, including the date upon which payment is due. The invoice credit terms form the terms and conditions of the transaction.

The credit period is the due date for payment.

The shortest credit period is “Net due upon receipt,” which means the invoice must be paid as soon as it has been received and checked. One of the most common credit periods for a small business is “Net 30”. This means that the invoice must be paid in full within the net period, 30 days from the date of the invoice. 

For example, under the terms of the current European Directive on late payments, the payment term for B2B transactions is 30 days. This can be extended, by mutual agreement and when to 60 days or more.

Extending credit terms involves the risk of customers paying late or not paying at all. Many businesses try to mitigate this risk by offering incentives encouraging customers to settle their invoices promptly.

For example, you may decide to offer 1% off a customer’s invoice if they settle it within 10 days, rather than the 30 days indicated on the invoice. In this case, the discount would be presented as follows:

1/10

n/30

The “1” represents the percentage discount being offered, “10” represents the number of days the discount applies, “n” represents the word “net”, and “30”  reprensents the standard 30-day credit term. The customer is incentivised to settle their invoice early, which, even taking the discount into account, is usually beneficial for you.

Overdue payments can cause difficulties and are to be avoided. Establishing penalties for late payment is one way of limiting the credit risk, avoiding bad debts and the need to turn to a collection agency.

Your credit terms should set out any penalties in place for late payment. If the customer does not pay within the agreed deadline, they are in breach of the credit terms and interest might be payable. The amount of interest which can be charged on the credit is governed by what are known as “usury laws.” These laws are designed to protect consumers from excessively high interest rates by setting caps on the maximum amount that can be charged.

In Europe, for example, the interest rate applicable on late B2B payments is given in the European Commission’s Directive on Late Payments and currently stands at 12% per annum. This is based on the European Central Bank refinancing rate on the payment date, plus eight percentage points. 

In different parts of the world, different past due payment rates are set by local or regional regulations. In the United States, for example, the penalty for late payment is ½% of the tax due for each month or part of the month that the payment is late.

It is important to research and understand the relevant regulations which apply to your industry, depending on your geographic location.

The credit terms should also specify acceptable payment methods. This may include cheque, bank transfer, credit card and mobile payment options. Discounts for payment in cash can also be offered. 

The key is to make payment easy for the customer while reducing the risk of non-payment.

Extending credit to customers is a logical step once a business is up and running. Allowing customers to buy goods or services on credit can attract new customers and build loyalty among existing ones.

Managing credit terms is a cornerstone of any business credit policy. Gauging the creditworthiness of potential customers before extending credit can mitigate the associated risks.

Incentives to encourage early repayment and disincentives to penalise late payment should be built into the credit policy to ensure you do not encounter cash flow problems.

Allianz Trade helps business establish solid, reliable credit policies and to implement procedures to monitor them.