As I noted in my previous article on this topic, Should You Extend Trade Credit Terms?, there are both benefits and drawbacks to offering customers the option of paying for your products and services later, rather than upfront or cash on delivery.
If you do decide to offer credit terms to your customers, you should do everything you can to try to ensure that these customers will be both willing and able to pay you in accordance with your agreed-upon terms.
While many small business owners rely on “gut instinct” when deciding whether to extend credit to customers, this can be dangerous. Instead, experts recommend that you follow a structured process when determining which customers to extend credit to and how much credit to extend. Consider the following steps.
- Create a credit policy. A formal credit policy will detail in writing exactly what your payment policies and expectations are. Putting a formal credit policy in writing shows customers that you’re serious about your business’ finances, and it gives you a legal leg to stand on should you ever have to sue a customer for nonpayment.
- Require customers to complete a credit application. The application should ask for key information about the customer’s background (for example, number of years in business, outstanding loans, and the name and branch of the customer’s bank) as well as the business’ structure (corporation, partnership, LLC, etc.), federal tax ID number, and at least three trade references you can contact.
- Check the customer’s trade references. Asking customers to list trade references does little good if you don’t follow through and call them. Ask them about the customer’s payment practices: Did it pay the full amounts due on time, every time? If not, try to determine if there were any extenuating circumstances you should consider in your credit evaluation.
- Run a credit check. This can be done for a small fee via your local credit bureau or one of the business financial-rating services, such as Dun & Bradstreet. It will tell you if there are any outstanding judgments against the customer and/or if the customer has a record of slow payment with anyone else.
- Request a personal guarantee from the business owner. If the customer’s company possesses minimal assets and/or assets that are hard to convert into cash, you can ask the owner to personally guarantee the credit. You can confirm that the owner possesses adequate personal assets to support the guarantee by requesting a personal financial statement and personal bank account information and by obtaining a personal credit report, for which you will need the owner’s permission (ask for this on the credit application).
- Take a security interest in your products. This will allow you to repossess the products you sold should the customer refuse to pay you according to the agreed-upon terms, rather than simply taking your place in line with other unsecured creditors. To do so, you’ll need to have your customer sign a security agreement and UCC financing statement, which you will then file with your secretary of state or county recorder.
- Set credit limits and payment terms. Based on all of the above, set a financial limit for each customer you deem to be creditworthy and decide how many days after delivery of your products full payment will be due to you. If your terms are net-30, for example, make it clear that receipt of payment is due to you no later than day 30. This isn’t the day the customer should put a check in the mail. Better still, set yourself up to receive payments electronically, so you can avoid the “check is in the mail” excuse.