Many small businesses make the mistake of putting off developing credit and collections policies until they have a problem with an overdue account or available cash. The first step in developing a credit policy is deciding whether you should extend credit at all.
Before developing a policy, examine your business goals then ask yourself these questions:
- Why do I want to extend credit? Business owners tend to view making sales as paramount, but if extended credit ties up large chunks of your cash then it is bound to cause you serious problems down the road.
- What do I want to achieve by extending credit? This should be answered in terms of expected incremental sales, incremental profits and/or incremental customers. In other words, you should be able to say for example: If I extend credit to 20% of my customers, my sales should increase by $100,000 and my profit should go up by $10,000 and/or I should be able to get 10 new customers.
- What costs are associated with the policy in terms of cash tied up? Would the interest expense on that cash be offset by the net gains (i.e. profit)?
- Is my business such that I even need to extend credit? Research what is normal for your industry. This can be your yardstick.
- Can I afford to offer credit? The answer to this will depend on your cash flow. Remember, credit is the same as having your business extend an unsecured loan to its customers. Avoid borrowing from the bank and paying interest to support cash flow shortages caused by slow paying customers.
Some factors to consider:
- The better you know your customers, the more likely you are to offer them credit.
- The bigger your customers, the greater the potential for them to dictate a Credit Policy that ties up large chunks of your cash, or significantly hurts your business if the customer fails to pay.
- The larger the size of the transaction, the more likely it is that you will need to offer credit.
- The more economically depressed the business neighbourhood is, the less likely that you will extend credit.
Think of a Credit Policy as your way of making your customers pay you when you want them to. Again, how you set it up should depend on your cash flow as well as what’s normal for your industry and your own business objectives.
This is an excerpt from “Financial Management: A Workbook for Small Business” published by Women’s Enterprise Centre (WEC) and available for download at wec.ca/LearningGuides.