Do you provide trade credit to your customers, or are you considering doing so in the future?
For many companies, it’s not a matter of whether they will or won’t grant trade credit, but rather what kind of credit and payment terms they will offer. That’s because vendor trade credit is expected in many industries — it’s the price of admission, so to speak.
By trade credit, we’re referring to the practice of allowing customers to pay for goods or services they purchase from you at some point in the future, rather than paying upfront or upon delivery. Net-30 days, for example, are common payment terms in most industries — this means that customers must pay you no later than 30 days after receipt of your invoice.
Many businesses just accept the fact that granting trade credit is an expected practice in their industry and go along with it, without taking steps to protect themselves from bad debt. Doing so, however, can be costly, as losses from bad debt can not only eat away at profit margins, but also jeopardize a company’s very survival.
The key to success is finding the right balance between granting the proper amount of credit and appropriate payment terms to customers that can prove they are creditworthy, while limiting or denying credit and terms to those who can’t.
Making this determination starts with drafting a comprehensive credit policy for your business. Such a policy will formalize specifically how you go about making decisions with regard to granting customer credit and setting payment terms. Consider these five tips to help you create the right credit policy for your company and your customers:
1. Put it in writing. If it’s not in writing, it doesn’t really count. Your written credit policy should specify your credit evaluation criteria (i.e., specifically how you will make credit decisions), how much credit (in dollar terms) you will extend to qualified customers, your expected payment terms (e.g., net-30), and penalties or interest that will accrue on late payments.
2. Ask for and contact credit references. Your written credit policy should include a formal credit application for customers to complete. Add a space on the application for customers to list credit references, which may include their bank and other creditors. Then be sure to contact these references. Also consider running Dun & Bradstreet credit checks before granting credit — you’ll more than cover the small fee if the check reveals potential credit problems.
3. Set appropriate limits and terms. The results of your reference and credit checks should enable you to set appropriate credit limits and payment terms for each customer. Note that these limits and terms can (and should) vary from one customer to the next, and that you can alter or withdraw credit and terms if customers don’t honor them consistently.
4. Strive for balance. If your credit criteria are too strict, you may turn away good customers and lose sales. But if they’re too lenient, you could end up with a high volume of uncollected receivables and bad debt. Strive for a middle ground that provides adequate credit to customers that qualify but flags those that might be bad credit risks.
5. Consider your cash flow needs. Your credit policy should be set with your monthly cash flow needs in mind. In other words, how much cash do you need in order to meet your day-to-day business expenses and ongoing working capital needs?
Read the next article in this series: Establishing a Formal Credit Policy.