Retail Dogma

Types of Payment Terms & Their Effect on Cash Flow

One of the points up for negotiation when dealing with suppliers is the payment method. There are different types of payment terms in international trade and here we will list the most common ones used by retailers in their buying.

Read also: Types of Shipping Terms

What Are The Different Types of Payment Terms?

Types of Payment Terms

We are going to arrange the different types of payment terms based on when they will be due in the process. The process here starts by placing the order and goes through shipping, followed by arrival and then actually selling the goods in your stores.

It is obvious that the earlier the payment the better it is for the seller and worse for the buyer, and vice versa. That’s why it is a point of negotiation, where everyone is going to use their bargaining power to get a better deal for their business.

Read also: Bargaining Power of Suppliers and How to Reduce It

So let’s start by explaining the different types of payment terms first and then explaining why it matters.

Advance Payment

In this payment term the seller will demand that the full payment will be made in advance before shipping the goods. This could be done over two installments, where 50% is paid to start arranging the goods and once they are ready for dispatch the other 50% will be due, and only then the merchandise will be shipped.

The payment itself could be done through wire transfer (TT).

In this payment term the seller takes no risk at all, and the buyer carries all the risk in case the shipment is not delivered.

Letter of Credit (LC)

In this term the seller requests that the buyer will submit a Letter of Credit through his bank to the seller’s bank. What the Letter of Credit does is shifting the responsibility of payment form the buyer to his bank and the payment will be guaranteed by the bank to be made to the seller once the goods are shipped, provided that all the listed procedures have been followed correctly.

This is a good way to lower the risk for both, the buyer and the seller, as the payment is guaranteed by the bank, but also it is usually a very costly method.

Documentary Collection (D/C)

Documentary Collection is also know as DP at Sight. It is also a process that is facilitated by the banks of the buyer and seller, where the payment is released upon receiving a defined set of documents. Once the buyer has made the payment and received the documents, he can then proceed to clearing the shipment and receiving it.

D/C is less costly than LC but doesn’t provide the same security.

Open Account

Open account payment term specifies a certain period (30, 60 or 90 days) after which the payment will be due. This will result in the buyer receiving the goods and trading them in the stores before making any payment to the seller.

This method of course is more risky to the seller and has no risk for the buyer.

Consignment

In consignment method the buyer receives the goods and sells them at his stores and is only required to pay for the goods that have been sold.

Read our article on Consignment & How it Works to know why you might want to consider it in your buying.

Types of Payment Terms & Cash Flow

Now that you have seen the different types of payment terms and how they shift the risk from seller to buyer and vice versa, you might ask what is the best term for me ?

Of course for the buyer the later the payment obligation the better when it comes to cash flow.

In fact, some of the biggest retailers, like Walmart, always receive the goods and sell them and by the time the payment is due, they have probably sold out of the shipment. But that’s also because Walmart is in the grocery retail segment, and grocery retail has very high inventory turnover rate.

See the different benchmarks for different retail segments in our : Retail Financial Benchmarks list.

This puts Walmart in a very good cash flow positive position.

For small retailers the goal will still be to improve our cash flow and try to negotiate the best payment term we can get

Read also: Cash Flow Management: 6 Actionable Tactics

It should be noted, however, that to get the best payment term will depend on how strong your position is during the negotiation.

Negotiating The Different Types of Payment Terms

If you are a big retailer with good credit history, many suppliers will be willing to sell you through an open account to win your business. It is a competitive market and everyone is trying to push more business.

If you are a small retailer, however, and has no credit history or no relationships with suppliers, they will probably demand that you either pay in advance or at least be supported by a bank through an LC.

We are saying this because you should know that, if you started out paying in advance, this doesn’t mean that you have to stay like that for good. If you have proven to be credit worthy to your suppliers and have given them consistent business, you can always demand better terms as the time goes by and your business grows.

That’s why we also always say that building a relationship with suppliers is not as simple as finding them on Ali Express and sending them some orders remotely through your VA and that’s it. My suppliers always come to visit me and my stores and I fly to meet them in Hong Kong or meet them at trade shows. This is how you build & sustain long term relationships with suppliers, that will reflect on your business’ finances as well.

If you are going to consider consignment as an option, you should know that this will typically reduce your margins. While it is going to be perfect for your cash flow, it is also going to reduce your profitability.

Remember: Cash is NOT equal to Profit

That’s why we recommend having consignment for only certain products in your store. Read our article on consignment for more details.

Bottom Line

Understanding the different types of payment terms used by retailers in buying and using this knowledge in dealing with suppliers will allow you to improve your cash flow management over time and run your business more efficiently.