This means it’s critical that you establish sound policies and procedures for checking the credit quality of customers before granting them payment terms. Otherwise you could end up spending inordinate amounts of time and money chasing after accounts receivable that are 30, 60, or 90 or more days past due. In many cases you won’t get paid at all.
Depending on the size of the invoice, nonpayment can be devastating to a small business. It can wipe out your profit margins and may even drive you into bankruptcy. But nonpayment isn’t the only risk of granting credit without conducting a thorough credit check. Payment delays can also prove costly by disrupting your cash flow.
The typical small business lives and dies by its cash flow cycle, which is the lag between the time you spend cash to buy materials, equipment, and inventory and pay employees and the time when you collect and deposit accounts receivable from customers. Late-paying customers can have a disruptive and potentially devastating impact on this cycle.
For example, let’s assume you’ve granted one of your large customers net-30-day payment terms. After a few months you realize that the customer has been paying in closer to 60 days and their outstanding receivables balance is closer to $20,000 than the $10,000 in trade credit you agreed to. As a result, your company’s working capital comes up short at the end of the month and you’re forced to tap a bank line of credit for $5,000 to meet expenses.
But what if you can’t access a line of credit? Maybe you can get a cash advance from a business credit card or sell some of your outstanding accounts receivable to a finance company or factor. But these options tend to be expensive, and they don’t solve the core problem: getting late-paying and uncreditworthy customers to pay their invoices on time.
You can avoid falling into this trap by drafting a formal credit policy that details specific procedures to be followed before you’ll grant trade credit and payment terms to a customer. In drafting your credit policy, pay especially close attention to the ebbs and flows of your cash flow cycle to ensure that you’ll always have enough cash on hand to meet your monthly expenses.
Start by measuring your days sales outstanding, or DSO. It will tell you how long it’s currently taking you to collect your accounts receivable. Next create an accounts receivable aging report so you can see the payment status of each customer (current, within 30 days, within 60 days, etc.) and the amounts due.
Based on this data, you can draft a credit policy that grants payment terms in such a way that ensures your cash flow remains consistent throughout the month -- and you don’t run out of capital when you need it most.
By Don Sadler
As noted in the previous article in this series, Why You Should Check Your Customers' Credit, you may not have a choice when it comes to granting credit and payment terms to your customers. In many industries, it’s the price of doing business. But before you grant credit, it’s vital that you minimize the risk of nonpayment or slow payment, which can throw a wrench in your cash flow cycle.
This means drafting a credit policy that specifies your credit-evaluation criteria: specifically, how you’ll determine who receives credit, how much credit they’ll get, your payment terms, and any penalties or interest that will accrue on late payments.
The first step is to draft a credit application to be filled out by all customers who are requesting credit -- no exceptions. On the application, ask customers to supply such information as the number of years they’ve been in business, the name and branch location of their bank (or other lenders), the amount of any loans or lines of credit they have outstanding, and their federal tax ID number.
Perhaps most important, ask customers to list at least three trade references you can call to ask about payment practices. For example, when contacting references, you could ask: Does the customer consistently pay the full amount due on time, or do they occasionally (or frequently) fall behind on payments? If so, are there legitimate reasons, and is the customer proactive in communicating openly and working toward a payment solution?
After checking trade references, the next step is to run a formal credit check on the customer. You can use your local credit bureau or one of the following financial-rating services.
Dun & Bradstreet’s Paydex numerical scoring system uses a multitiered approach to rate a business’s credit. A Paydex score of 80 indicates that a business pays its bills on time. This is usually the minimum score you’ll want to see before you grant credit. A score of 70 or below indicates consistently late payments, ranging from 15 days late to 120 days or longer. (Full disclosure: D&B is the parent company of AllBusiness.com.)
Equifax’s Credit Information Score is based on a wide range of payment data, including how long a company has been in the Equifax database, its current payment index, the number of payment references or inquiries on the company in the past 90 days, and the number of and most recent negative items. A score of 0 to 9 is the lowest credit risk, while a score of 41 to 69 is the highest risk.
Experian’s Corporate Credit Profile ratings use two different rating systems. The first, Intelliscore, assigns a score ranging from 0 to 100, with a higher score indicating lower credit risk. It’s designed to predict payment delinquencies in excess of 90 days. The second, Vantage Score, aligns a company’s credit scores from different rating agencies to create a single score ranging from 501 to 990, with a higher score indicating lower credit risk.
Fees for these reports range from $30 for an Experian CreditScore Report to $50 for an Equifax Business Credit Report to $119 for a D&B Business Information Report. This can be a small price to pay when compared to the cost of granting credit to uncreditworthy customers.
By Don Sadler
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