Contractual ways to improve cash flow

In volatile market conditions, liquidity is more important than ever. One of the key ways for businesses to manage cash flow is to manage their contracts. Read more about The importance of pro-active contract management in an economic downturn here.

Cash flow issues might include:

• Customers taking longer to settle invoices (or not settling invoices at all);

• Businesses with stock and work-in-progress with significant cash tied up;

• Businesses needing to incur onward costs (e.g. buying materials) in advance of payment; and

• Businesses with foreign currency payments dealing with fluctuating exchange rates.

Conducting a review of existing commercial contracts to understand the risks and seeking more favourable terms may stand businesses in much better stead during a recession and beyond.

How can businesses improve the payment terms in their contracts?

A clear payment provision is vital for the contracting parties to understand exactly what money is owed and in what circumstances, when payments are due, and what rights and protections each party has in respect of sums owed. Such provisions should be in writing and unambiguous, with any agreed changes clearly documented. You can read more about the issues around varying commercial contracts here.

What payment incentives and provisions for late payment can be included in a contract?

When the economy slows down, the likelihood of late and missed payments goes up.

Typical incentives for prompt payment might be early payment discounts. This might be, for example, a 5% discount on invoices paid within 7 days. It could also be a discount on future orders.

If one party does not have enough cash to make payments in accordance with the contract, typically the contract terms will govern how to handle a default. On the whole, most parties won’t want to end a business relationship over a brief delay in payments. A better alternative is therefore to include a provision for failure to pay on time. Normally this will be for interest on the outstanding debt (see below), but may extend to the creditor’s other legitimate costs incurred as a result of the failure to pay on time. Such provisions must not be out of proportion to the creditor’s interest in being paid on time, or they will be unenforceable penalties.

How can a business speed up receiving cash?

Payment on purchase and upfront cash is the gold standard for payment terms when managing cash flow, however this often isn’t feasible.

Short of simply asking the counterparty to agree a shorter payment deadline, an alternative way to receive some income in the shorter term is to include a provision for the payment of either a deposit, or for staged payments. Staged payments can be made on pre-set dates in a payment schedule, or at certain agreed milestones. Where permissible, more regular invoicing (for example, monthly rather than quarterly) will also help prevent cash being “locked up”.

Can businesses charge interest on late payments?

Contracts will often include an express provision providing for the payment of interest on any unpaid sums. If so, the interest rate will normally be set out as a set percentage or as being tied to a bank base rate. If the contract contains no such express provision in relation to interest, and is a business to business contract for the supply of goods and services, then the Late Payment of Commercial Debts (Interest) Act 1998 (LPCDIA) will imply such a provision into the contract. Where applicable, the LPCDIA entitles businesses to charge statutory interest at 8% above the Bank of England base rate on any overdue commercial debts. Additionally, the LPCDIA entitles the creditor to a fixed sum for each overdue debt based on the value of the debt, together with its reasonable costs of recovering the debt.

With base rates going up, contractual and statutory interest rates which are tied to base rates will carry more heft and will have more of an impact on debtors.

Can businesses extend payment deadlines with suppliers?

Whilst businesses want to speed up accounts receivable, the opposite strategy should be deployed for accounts payable. One of the most effective ways to improve cash flow management is to extend payment terms with suppliers. Businesses receiving services will then have more cash to pay expenses and salaries, and to invest back into the business.

Rather than making full payment of an invoice as soon as it is received, consider the contractual terms to see how long payment can be withheld before it becomes due, or whether the contract allows for payment to be made in stages. Simply waiting for the deadline can prevent cash shortages.

Businesses finding it difficult to comply with payment deadlines should communicate with their suppliers to ask for extensions to temporarily ease cash flow problems. If agreed, these should be clearly documented to avoid any later disputes. You can read more about the issues around varying contracts here.

It is also worth considering cancellation terms in onward supplier contracts. If the contract is no longer economically feasible, businesses should check to see if they are locked into the contract and, if so, for how long, as it may be possible to get a better deal elsewhere.

How can businesses manage fluctuations in pricing?

Some contracts might contain a mechanism under which the contractual sum increases if defined fluctuation events occur. This could include increased onward costs such as labour, materials, distribution, transport, currency and taxation. This is more common in longer term contracts. For suppliers / sellers, these can be very useful provisions where market conditions fluctuate and where the contract would no longer be profitable if it were for a fixed lump sum.

Can businesses retain some flexibility with products ordered?

No business wants to be in a situation where its cash is tied up in stock which it cannot shift. If this is a concern, businesses should check contractual terms for the following:

• Minimum and maximum order quantities – discounts might be offered on large bulk orders. Similarly, the option of small orders might be useful if cash is tight.

• Returns policy – if products are not selling/ expired/ out-of-season, suppliers might offer the option to return such slow-selling items.

• Inspection of products – businesses might seek to include a term which enables them to withhold any payment until products pass inspection, so that cash is not tied up in products which cannot be sold onwards.

Should payment terms be offered as a “one size fits all” approach to different customers?

There are pros and cons of this approach. Having the same payment terms across all contracts certainly makes it easier to manage and keep track of contracts and respective accounts payable/ receivable. However, it might be that a more risk-based approach can be offered where credit checks are conducted on customers. Tighter terms (such as shorter payment deadlines) and/or higher prices might be offered to lesser-known or riskier customers, whereas more lenient terms might be offered to long-standing trusted customers with a history of prompt payment.

How can businesses enforce the terms of the contract in the event of late/ non-payment?

If a business does not get paid for goods or services it has provided, the first port of call is to check the terms of the contract to ensure the payment is due and owing. If it is, then typically this party might remind the defaulting party of its payment obligation and seek to understand genuine reasons for delay before considering any next steps. With good communication, parties may be willing to agree to an extension or to an alternative repayment schedule in order to facilitate payment.

The contract might also provide that the defaulting party must be notified (sometimes formally in writing) and must be afforded an opportunity of, for example, 30 days, to remedy the default before any further action can be taken. If the defaulting party fails to remedy within this period, then the innocent party may then be entitled to immediately terminate the contract and claim damages. Termination of a contract is a serious step and it is often advisable for businesses to seek legal advice before seeking to terminate. Businesses may have both contractual and common law rights to terminate, which can lead to different rights to damages. Getting termination wrong can have serious consequences, and it is best to understand your position before acting – you can read more about issues around terminating commercial contracts here.

Finally, the contract may include a dispute resolution provision which sets out precisely how parties should deal with any disputes. This might include a provision for parties to engage in alternative dispute resolution, such as negotiation or mediation, prior to pursuing legal action. Such mandatory steps should be adhered to before any claim is issued. To do otherwise may well lead to an application to stay proceedings whilst these steps are completed. Find out more about your options for taking formal legal action to deal with late or non-payment of debts here.

What if a counterparty has a cross-claim and is refusing to pay under a right of set-off?

If a business is owed monies by a counterparty, but that counterparty has a genuine cross-claim against the business, the counterparty may seek to avoid paying the sum owed under a right of set-off. To ensure that undisputed debts are paid without delay, sellers / suppliers can mitigate this risk by including an express contractual provision excluding the right of the other party to withhold payment on the grounds of set-off.

What is the key take away?

Don’t leave it until it is too late to review and/or seek to amend contractual provisions to ease cash flow. All businesses are feeling the pressure of rising prices and so keeping communication lines open is likely to help unexpected difficulties as a result of market volatility later down the line.

LS Unlock

We have created an initiative called “LS Unlock” to help businesses access legal advice during the uncertain times ahead. LS Unlock comprises a free initial assessment of significant commercial claims together with a menu of alternative fee arrangements which can reduce and, in certain cases, eliminate the upfront cost of pursuing a claim. This initiative has been designed specifically to assist clients in this uncertain economic climate and is part of our commitment to working with clients to help them survive its effects.