One summer, a young girl set up a lemonade stand at the end of her driveway. After several weeks, she had done very well, selling an average of 20 glasses of lemonade per day. At $0.50 per glass, she had average daily sales of $10.00. Not bad at all! But she noticed that many people told her, “I’d love to buy some lemonade, but I don’t have any cash with me.” And they continued on, without buying any lemonade.
Then one day she thought she might be able to sell more lemonade if she let these people have the lemonade today, as long as they agreed to pay her the next time they came by. Sure enough, most of those same people agreed to buy the lemonade and pay her for it the next day. After several weeks, her sales have increased to 30 glasses and $15 per day! Wow!
What a great business decision! She increased sales by making it easier for her customers to buy from her!
Using credit to buy something is a common practice for both consumers and businesses. Simply put, “credit” refers to the practice of purchasing something now, and then making your payment some time later. As an easy example, consumer credit cards are used millions of times each day to make a wide variety of purchases, but actual payment isn’t made until later when the statement arrives in the mail. Similarly, businesses use credit to simplify their purchasing process and make better use of their cash by delaying payments.
Of course, in order for either the consumer or the business to do this, the credit card company or the selling business must be willing to extend credit to their customers to begin with. So, credit really boils down to a matter of faith that a customer will pay as promised. This blog will discuss the strategic factors that affect how a business decides to offer credit to its business customers. We will cover the tactical decisions in establishing a credit policy in a later blog, and we’ll let the credit card companies worry about consumer credit.
The main purpose of extending credit is to increase sales.
The first question business owners should ask themselves is, “Will extending credit to my customers help grow sales?” Or, at a bare minimum, “Will extending credit help me keep up with my competition?” If the answer to either of these is “No,” then extending credit really doesn’t make any sense. But, if the answer is “Yes,” then we can move forward to additional factors to consider in creating a credit program.
But before we do that, a simple, yet critical point to make here is that extending credit is an optional business practice, not a requirement like filing taxes or other regulatory items. Although, extending credit may sometimes feel like a requirement if all of your competitors are doing it. And, in many industries, this is the reality.
How do I begin to offer credit to my customers?
Once you have decided that offering credit to your customers will benefit your business (i.e. it will help grow sales!), it’s important to understand how credit benefits your customers. Remember that a commercial transaction is an exchange of value. In many transactions, this exchange is immediate, like when you pay cash for a glass of lemonade. The use of credit, though, affects the timing of the exchange of value. Both parties benefit from this shift in timing. The seller gets a sale that he or she otherwise may not have made. And the customer benefits from an easier purchase and the ability to pay later. In many cases, customers will make multiple purchases, and pay for all of them at once, at a later time. This makes buying and paying for materials more efficient and easier to manage for your customers.
Some other important questions to consider include:
- What is the nature of your business? Are the items you’re selling critical or incidental to your customers’ businesses? The answer may affect how your customers look at your offering credit terms, and may impact how aggressive you are willing to be with your credit program.
- What credit terms does your competition offer? It is critical to always understand how your credit program compares to your competition, both initially and on an ongoing basis.
- What impact does your credit offering have on pricing? Extending credit to your customers does cost your company something (more on this below). You may need to borrow more money to extend those terms to your customers. Do you raise your prices to account for this additional expense, or do you absorb it, considering it just another cost of doing business?
What are the elements of a credit policy?
Once you’ve carefully considered whether you need to offer credit, you can proceed to the details. This is where it’s important to develop and clearly define aspects of a formal credit policy:
- Credit Criteria – while extending credit is not a requirement for businesses, any policy must be applied consistently. Establishing how you will make credit decisions is very important in terms of deciding which customers qualify for credit and setting a credit limit for them. This is a balancing act. If your credit requirements are too strict, you may lose sales. If they are too lenient, you may suffer from bad debt losses.
- Credit Terms – Establishing your credit terms and clearly spelling them out is extremely important. Credit terms become a critical part of the sales transaction, so it’s important to make sure they are clear in any agreements, listed in the terms and conditions of sale and on all invoices. Also, it’s important to know how your terms compare to your competition. A common example of credit terms is “Net 30 Days”, which means the customer promises to pay the full amount of the invoice 30 days from the date of the invoice.
- Discount terms – Some sellers will allow customers to take a small discount if they pay before the due date on the invoice. For example, “2/10, Net 30” means the customer can take a 2% discount off the invoice amount if they pay within ten days, or pay the full invoice amount in 30 days. Note that allowing discounted payments has an effect on your net income. But, if the benefit of having cash in hand sooner (in addition to increased sales) offsets or outweighs the impact on income, then allowing discounts makes sense. Many companies account for these discounts when setting their prices.
- Collections – Unfortunately, there are times that customers don’t pay their invoices on time. Because of this, sellers that extend credit need to engage in collection activities. These may include reminder letters (sometimes known as “dunning letters”), collection calls, suspending further shipments, and unfortunately, sometimes even legal action. It is important to clearly define your collection policy within your overall credit policy. A clearly defined collection policy takes the decision making out of whether a particular action should be taken. The more even handed and consistent you are in enforcing your collections, the easier this very difficult task will become.
What is the cost of extending credit?
Developing, or more importantly, executing a credit program is a serious undertaking. And, it’s not without its costs. But since the purpose of extending credit is to increase sales, the benefits should outweigh these costs. Nevertheless, business owners should be keenly aware of the costs associated with their extending credit to customers. Here are some cost considerations to think about:
- Cost of Credit and Collections activities – Depending on the size of your company and the number of customers you have, evaluating customer creditworthiness and conducting collection activities might require additional qualified staff.
- Carrying Costs –Extending credit means that you won’t be getting paid till sometime after the sale. During this time, your business will still need money to operate. This means that you might have to borrow money short term to meet your obligations until your customers pay. Or, you will have to use cash on hand, which means you may have to put off purchases of your own. This is called “opportunity cost.” It occurs when an opportunity is missed because you weren’t able to do it for other reasons, like a lack of cash because you allowed customers to pay on credit.
- Bad Debts – Some customers will pay you later than the credit terms you offered them. While this can be a nuisance, being paid late is better than not being paid at all. When a customer doesn’t pay you, regardless of the reason, that invoice amount must be written off as bad debt. Obviously, you don’t plan for those losses when you extend credit, which is why pre-sale credit evaluations are important. And, it is important to note that some credit-management experts feel that if you do not have any bad debts at all, you may be missing out on sales opportunities because your credit policy is too strict. Of course, those are decisions that only you can make.
- Other Costs – Other costs of extending credit include subscriptions to credit rating agencies or possible legal fees associated with collection activities, in the event of some of the more extreme cases of delinquency or non-payment.
Whether you are new to establishing a credit program or you have an existing one, consult with qualified financial professionals to review the considerations provided above. Whereas an effective, carefully developed credit program can provide significant benefits to your business and value to your customers, a poorly-conceived or managed program can have disastrous consequences.
CFO Simplified is your strategic financial partner to drive growth, profitability and value into your business. For more information and examples of how CFO Simplified has helped clients achieve these objectives, please review the services offered and case studies available on our website.