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Credit and Collections

Filed under Basic Accounting. Fact checked on May 24, 2012.

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Establishing appropriate credit policies and collection procedures is vital to the success of any small business. You must decide what types of credit to offer, or even if offering credit is right for your business.

Credit and collections are for many small employers what changing diapers is for many parents: although everyone agrees it's essential, no one really wants to do it (but they're sure glad they did after the fact).

As a result, many small business owners put off creating a credit and collection policy until they absolutely have no other choice. As their customer base builds, and more and more customers want to pay by credit, they realize that they need to open up a credit card account or offer credit terms.

Or they ignore those few customers who don't pay their bills, until the few grow into many, and suddenly they realize that they need to spend time collecting overdue accounts.

The problem with this approach is that small businesses that don't plan ahead frequently end up spending a lot more of their time fixing the trouble than they would have taken if they had spent a little more time thinking about their credit policy beforehand. And, in countless cases, a poorly planned credit policy has ruined what was otherwise a thriving business.

To better serve your business and your customers, we'll guide you through the process of setting up a credit and collection policy. No one wants to spend all of their time collecting debts (unless, of course, you're in the debt collection business). Your time is much more productively spent doing what you do best—running your business. But if you just spend a little bit of time thinking about your credit policy early on, you can save yourself time and money down the road. The success of your business may depend upon it.

Understanding Your Credit Options

Many people will tell you that, as a business owner in today's economy, you don't have any choice but to offer credit to your customers. They'll tell you that credit is as essential to business success as oxygen is to breathing. Well, they're mostly right. But it's not an absolute rule for every business, particularly for smaller businesses with fairly small customer bases.

Don't fall into the trap of thinking that you should offer credit just because everyone else does. As you'll see as you go through this discussion, trying to collect from those who don't pay you can be extremely time-consuming, costly, and frustrating.

Should You Offer Credit to Your Customers?

Your decision on whether to extend credit to your customers won't involve a lot of complex analysis. It'll be based mostly on good common sense.

If the benefits of offering credit, such as increased sales, outweigh the costs of offering it, such as the risks and costs of nonpayment, you should offer it. If not, you shouldn't. Just don't forget that if you extend credit freely and don't get paid, it won't matter how much new business you generate.

Abiding by the Guiding Principles

In deciding on a credit policy, you should be guided by the following principle: If you can demand cash up front, and your customers are willing to give it to you, that should be your policy. If that's not possible, follow this principle: Get as much of your payments up front and in cash as possible. In other words, extend credit only if business conditions demand it.

Be sure to consider the factors that will come into play in determining the likelihood that you'll have to offer credit. And you'll need to figure out which types of credit are best for you, if conditions will demand it for your business, as they do for most others (particularly those that sell mostly to other businesses). 

There are several from which to choose: credit cards, checks, and a wide variety of credit terms (payable in 30 days; half in cash up front, the other half on delivery; 10 percent down, the remainder within 60 days; etc.).

Factors to Consider When Deciding Whether to Extend Credit

As mentioned before, extending credits isn't for everyone—but it is smart for many small businesses. Here's a look at some of the factors that should play a role in your decision whether to offer credit to your customers, and under what terms and conditions.

Following Your Industry

If the custom in your industry is to provide credit, you may have no choice but to offer it. If you own a fast food restaurant, you probably can get away with requiring full payment in cash. But if you're a consultant or a lawyer, you may lose business if you don't extend credit. An angle you should consider is whether you can gain an advantage over your competitors by offering credit where the industry custom is not to offer it. Can you make more money by letting your customers buy a hamburger with a Visa card? If you can, perhaps you should.

If the type of business you're in is one where credit plays an essential role, you also may have no choice but to offer credit. For example, if you sell your goods through the mail, you'll probably have to extend credit to your customers.

Knowing Your Customers

Consider these examples of knowing your customers to determine a credit policy:

  • The more dependent you are on repeat customers, the more likely it is that you'll extend credit to them. If your business is catering, you may be more likely to extend credit than if your business is in the tourism sector.

  • The better you know your customers, the more likely it is that you'll extend credit to them. If your business is consulting, you're more likely to offer credit than if your business is palm reading.

  • The bigger your customers are and the more buying power they have, the more likely it is that they'll dictate to you whether you offer credit. If your business is selling goods to IBM, you're more likely to offer whatever means of payment IBM wants than if your business is selling lemonade to the neighbors. Also, the wealthier your customers are, the more likely it is that you'll extend credit to them.

Considering Your Location

The more economically depressed the area surrounding your business is, the less likely it is that you'll extend credit to your customers (assuming you sell goods and services to people in the community). If your business is selling shoes in a poor area of town, you're less likely to extend credit than if you sell shoes in a wealthy area.

Measuring Your Transaction Size

The larger your typical transaction is, the more likely it is that you'll have to extend credit. If you sell your own oil paintings at art fairs, your customers will probably expect to be able to pay by credit card. On the other hand, if you sell ice cream cones at art fairs, your customers should expect to pay in cash.

Assessing Your Financial Condition

The stronger your financial condition and the better your cash flow, the more likely it is that you'll extend credit. If your cash flow is poor, and you cannot afford to carry much credit, then you'll be less likely to extend credit than if your financial condition were stronger.

Various Methods of Extending Credit to Customers

When we picture extending credit to a customer, we typically think of the situation where the customer receives a bill in the mail after receiving the goods or services. But credit comes in many varieties. In fact, any time you don't collect full payment from your customer in cash up front, you've extended credit.

Example

If you give your accountant a check when you pick up your income tax return, your accountant has extended credit to you because the work was finished before you paid for it. The period for which credit is being extended is from the time of payment until the check clears and the funds are deposited to his or her account.

Here's a look at the types of credit available to you, in ascending order of risk.

Extending Credit Through Credit Cards

If you decide to accept credit cards, you'll first have to decide which ones you want to accept: Visa, MasterCard, Discover, American Express or any of the others (like Diners Club). The charge you'll pay to the credit card company per applicable transaction will vary, depending upon the volume of your sales and the size of your transactions.

The average fee usually runs between 2.5 percent and 5.5 percent of your credit card sales, although American Express runs a bit higher. Accepting credit cards is the least risky of the credit options because most of the risk falls on the credit card company. You'll want to learn more about accepting credit cards before committing to this form of credit.

Extending Credit Through Checks

Although checks are usually considered to be cash rather than credit, they do involve risk on your part. Whenever you accept a check at the time the goods or services are delivered, you've extended credit because you're bearing the risk that the check will bounce—and if you accept checks after service is rendered, you bear the risk of ever receiving payment. 

If you accept checks, you'll have to decide which types of checks you'll accept (for example, will you accept multi-party checks?), and you'll have to decide which types of identification you'll require. For more on the precautions you should take when accepting checks, see credit information on individuals.

Extending Credit Through Credit Terms

In some cases, you may want to offer credit terms to your customers. Most often that will occur if you sell your goods and services to other businesses, but sometimes you'll want to extend terms to individual customers (just as your credit card company does to you). This is the riskiest option because you're forced to rely completely on the creditworthiness of your customers.

In most cases when you extend credit terms to your customers, you'll want to have them sign a sales contract, so you'll have to decide what the credit terms will be in the contract. You have any number of choices, such as COD, net 30 days, net 10 days, etc. To be binding, the credit terms must be in writing and the document must be signed by the customer.

In many situations, the credit terms will not be formal and don't need to be in writing. The example above, involving the accountant, is one such situation.

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