Can I put this on my account?

This is the question many small business owners are hearing more and more in trying financial times. And, many are responding by installing standards for issuing credit to customers and clients. Having a clearly defined policy extending credit under terms and conditions, with qualifications, is an easy way to grow at a faster rate.

Throughout the manufacturing and distribution spectrum, the use of credit has been in place for hundreds of years. On a semi-regular cycle, it goes through times of tightening and loosening, both dependent on the economic factors and the position of monetary policymakers. When both elements merge, watch out! This usually means that tougher credit times are in store for everyone.

Establishing a credit policy can be used effectively, efficiently, and profitably, if installed correctly from the beginning. There are three elements that dramatically affect the policy and how it might be utilized.

Qualifying the customer

man and woman reviewing financials at tableCustomers today come in many and varying forms. Consequently, a small business owner must effectively screen clients to ensure payment for goods or services rendered. Screening clients involves clearing hurdles that allow credit to be comfortably issued. Some examples of those hurdles might be:

  • Completing an application for credit designed generically or specifically for your company;
  • Trade reference checks where larger credit is granted to your customer than what you are contemplating granting the customer;
  • Most current financial statements of the business;
  • Personal financial statements of the principal owners of the business;
  • Personal guarantees from the owners.

The customer has several possible needs for credit from your business. Many times it assists the customer in managing cash flow. By granting terms allowing discounts for payment in a specified time, a supplier can assist the customer by extending the time when supplies or merchandise must be paid for, more closely matching it to the inflow of cash from their customers. Confusing? Think of it as a temporary loan to your customer, with a discount for paying promptly when due.

Assessing the market need for credit

It may be that your industry, as a matter of practice, does not need to issue credit to operate in the regular business cycle. Food suppliers, for example, mostly operate on a cash basis. When a supplier delivers food products to a restaurant, typically, the supplier is paid at the time of delivery. This policy was established long ago in response to the perishable nature of the supplies and short-lived existence of many businesses in the food-service industry.

The market need for credit may also be dictated by the size of the purchase. Most small businesses find it a major stretch to make large purchases without credit, whether from the supplier or from their banker. In many industries, purchases can run into the tens of thousands of dollars before a single dollar is collected from the sale of that product, so many customers must have another form of “bank” to assist them in financing that swing time.

Yes, issuing credit makes you a form of a bank. Issuing credit to your customer is an additional “loan” to allow them to effectively manage their cash flow between the time the product is delivered and invoiced and the product is paid for by the customer. In addition, your bank and your customer’s bank both issue loans most commonly known as a Line of Credit (LOC). Many banks will allow their customers to borrow against a collateralized LOC to purchase tangible goods or accounts receivable.

Managing your business

Not all business is good business. For many of us in the small business world, we need to be ever diligent that we watch our entire organization, particularly when it comes to credit. Extending credit to customers can vastly and quickly grow any business. However, if not properly managed, it can also quickly strangle it.

Most small businesses depend significantly on adequate cash flow to operate. By extending credit to a worthy customer, at a reasonable price, your business will benefit by moving your inventory from a non-earning position to an earning position. However, it is important that the customer understand your need to be paid, according to your terms, for that merchandise. Many customers tend to rely on suppliers to “bank” them, as we talked about earlier, assuming that the supplier is in ready possession of extra cash to operate. This definitely is not always the case.

Collecting for invoices, on a timely basis, for goods and/or services is the basic instrument to turn inventory to accounts receivable to cash. Many small business people have a hard time making a “collection” call, fearing they will lose the customer forever if they ask to be paid. Don’t be reluctant to say to yourself: “Hey, this is my money! I just loaned it out to the customer to make it easier for them to do business.” By recognizing that, it makes it easier to make the payment call.

Don’t forget finance charges!

If you extend credit to customers, be sure to include your right to charge them interest in amounts owed your business for goods or services delivered to that customer. Many of us are just happy to get our original money repaid. But, if we borrowed money from our bank to finance that inventory, then converted it to an account receivable, we actually lost money in the portion of the transaction where we are paying interest to our bank while not collecting it from the customer. That’s not good! Be sure to check out the legalities and fine points of charging finance charges. You will find them to your advantage over time.

Effective credit policies can be implemented or modified at any time. It is never too late to begin the process of turning your paper receivables into real cash!

– Contributed by Mark Allen, prior business development consultant, UMKC SBTDC