Credit and your small business operations

Buying and selling on credit is a normal part of business. Establishing and maintaining a clear credit policy and following the proper credit practices and procedures should therefore be a fundamental part of your small business operation. Sales and marketing, production and delivery, and customer service are obviously important aspects of your business, and your credit and collections practices round out the operating cycle.

Three key concepts involved in credit are:

• Information
• Communication
• Control

Since selling on credit is basically agreeing to deliver the products your customers order, or to perform the services they request based on a promise to pay at some future date, you will want to make an informed decision about extending credit, before committing your time and resources.

Clearly communicating your terms to the customer will avoid any misunderstandings later on. Once you decide to extend credit to a customer, the terms should be documented so that they are clear to both parties. It is also important that all persons internal to your small business, whether they work in sales and marketing, production and distribution, or accounting, operate from the same base in terms of credit.

Control involves consistency and follow-up. A credit policy can only be effective if it is carried out in practice. Guidelines should be consistently applied in the sales and billing phase, and enforced through follow-up in the collections phase.

Common credit practices

One of the factors to take into consideration in establishing a credit policy will be the standard practices in your line of business. Your customers may work with 30-day payment terms, which is common in many businesses. While your small business is not obligated to accept terms imposed by your customers, it is important to recognize these standard or common practices. Many businesses operate on a standard pay cycle, issuing payments once a week, for example, based on an accounts payable system that ages invoices and calls up for payment those that are due. In many cases, when the invoices are entered into the system, the due date will be assumed to be, or will default to 30 days.

This 30-day payment period is taken as an example and it varies, depending on the nature of the business, the type of industry, general economic conditions, and individual companies’ financial policies and practices.

You will want to make it easy for your customers to pay you, and provided your small business cash flow permits, it may be acceptable, and even beneficial, to accept the standard terms of your customers.

Or you may be in a business that normally involves payment on cash terms; that is, you receive payment for your sales basically by cash, check, credit or debit card, or electronic transfers of funds. In this case, your credit policy would involve the exceptions, when you would extend credit to a particular customer based on a certain set of circumstances. But even in the case of an exception, the same principles would apply in deciding whether to grant credit to that customer.

Considerations involved in deciding whether to extend credit

The most basic consideration in extending credit is obtaining reasonable assurance that you will in fact get paid. This primarily means knowing who you are dealing with. Credit should not be granted without first having sufficient knowledge of the potential customer and their ability to pay.

The decision as to whether to extend credit to a potential customer of your small business will probably be a function of the amount involved in the potential sale and the probability of continued, ongoing business with that same customer. If the amount of the sale is significant, in terms of your small business, you should do an evaluation before extending credit, even if it is a one-time sale. And if this is a customer with whom you hope to continue doing business in the future, it will be important to first assure yourself of the credit-worthiness of the potential customer, and then to establish clear credit guidelines that are acceptable to both parties. This will enhance your business relationship with that customer, as well as your own reputation as a solid business, for other potential customers in the future.

The decision to grant credit terms obviously has a direct effect on your small business’s cash flow, so it is a decision that merits the necessary consideration. When you are just starting up and are short on cash, it may be more difficult for you to grant credit terms. But at the same time, you won’t want to lose a valuable customer just because they normally work with payment terms of 30 days. So you will need to weigh these factors in your decision. In many cases, credit terms can be negotiated. A basic rule would be not to extend credit to the point where it jeopardizes the solvency of your small business.

There are different spheres in which to evaluate the credit-worthiness of the potential customer. These include an evaluation of the financial situation of the potential customer, the conditions in the market segment in which it operates and general economic conditions, and data related to the company itself and its management.

Financial evaluation for extending credit

A financial evaluation can be performed based on concrete, objective financial indicators that can be obtained from, or calculated based on information contained in financial statements, annual reports, and other sources. These types of reports may be public or they may need to be requested directly from the potential customer.

In determining a potential customer's ability to pay, some of the financial indicators that can be evaluated from data on the balance sheet include:

• overall cash balances
• ratio of current assets to current liabilities
• debt to equity ratio
• capital or net worth

Since the balance sheet represents the financial position as of a given date, it may be advisable to review more than one.

Some indicators from the income statement include:

• overall profitability in terms of net earnings
• ratio of net earnings to sales
• debt carrying costs, namely interest, as a percentage of total expenses

Here again, it is advisable to review income statements for more than one period, in order to make a decision based on performance over a sufficiently representative period of time.

While acceptable ranges can be applied in evaluating ratios and other financial indicators, the general idea is to have a clear picture of the potential customer's overall financial health.

Economic and market considerations for extending credit

Overall economic conditions, and conditions in your potential customer’s industry or market are factors that should enter into your evaluation. A general economic downturn affects everyone, but may affect certain companies or businesses more quickly or more severely than others. Some markets may be susceptible to cyclical fluctuations that affect a particular company’s profitability and cash flow. And markets are constantly evolving and changing, benefiting some companies and leaving others at a disadvantage.

Your small business may be local and subject to economic and market conditions in a relatively limited area or sphere of activity. Or you may be global and subject to a wide range of factors in an on-line, interrelated business world that could potentially affect your business.

This is an area that may be difficult to quantify in concrete terms, since there are so many variables that enter in, and that are often intertwined. The idea is to maintain a constant awareness of prevailing economic and business conditions, paying particular attention to how these fluctuating conditions affect your own business and that of your potential customers.

Considerations regarding the customer company

Some of the questions that may form part of a credit evaluation of a particular company include the following:

• Are you familiar with the company?
• Is the company generally recognized in your market, industry, or community?
• How long has the company been in operation?
• Does the company have a physical address?
• Do you know the management?
• Who are the owners?
• Has the company undergone a change of ownership?
• Has the company undergone a change of management or a restructuring?
• Is the company in bankruptcy or has it declared bankruptcy in the past?

One of the best ways to gain assurance regarding a company’s ability to pay is through references, especially from people you know and trust, or from other companies in your same line of business. There are credit reporting agencies that provide information regarding potential customers, generally for a fee. And it is not unreasonable to directly ask a company for references, if you are unable to obtain them from another source.

Monitoring your credit policy

The establishment of a credit policy and a customer credit evaluation are not one-time-only exercises. You may need to review your credit policy periodically, based on how your business is doing in terms of cash flow and profitability. Any changes that you need to make in your policy would need to be communicated to your customers, possibly negotiating new credit terms.

Your credit policy does not necessarily mean granting the same terms to all your customers, and does not have to remain constant over time. It is important to consistently apply your credit terms once they are established. But credit is extended based on an evaluation of the customer’s ability to pay. And this may change. Each customer’s credit profile should be updated periodically, especially as new information comes in, and as a customer’s payment history evolves. Credit may need to be restricted on a customer who consistently pays late, or who has accumulated a significant unpaid balance.

Summary

A credit policy based on solid information and a thorough evaluation, which establishes credit terms that are openly communicated to all parties involved and that are consistently applied and controlled, will facilitate your collection process, your cash flow, and ultimately the success of your small business.