Establish Credit Criteria for Customers

Unfortunately not all customers are created equal.  The larger customer who makes a significant purchase may require extended purchasing terms.  Even on those extended terms large customers may pay late because they know they can.  Because you are essentially lending money to your customer, this increases the cost to your business.  The same can be said for many smaller customers.

There are different types and levels of risk associated with customers:

  • Extended terms
  • Late payment
  • Non-payment
  • Partial payment
  • Discount for early payment or for cash
  • Combinations of the above

It is important, therefore, to understand what type of customers adding if they aren’t  cash customers.  This doesn’t necessarily mean you won’t see to the customer, but it does mean you will know the “full cost” to your business when you decide to make the sale.

A customer who requires extended terms but 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 (extended or normal) and then pays late burdens the business with the uncertainty of when the payment will be received.  If the customer is consistently 10 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 increase.  Your business is also faced with trying to determine if this is just a cash flow “management” tool of the customer or a solvency issue which is signaling a more dangerous risk –  default.  If your business has enough leverage to collect, financing charges may be an incentive to change behavior. If you can’t collect them, adding finance charges to the bill will demonstrate your awareness of the issue and that nonpayment isn’t acceptable.  Why would you take this step?  Because you are signaling that the customer’s terms remain those agreed to – you aren’t changing the terms.  If you have to pursue legal action at some point, then you have documentation that you were enforcing your terms and conditions, even if you weren’t able to collect.

Non-payment differs in that the customer has your goods or services and isn’t paying for them.  This is the double jeopardy risk – you have spent money to acquire the “product,” you haven’t recovered the cost, and you are no longer able to sell the “merchandise” to someone else.  This is the customer who may be screened out through the use of a credit application.  The credit application would include credit references from companies doing business with the prospect of similar size.  (The criterion of similar size company credit reference is a means of assessing how the prospect deals with companies of similar “leverage” and market power.)

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 the “I live in hope” client, not completely good, not completely bad.  This is the type of prospect you hope to screen out or provide cash-only terms.

Discounts for early payment or for cash are incentives to customers to pay earlier in exchange for paying less.  You may offer a one or two percent discount for cash or for payment within 10 days of purchase.  Incentives of this type recognize the “financing” aspect of extending credit to customers.  The reduced collection amount or “price” is less expensive than carrying the outstanding accounts receivable balance for a customer. When making this offer, you have made the decision that having the cash today is more valuable than collection of the full price later.

In many instances, customers will utilize over time most of the credit options you make available to them.  Circumstances change.  The customer who was the most reliable may go through hard times and become a cash only customer.  The customers who were slow to pay may get a handle on their own businesses and start taking advantage of cash discounts.  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 your credit terms and cash flow.  At a minimum, your credit policies and the activity of each customer should be reviewed annually.  It would also be wise to utilize standard accounting reports such as accounts receivable outstanding balances, aging of accounts receivable (shows how long each account or group of accounts has been outstanding), and reports by customer to understand how your 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.

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