Extending credit to customers can be chancy. How will you knowif a customer is a good credit risk? How can you tell if extendingcredit will actually increase your bottom line? Will it cost extrato sell on credit? Make sure you know the answers to all thesequestions before you decide to proceed.
Cash and carry is the most efficient way to do business. Iteliminates the need for credit checks and costly monitoring ofreceivables, and it minimizes the chances of operating losses.
By their very nature, certain types of business–custommanufacturing, professional service providers and conveniencestores–demand straight cash transactions. Otherbusinesses–construction contractors and clothing manufacturers,for example–must offer credit to customers.
Offering credit can
- Encourage customers to spend more, which can result inincreased sales if receivables are turned to cash;
- Increase customer goodwill and build good customerrelations;
- Make your customers less sensitive to price and more focused onthe services you offer.
To illustrate these points, consider a small bookstore inMinnesota that sold books to college students on a cash-only basis.After one year of operation, the store had fallen 60 percent belowits projected first-year volume and was facing a loss of severalthousand dollars.
Then the owner did a simple study of the store’s customers anddiscovered that most operated on a monthly budget; funds wereprovided either from scholarships or from home. In this market,people traditionally sent money to their children on the first ofthe month.
For three or four days around the first, sales volume and foottraffic 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 ownerbegan granting credit to students. Business zoomed, and hisfirst-quarter sales were up more than 200 percent.
Certain costs are involved in granting credit. The major gambleis that the customer might not pay. Statistics indicate that 97 to98 percent of all credit bills in America are paid on time.However, that remaining 2 to 3 percent can sink some smallbusinesses.
Credit costs you money. When you offer credit, you’re selling anitem you’ve already paid for on the premise that you’ll be paid bythe buyer tomorrow. The dollars to pay for the product come fromoperating capital that you then don’t have on hand to reinvest inyour business.
Your customer is, in effect, using your product on loan whileyour operating costs and cash needs continue to mount. If youdecide you can safely carry receivables of $20,000, then one way oranother you’re going to have to replace that $20,000 in your cashflow.
Credit also costs you time. For most small-business owners, timeis a precious and finite commodity. When you add credit decisionsto your workload, you spend time making those choices instead ofspending time running other aspects of your business.
Other major disadvantages of offering credit are the potentiallosses when a customer fails to pay or takes a long time to pay andthe additional expense of credit checking, credit-bureaumemberships and fees, discounts on sales, and costs of collectionagencies and lawyers.
When all is said and done, however, your competitors may simplyforce you to offer credit. You may have to provide credit not justto 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 yourcustomer is accurate.
Credit data and a past history gives you an initial indicationof your customer’s intention and ability to pay. Past paymenthistory helps with the third assumption. The fourth assumption canonly be dealt with by calling on your experience in business, yourknowledge of human behavior, and what you know about yourcustomers.
Verifying credit is fairly easy. On your credit applicationform, request three trade references and the name and branch of theapplicant’s bank. Call the bank, give your name and company name,and ask for a credit rating on your customer. Ask how long theaccount has been open, the average balance, and whether the bankhas credit experience with this account.
Then contact each of the customer’s trade references and tellwhoever answers that you’d like a credit rating on one of theircustomers. Ask how long the account has been open, the highestamount of credit that’s been granted, and how the customer pays.Once you’ve reached the bookkeeper, you usually don’t even have toask these questions–the necessary information will be volunteered.You might also obtain membership in your local credit bureau anddraw reports on each account or utilize one of the financial ratingservices for businesses such as Dun & Bradstreet. This way, ifthe customer has any judgments against him or her or a record ofslow payments with anyone, you will know.
