Hey there, business owner! Is providing credit to your customers while keeping your profit margin the balancing act you are facing? You're not alone. Credit for business owners can be like walking a tightrope: you want to extend credit (in the form of accounts receivable) to grow sales but also avoid unpaid invoices that damage your bottom line.
In this guide, we’ll look deeper into how your customer credit policy will affect your business profitability. You'll discover credit scoring models, negotiating better payment terms, and how to mitigate risks to make better decisions. By the time you’re done, you’ll feel confident about developing credit policies to maximize sales but with a minimum of financial risk.
Do You Know the Profitability to Credit Relationship
It is a good way to increase sales volumes, but it also carries some risk: giving credit to customers. The trick is seeing which customers will yield profitable business and which ones might lose you money by defaulting.
How Profitability is Directly Impacted by Credit Policies
Credit policies determine:
- Which customers you work with
- How much credit you extend
- Your cash flow patterns
- Your bad debt expenses
- Your capacity for investing in growth opportunities
The Main Elements of Effective Credit Policies
Credit Application Process
A well-designed credit application captures the information you need:
- Business background
- Financial history
- Ownership structure
- Trade references
- Banking relationships
Credit Limits
Determining appropriate credit limits includes:
- Data up to October 2023
- Industry standards
- Working within your risk tolerance
- Periodic review and adjustment of limits
Payment Terms
Payment terms should be clear; specify:
- Invoice due dates
- Discount periods
- Late payment penalties
- Consequences of non-payment
Credit Scoring Systems and Risk Assessment
To assess the risk of customers, a credit scoring system is implemented.
Internal Credit Scoring
Develop criteria based on:
- Financial statements analysis
- Business reputation
- History of payments to your company
- Industry risk factors
External Credit Reports
Use credit reporting agencies to:
- Verify financial information
- Identify red flags
- Get impartial risk assessments
- Track bankruptcy filings
Setting Appropriate Payment Terms
While terms favor customers, you also have cash flow requirements which need balancing.
Net 30 vs. Net 60
Shorter durations help cash flow but could decrease sales volumes.
Dynamic Discounting
Consider providing early payment discounts to facilitate cash flow while still sustaining profitability.
Milestone Billing
On large projects, bill at key completion milestones to mitigate risk.
Managing Defaulted Accounts and Writing Off Invoices
Even with good credit policies, some customers will default on payments. Hence, you should be aware of how to write off invoices in QuickBooks.
Collection Process
Get it organized:
- Send polite reminders
- Escalate to formal demands
- Involve collection agencies
- Take legal action if necessary
Bad Debt Accounting
Make appropriate entries for bad debts to keep the books balanced.
Policies on Credit: A Balancing Act Between Risk and Reward
Regular Policy Reviews
Review credit policies at least once a year, or whenever market conditions change.
Customer Segmentation
Depending on risk and profitability, treat different customer segments differently.
Technology Integration
Credit management software: Automate the monitoring and alerts.
Frequently Asked Questions About Customer Credit Policies
Q: What are the best ways to assign reasonable credit limits to new customers? A: Set conservative limits based on the information from their credit application and then adjust based on their payment history with your company.
Q: Is it beneficial to offer short-term payment terms like Net 15 or Net 30? A: Generally, short-term payment terms can result in better cash flow, but you may have to weigh this against what is customary for customer wishes in your sector.
Q: How frequently should I review customer creditworthiness? A: Annual reviews are typical, but high-risk customers or during economic volatility may warrant more frequent assessments.