Trade credit is an almost inevitable part of business-to-business commerce. Whilst more business is a positive outcome from offering credit to the customers, it has a negative impact on a business’ cash flow.
Once again we have a revenue (sales) trade off against the availability of credit. A business needs to find the right balance – offer credit, but not to the extent bad debts become an issue.
Businesses should try to work on a cash and credit card basis wherever possible. Credit sales are a risk, unless you have performed a credit check on your customer.
If you can offer concrete advantages, such as a lower price or better service, you may be able offer less generous credit terms than your competitors without the risk of losing sales.
However, too liberal a credit policy can starve your business of cash, causing liquidity crises. Customers who are attracted by generous credit terms are invariably the slower payers and poorer credit risks.
To manage credit properly, it is important to balance the need to optimise cash flow and the need to avoid bad debt.
Here are some useful guidelines for controlling it:
Define carefully when the credit period starts. Does it start from your date of dispatch or from the date of receipt of goods by the customer or from the date of receipt of invoice by the customer? Take the necessary actions to complete all the actions on your part to clear the payment as fast as possible.
Wherever possible, build an element of interest to be paid by the customer in case the payment is delayed beyond the agreed credit period.
Determine what should be the amount of credit extended to a particular customer. This may be based on the volume of business or your cash flows.
Design the accounting system to handle credit control – with late payment letters, etc. which are generated when debt falls due.
Assess the cost of debt collection, should you need to pursue that avenue. Sometimes this might not be worth it, and you may need to carry out a cost benefit analysis.
Consider the cost of borrowing, should you need to finance the delay in receiving a payment to conduct your business.
Ensure you have a mechanism in place that constantly reviews your credit policy.
Credit Terms
You may have little choice about offering credit terms if this is usual in your industry, because this is what your customers will expect.
These terms, however, should be clearly stated to customers before they make a purchase. Include them, for example, as part of a sales contract.
Amongst the terms specified you should include:
The period of time for which credit is provided (eg. 30 days from the date of issue of the statement of account)
The amount of discount (if any) to be provided as a settlement discount and the time in which payment must be made to qualify (for example, two percent discount if an account is paid within 14 days of statement date is common )
The amount of interest (if any) to be charged on accounts unpaid after the due date (eg. one percent interest to be added to overdue accounts each month).
Carry Out A Credit Check
You should carefully screen new applicants for trade credit to evaluate the business’ likelihood of paying their bills on time. There are at least two basic types of financial references:
1. Trade references. This refers to suppliers of the business in question. Ask for a contact name with each reference.
2. Bank references. This refers to the business’ bank(s). Again, ask for the name of someone who is familiar with the firm, if available.
Asking for four or five financial references is customary, but you should ask for as many as you will need to make you feel comfortable with the credit risk you are considering.
You might also want to find out if they are trading as individuals or as a limited company. Remember, a company is used to protect the assets of the shareholders.
Set A Credit Limit
Set a realistic limit on each customer’s access to credit, based on his or her requirements, past payment record and so on. Provided the customer does not exceed the agreed limit, and there are no overdue existing commitments, you should do business with that customer again.
However, if they place an order which would take an account past its agreed limit, you should discuss the order with the client.
Discounts For Prompt Payments
Some businesses offer quite significant discounts off the total amount due if the account is paid promptly. You should consider such an offer to your clients.
For example, you may offer 2.5 percent off the full invoice if paid within seven days of receipt of goods. This represents an interest rate earning of 130 percent per annum on the discounted amount. That is generous, but more importantly, you have been paid.
If you offer a lower rate (say one percent), this is unlikely to attract early payment. You also run the risk of offending customers who pay a day or two late and do not receive the discount.
Don’t give too high a discount either. This may infer that your business is desperate for funds.
Credit Charges
Some businesses add a credit charge to each invoice with the proviso that this is waived if the account is paid within 30 days. This term must be clearly stated in your original contract or debtors will ignore it and you will have no recourse.
Credit charges are usually a specified amount or a percentage of the amount outstanding – in other words, they are the equivalent of interest on the amount outstanding.
Alternatively, you can apply a monthly flat account charge of, (say) $5.00, as long as you have agreed to this amount with the debtor when the account was set-up. Note that this is to pay for the account, not the interest on outstanding amounts. If this is the only charge, the account is exempt from most of the credit laws.
Credit charges have the disadvantage of implying that you are offering extended credit. Some customers may be prepared to pay the extra interest for the chance to delay payment, perhaps indefinitely!
Identifying Credit Risks
Your main way of avoiding credit risks is to subscribe to a credit reporting service. Many services will regularly fax lists of known bad payers for specific industries.
One appearance on the list may be of little concern because it could be triggered by a disputed account or clerical error, but you should refuse to deal with businesses that regularly appear on such a list, except on a cash-only basis.
The most likely business problem arises when a customer, who has been paying regularly, starts dragging his/her feet. In this case, you need to ask why and to decide whether the change is temporary or likely to be ongoing.
Most companies that fail to pay their creditors usually show one or a number of early warning signs. The following list will give you a point of reference, but you should not act on any one piece of information. You need to base your decisions on substantive evidence.
A new signatory – especially if new signatory not known
Cannot meet 30 day invoices after 50 days: after 60 days you most likely have a bad debt
A change in order patterns
A change of banker
Signatories away for longer than two weeks
A change of director/secretary
Customers product constantly changing – out of normal goods/services supplied
A change in payment pattern
Customers premises in shambles – stock levels low
Rumours in the industry, from customers’ staff, your sales staff, other creditors
A change of delivery/invoice address
Cannot contact customer by telephone
Customer will not return messages or answer calls
Customer will not accept reasonable resolvement of queries.
It is difficult to turn away sales on a hunch, gut feeling or any one of the above warning signs. One way of thinking is to imagine what damage would be caused to your business and cash flow if the creditor was to file for insolvency – if your conclusion is somewhere in the area of having to secure bank funding to meet the shortfall in cash flow, you need to make hard and fast decisions.
Assess the risk of your customers. Walk away from high risk situations, as inevitably, a bad debt results.
