Whether you should offer credit terms to your customers and how much you should extend are among the most important questions any small business owner must answer.
There are clear benefits to offering customers the option of paying for products and services they purchase from you at a later date rather than upfront or upon delivery. But there are some big potential drawbacks as well.
- Customers may spend more money with you, which will increase your sales and, assuming you collect your receivables, your cash flow.
- Customers will appreciate being able to pay on credit as opposed to having to pay cash, which can help increase customer goodwill and loyalty.
- Customers may focus less on your price and more on the quality of your products and services and your flexibility. Also, extending credit can give you a competitive advantage in the marketplace if your competitors aren’t offering the same benefit to customers.
- The biggest is the risk that you won’t get paid at all.
- It will take time for you or your staff to perform the research and due diligence that’s required to make informed credit decisions about your customers.
- When you grant credit, you’re essentially giving customers the use of your money for a certain period of time. In turn, you may need to borrow money yourself in order to maintain your business operations. This is most evident in companies that manufacture and deliver finished products to their customers.
The Cash Flow Cycle
Virtually all manufacturing companies experience a concept that’s known as the cash flow cycle. This is the period between the time when a business must expend cash for everything that’s required to manufacture a product (equipment, raw materials, salaries and wages, employee benefits, etc.) and when it collects cash from the customers it has granted credit.
The manufacturing cash flow cycle starts with the conversion of cash into raw materials and then finished goods, which are delivered to customers. But if the customer has been granted credit, the business gets an account receivable in return for the product, not actual cash. The cycle isn’t complete until the account receivable is actually collected and turned back in to cash, at which point the cycle starts all over again.
The biggest danger to a manufacturing company is running out of cash during this critical period, which can stretch out as far as 90 to 120 days or even longer, depending on the production cycle, payment terms, and collection practices. Many supposedly “profitable” businesses have failed because they weren’t able to fund the gaps in their cash flow cycle.
Ideally, the business will have enough working capital on hand to carry it through until receivables are collected. If it doesn’t, it will need to borrow the money, typically via a revolving line of credit. Of course, there’s a cost involved in borrowing, and this cost should be considered as part of the decision about whether to grant credit to customers in the first place.
Often, businesses have little choice when it comes to extending credit, because doing so is standard industry practice. Regardless of whether you grant credit because you have to or you’ve made a strategic business decision to do so, you should only extend credit terms to customers after you’ve followed a series of specific steps. To find out more, read Steps to Follow Before Granting a Customer Credit.