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      Few companies have the luxury of being able to demand—and receive—cash in advance from their customers. Most businesses must extend credit to their customers to be competitive. Even when competition is not a major concern, a customer may just refuse to buy unless he receives some type of payment terms.

Your Credit Terms Directly Affect the Bottom Line

      Although extending credit is an excellent way to increase sales, you must still be careful how and when you offer credit. Your revenues and profits are directly affected by the credit terms you offer and the way in which you manage your credit accounts.

      Let’s look first at the income side. You have to decide how accommodating you want to be. If you make your credit terms restrictive because you want to be cautious, you will have fewer bad debt losses and less cash tied up in receivables, but your customers will react negatively and your sales will decline. On the other hand, offering liberal credit terms means revenues will increase, but so will your risk of loss, while the cash available to support ongoing operations will decline.

      You should recognize, though, that there may be times when it makes good business sense to selectively loosen or tighten credit terms. For example, if you have obsolete or excess inventory, you may want to offer special terms to customers just so you can get the inventory out of your warehouse. In this case, the financial benefit of not having the investment in inventory outweighs the risk of loss and the cost of carrying the receivable.

      On the expense side, what is the true cost of extending credit to your customers? It is not only the interest expense you pay on the money you borrow from the bank until your customer pays the receivable.      You also have a significant administrative expense—the salaries and benefits for your credit staff. You can reduce this cost by outsourcing the administrative function. After all, you are not in the receivables billing and collection business, are you? There are many companies that can do this task at a cost that is substantially less than what you would pay your staff.
Originally published in Kaufmann’s Capital Comments.
Practical Information.     Process Improvement.     Profit Enhancement.

      To minimize your bad debt losses, you can buy credit insurance, which reimburses you if a customer fails to pay his invoice. Consider your historical bad debt losses and your ability to absorb a loss when deciding if the cost of the credit insurance is a good investment.

      There are also procedural changes you can make to protect your profits. One possibility is to establish a set of deadlines for processing receivables: bill within 2 days of production, call 5 days before the receivable is due, call 2 days after due date if bill is not paid. You can also make it a policy that no products are shipped if a customer is more than 30 days delinquent.

      Consider having tiered credit limits for your customers. For example, you might grant a customer an overall limit of $50,000, but limit the amount of credit per order to $20,000.

      Finally, although you may be tempted to use a collection agency to recover an unpaid debt, only do so after very careful consideration. Even though you may eventually collect-and there is no certainty you will-the cost to you may too high. Collection agencies are expensive and, too often, their aggressiveness only serves to alienate customers. Not only do you risk never doing business again with a particular customer, but you may also gain an unwanted and negative reputation. 

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