Definition: Offering your customers the option of paying for the products and
services they purchase from you at a later date instead of upfront
Extending credit to customers can be chancy. How will you know
if a customer is a good credit risk? How can you tell if extending
credit will actually increase your bottom line? Will it cost extra
to sell on credit? Make sure you know the answers to all these
questions before you decide to proceed.
Cash and carry is the most efficient way to do business. It
eliminates the need for credit checks and costly monitoring of
receivables, and it minimizes the chances of operating losses.
By their very nature, certain types of business--custom
manufacturing, professional service providers and convenience
stores--demand straight cash transactions. Other
businesses--construction contractors and clothing manufacturers,
for example--must offer credit to customers.
Offering credit can
- Encourage customers to spend more, which can result in
increased sales if receivables are turned to cash;
- Increase customer goodwill and build good customer
relations;
- Make your customers less sensitive to price and more focused on
the services you offer.
To illustrate these points, consider a small bookstore in
Minnesota that sold books to college students on a cash-only basis.
After one year of operation, the store had fallen 60 percent below
its projected first-year volume and was facing a loss of several
thousand dollars.
Then the owner did a simple study of the store's customers and
discovered that most operated on a monthly budget; funds were
provided either from scholarships or from home. In this market,
people traditionally sent money to their children on the first of
the month.
For three or four days around the first, sales volume and foot
traffic were good. But for the remaining days, sales bottomed out.
The owner tried everything--more advertising, sales promotions,
discount offers--but nothing worked.
In the bookstore's second year of operation, however, the owner
began granting credit to students. Business zoomed, and his
first-quarter sales were up more than 200 percent.
Certain costs are involved in granting credit. The major gamble
is that the customer might not pay. Statistics indicate that 97 to
98 percent of all credit bills in America are paid on time.
However, that remaining 2 to 3 percent can sink some small
businesses.
Credit costs you money. When you offer credit, you're selling an
item you've already paid for on the premise that you'll be paid by
the buyer tomorrow. The dollars to pay for the product come from
operating capital that you then don't have on hand to reinvest in
your business.
Your customer is, in effect, using your product on loan while
your operating costs and cash needs continue to mount. If you
decide you can safely carry receivables of $20,000, then one way or
another you're going to have to replace that $20,000 in your cash
flow.
Credit also costs you time. For most small-business owners, time
is a precious and finite commodity. When you add credit decisions
to your workload, you spend time making those choices instead of
spending time running other aspects of your business.
Other major disadvantages of offering credit are the potential
losses when a customer fails to pay or takes a long time to pay and
the additional expense of credit checking, credit-bureau
memberships and fees, discounts on sales, and costs of collection
agencies and lawyers.
When all is said and done, however, your competitors may simply
force you to offer credit. You may have to provide credit not just
to increase sales but to maintain them.
When you offer credit, you make four basic assumptions:
- That your customer has every intention of paying;
- That your customer is able to pay;
- That nothing will happen to prevent payment;
- That your judgment about the character and integrity of your
customer is accurate.
Credit data and a past history gives you an initial indication
of your customer's intention and ability to pay. Past payment
history helps with the third assumption. The fourth assumption can
only be dealt with by calling on your experience in business, your
knowledge of human behavior, and what you know about your
customers.
Verifying credit is fairly easy. On your credit application
form, request three trade references and the name and branch of the
applicant's bank. Call the bank, give your name and company name,
and ask for a credit rating on your customer. Ask how long the
account has been open, the average balance, and whether the bank
has credit experience with this account.
Then contact each of the customer's trade references and tell
whoever answers that you'd like a credit rating on one of their
customers. Ask how long the account has been open, the highest
amount of credit that's been granted, and how the customer pays.
Once you've reached the bookkeeper, you usually don't even have to
ask these questions--the necessary information will be volunteered.
You might also obtain membership in your local credit bureau and
draw reports on each account or utilize one of the financial rating
services for businesses such as Dun & Bradstreet. This way, if
the customer has any judgments against him or her or a record of
slow payments with anyone, you will know.