Cash Flow

Cash Flow

Posted: May 7, 2009 1:41 PM
Updated: May 7, 2009 1:41 PM

Real Small Business: Money Matters

From the Editors of Real Small Business

E. James Burton on Cash Flow

By E. James Burton

E. James Burton is Dean of the Jennings A. Jones College of Business at Middle Tennessee State University in Murfreesboro, TN. He holds a Ph.D in accountancy, as well as an MBA. His books include Total Business Planning, Accounting and Finance for Your Small Business, and Sales and Operations for Your Small Business, all published by John Wiley & Sons.

Q. What's the biggest mistake small business owners make regarding cash-flow management in a recession?
A. One of the big mistakes is in the area of early payment discounts. To encourage faster collection of receivables, vendors sometimes offer discounts to customers who pay within a certain period of time. And cash-starved customers sometimes decide not to accept those terms, even though they may be more favorable than usual. Both may be bad decisions.
Consider the consequences of deciding not to take advantage of early payment terms. Specifically, let's say you owe $1,000, but, by paying by day 10, you could reduce the bill to $980. Instead, you pay the full amount by day 45. Therefore, it has cost you $20 to hold on to your $980 for 35 additional days. What's more, what if you look at that $20 as though it were really interest paid on $980 in principal? When you do the math, you find that forgoing that $20 discount and waiting 45 days to pay, is like borrowing money at a 21.3% rate. Clearly, that's a mistake.
From the vendor's side, offering a discount can have similar consequences. For example, suppose you offer a discount for paying within less than 30 days. It's quite possible that, unbeknownst to you, that customer had planned to pay the full amount early, anyway. Plus, the money you'd lose would be equivalent to borrowing at an 18.4% rate.
The bottom line: Offering an early payment discount, or not taking one, may be a good choice. But don't make the decision without fully understanding the benefits -- and the costs.