Allowing customers to pay on credit has a large number of advantages when managed efficiently. Most businesses pay on credit, which means you’ll likely attract more customers and experience growth if you offer payment on credit.
Balancing the advantages of extending credit with the disadvantages is where proper management of the accounts receivable (A/R) process comes into play. In short, the A/R process is sending out an invoice for merchandise or services rendered, waiting for some predefined number of days for payment, and finally receiving payment and recording it.
In this article, we’ll look at a balanced view of the pros and cons of offering net-terms financing.
If a customer can delay payment vs. paying immediately, most likely that will be the approach taken. For businesses, paying on credit is the norm. If you know the majority of businesses will seek merchants who allow credit payments, you need a good reason not to offer credit.
The end result of offering credit is growth in new customers, which, of course, means more revenue growth. Further, keep mind that paying on credit is expected in certain industries. If your industry is one of them, not offering credit is stacking the odds against you.
More customers can mean more diverse customers. The more customers you have, the less dependence you’ll have on any one customer. A diverse customer base can also mean some shielding from cyclical events in specific industries, seasonality, and bankruptcies.
Paying on credit works in the customer’s favor. You also have the option to customize your credit offering. Some customers may get longer terms than others. This can create great customer loyalty. Most customers will appreciate the fact that you’ve extended additional credit to them or even customized credit to work on the customer’s unique terms. Not every business does this, but those that do can see big benefits in customer loyalty.
After looking at a number of advantages to offering payment on credit, let’s look at a few disadvantages to give us a well-rounded view of offering customer credit.
Extending credit can mean short-term pain for long-term gain. In exchange for forgoing immediate payment, you potentially increase your customer base and loyalty, all the while driving up revenues. Your cash flow will see it quite different though.
Since immediate payment for merchandise or services is now delayed, cash flow drops. Your business needs to be able to cope with this decrease in cash flow. There are several ways to manage cash flow shortages. Without incurring additional cost, the business will need savings on which it can lean. Without cash to cover payment net terms, you can end up in a precarious position as bills come due, but there isn’t any cash flow to cover them.
Late payments can certainly happen without extending credit (i.e., due upon receipt) but they are exaggerated through credit extension. What should have been 30 or 60 net terms can turn into 45 or 70. If you’re expecting a 30-day net term but instead receive payment 15 days late from 10 - 15 percent of your customers, the company may find itself quickly having to renegotiate terms with suppliers and re-evaluate future projects.
Building in an allowance for late payments can help better manage them and avoid the above scenario. How many days late should you expect payments to be and from what percentage of your customer base? A good place to find this answer is to check the averages in your industry.
Along with late payments come no payments. While rarer, some customers will default on their payment arrangement. Some will even go bankrupt. Again, building in an allowance for these rarer events will allow the company to absorb such shocks better.
By allowing clients to pay on credit, you’ve added another cog into the finance machinery. There are now more parts to juggle. Payments are coming in while others are outstanding on net terms. You have to know who is late and if a notice has been sent. Some clients are new and need to be vetted for creditworthiness. Some clients are paying early and should be rewarded with a small discount (per invoice terms).
The way to keep up with all of these moving parts is to define your accounts receivable process well ahead of time. A few important factors to consider are:
- Do all clients get the same net terms or will they vary by client size and creditworthiness?
- Will you offer ranges of net terms (i.e., 30, 60, 90)?
- Will a discount be offered for early payment? If so, how much and does it vary by days paid early?
- How are late payments handled?
- Do we extend more advantageous terms to loyal clients? At what point should this happen?
As you start thinking through how your A/R process will look, the above list will grow. The more items you can add to the list, the more prepared you’ll be when something unexpected happens.
Extending customer credit can certainly work in your favor when done right. Knowing what the challenges are and building contingencies into your process can help ensure your cash flow remains robust and your customers are satisfied.