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.