The use of credit cards and other automated payment systems that allow the customer to conveniently make purchases on credit makes it much easier to sell your goods and services. In particular, offering payment terms such as zero percent interest for credit card purchases can attract new customers, which of course can boost sales and lead to bigger profits.
But to do good business through customer credit, it is very important to maintain a strong cash position to finance it. So, before deciding to tie up your company’s cash in customer collectibles, it would be wise to first create a credit policy and a realistic, doable set of procedures for giving credit and collecting payments. This will give you a better control of your cash flow.
A credit policy is simply a set of rules and procedures that you need to apply to all customers in every foreseeable situation.
In a credit policy, you normally need to decide on the following major credit aspects: the maximum amount of credit you are willing to extend to a customer, the terms of payment (whether 30 days, 60 days, 90 days, or longer), the down payment required, and the credit evaluation criteria for new customers.
You also need to include in the policy how to go about notifying customers who have past due accounts, and how to write off account receivables that you have already considered as bad debts or un-collectibles. When planning your credit policy, it is advisable to consult your accountant or business advisor for insights and advice on how to best reduce your company’s credit exposure.
The next step is to determine how much cash reserve you can afford to finance your credit sales. This is important because your cash is part of your working capital, and you need to always have enough cash for your inventory purchases and overhead expenses.
For this reason, over-investing in receivables may result in imbalances in your working capital, which could force you to borrow money to finance your inventory replenishment and operations. Your accountant can advise you on the maximum credit that you can extend per customer.
When you sell on credit, there’s also the risk of late payments or even non-payment, which could impact on the price of their goods and services. These should be budgeted in the costing, perhaps as a percentage of selling price or of the average receivable balance; the specific percentages will depend on the nature of the business.
The other issue that you need to establish is the cutoff for charging interest on late payments and how much that interest should be. You should plan this carefully based on the historical performance of your collection efforts or based on the advice of your business consultant.
Once you have finished writing your credit policy, you will need to methodically and consistently implement it in your business. This process should start with an evaluation of the risk profile of every new customer. You may need to require references, specifically the creditors that your customer has dealt with in the past.
A prospective customer’s payment pattern history normally can provide good information about his or her attitude in paying. Does the customer normally pay in cash or by installment? Are there any other issues about the customer regarding his dealings with suppliers? Have there been any legal proceedings in the past against the customer about non-payment?
Past business transactions can’t guarantee the future, of course, but the information helps in making a fair evaluation of your customers before deciding to extend financial credit to them.
Monitoring outstanding receivables from customers is another very important aspect of credit management. One way to do this is to compute the average collection period per month. You can arrive at this by first computing the accounts receivable turnover, which is your total accounts receivable balance divided by the total sales for the month.
Let’s say that your outstanding accounts receivable balance as of November 2006 is P500,000, and that your total sales for the month is P1,000,000. Then the computed accounts receivable turnover ratio would be P500,000 divided by P1,000,000—or 0.5 times. To get your average collection period, you have to divide 30 days by this turnover ratio. In the given example, 30 days divided by a turnover ratio of 0.5 yields an average collection period of 60 days.
By closely monitoring your collection per month based on this computation, you’ll be able to effectively assess your credit management performance on a regular basis. You have a choice of doing the monitoring yourself or getting your accountant to do it. The advantage of having an accountant to do it is that he or she will be able to substantiate the receivable figures with a receivables aging report, which can help you identify customers with overdue accounts and alert you early enough on who are most likely to default.
So what do you do when you have past due accounts? Experience shows that the likelihood of collecting receivables decreases significantly with the length of non-payment. For an account receivable that’s 90 days past due, the probability of collecting it is about 70 percent; after 180 days, 50 percent; and after 360 days, 23 percent.
When an account becomes past due, of course, the first thing to do is send out a polite reminder, which can then be followed by a series of collection letters, fax, or e-mail. Sometimes you may need to call or visit your customers personally to find out for yourself if they are still capable of paying.
In extreme cases, such as when collection of the receivable begins to look hopeless, you may have to hire a collection agency. Usually, collection agencies will only charge you a percentage of what it collects. At this point, of course, you would have already written off the bad account from your books, so you can consider any successful collection made by your agency as an “income”
You have to carefully manage credit to avoid situations like this. One way is to encourage early payment with the aid of positive incentives to customers such as price cuts for cash payments or discounts. On the other hand, you may also impose negative incentives, such as charging interest for late payments or reducing the credit limit for customers who habitually pay late.
When you have a past due account situation, it’s always best to first seek a workable solution with your customer. By patient negotiation, you may be able to work out a favorable repayment schedule. In the case of large past-due receivables, perhaps you can negotiate a one-time cash payment plus some payment in kind such as inventory, a laptop computer, a car, or some other tangible asset of the customer that’s acceptable to you.
Keep in mind that the longer the account stays overdue and the longer you fail to resolve it with your customer, the less likely you are going to be paid.