Creating a Healthy Credit Policy
Before you extend credit to a customer, make sure you’ve established a competitive and practical credit policy. First, consider two components:
- Your terms and conditions
- Your collection policy
Terms and conditions:
When deciding on your terms and conditions, consider the length of time you’ll extend credit and whether or not you’ll offer a discount for early payment.
Length of credit period:
You can establish the length of your credit period by learning your competitors’ terms. If you ask to be paid in 30 days in an industry that has a 45-day standard, you could lose sales.
You may try to increase sales by extending credit more liberally, while being aware of cash flow issues due to longer collection times and possible bad debt expense.
Especially if it’s common in your industry, you may offer a discount policy that persuades customers to pay their accounts sooner. Consider your own needs for cash, industry expectations, customer goodwill, and your own borrowing costs when deciding on a discount.
A standard term is “2/10 net 30”, meaning a 2% discount is given to customers who pay within 10 days. If they don’t pay within 10 days, then full payment is due within 30 days. When deciding on your own terms, consider how credit affects your cash conversion cycle.
To illustrate how a discount may affect your accounts receivable, let’s look at a scenario of a customer who owes you $5,000, assuming your own cost of borrowing is 10%.
|TERMS||Received in||($5000 x 2%) (A)||(10%) (B)||(A+B) (C)||($5000-C)|
|Net 30||30 days||$0||$41.10||$41.10||$4,958.90|
|2/10 Net 30||10 days||$100||$13.70||$113.70||$4,886.30|
Not taking into account industry practice or customer goodwill that you may earn in giving a discount, your business earns $72.60 more by not offering this type of discount. However, this may be fully or partially offset by the opportunity cost of receiving funds 20 days sooner.
If you are thinking about offering this type of discount, you may want to discuss a cost-benefit analysis with your accountant or business banker.
Creating a healthy credit policy for your business means balancing your industry’s standards, your own cost of borrowing, and the loyalty you may gain from customers when you offer discounts for early payment.
If your business involves inventory, you know that the goal of inventory management is to have goods in stock when you need them. Being low in stock may jeopardise sales, but tying up too much cash in inventory can hurt your cash flow. Learn more about best practices for inventory control.