When done professionally, extending credit can be a boon to business. It is a disadvantage if a business does not offer some form of credit. Tough times are precisely when business owners begin extending credit to lure customers that are reluctant to part with cash. Some customers will owe and probably never pay. This can push businesses dangerously close to the edge, and business owners can find themselves so consumed with collections, they are left with little time for their business.
Establishing & Extending Credit Terms
Extending credit to customers is a fact of business life. It is necessary to figure out how much a business can afford to tie up in accounts receivable without losing sleep. It is a big mistake not to create and follow strict credit policies when extending credit. Thus, it becomes very important to decide who gets credit and who does not, as well as adopting a policy for evaluating credit risk and establishing credit criteria.
Unfortunately, not all customers pay on point of sale. The customer who makes a significant purchase may require extended purchasing terms. Even on those extended terms, customers may pay late because they know they can – this is because you are essentially lending money to your customer, and this increases the cost to your business. Not every purchase will require a credit application. The different types and levels of risk associated with customers include; Extended terms, late payment, non-payment, partial payment, and discount for early payment.
It is important therefore, to understand what type of customer you are dealing with, if they are cash customers or not. This means you will know the ‘full cost’ to your business when you decide to make the sale. A customer who requires extended terms and pays on time is predictable and reliable within the terms extended. The business' extra expense is the financing required to meet its own cash obligations or missed opportunities to use those unavailable funds during the longer collection period. The business knows, however, the cost of doing business with this customer.
A customer, who accepts terms, then pays late, burdens the business with the uncertainty of when the payment will be received. If the customer is consistently, ten days late, then the business may be able to change the timing of cash inflows; but if the customer is unpredictable in being late, then uncertainty increases, which is signaling a more dangerous risk – default. If your business has enough advantage to collect, financing charges may be an incentive to change customer behavior. If you cannot collect them, adding finance charges to the bill will demonstrate your awareness of the issue and that nonpayment is not acceptable. By doing so, you are signaling that the terms remain those agreed on. If you have to pursue legal action at some point, then you have documentation that you were enforcing your terms and conditions.
Partial payment is perhaps the most difficult to address because the customer is making limited payments of some amount, just not the full amount. This is not completely good, not completely bad - the type of prospect you hope to screen out or provide cash-only terms. Regardless of the terms, it is proper to ask for an advance payment; this insures that the buyer is serious and that the business actually has some revenue.
Discounts for early payment, especially for cash, are incentives to customers to pay earlier in exchange for paying less. You may offer 1 – 2.5 percent discount (depending on volume) for cash or for payment within 10 days of purchase. Incentives of this type recognizes the financing aspect of extending credit to customers. Customers will utilize most of the credit options available to them.
Circumstances change. The credit policies you have in place today and the terms you extend to each customer will undoubtedly change because circumstances change. Recognizing when customers’ purchasing patterns and payment habits change is part of managing credit terms, by extension - cash flow; then it becomes important to review credit policies and the activity of each customer periodically. It would also be wise to utilize account receivables, outstanding balances, and reports by customer to understand how accounts receivable - management practices are working. It is smart business to understand that you may have to offer certain terms to customers because of industry practice, or because your competition does. It is critical to your business to understand the full cost of those offers on your cash flow and profitability.
Progress payments are also a way to ensure that you are not open to financial risk. The key to successfully securing progress payments is to prearrange your payment terms. Agree on what percentage of the amount due at various stages. Alternatively, you may arrange for progress payments based on indicators that are relevant to the specific scope of work, the job, or the services provided. Regardless of the system, progress payments on larger jobs can dramatically lessen exposure to financial risk.
If, extending credit sounds iffy, consider offering credit through a third party, such as partner banks and other financial institutions; thereby transferring the risk, and allowing the real lenders do what they do best. Nevertheless, the onus for collecting is off you, its fewer headaches, little or no paperwork.
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