Most companies sell on credit without charging a fee for the service, and this gives rise to “accounts receivable,” the asset account in the balance sheet representing the total of all outstanding credit sales.Normally, a company will extend credit to a customer only if it believes that will increase its sales and profits. No business will want to extend credit to someone unable to pay back what he owes, since the grant of credit involves administration and collection costs, cost of funds tied up in accounts receivable, and finally defaults. However, the reality is that there is always a possibility that one or some of your customers may never pay you back.
How do you avoid bad debts or minimize your losses from them?
• Set credit standards and limits
Decide on the credit worthiness of your prospective customers. Know their paying ability, credit record, and the maximum credit you are willing to provide them. Obtain reports from a credit agency if necessary. For old customers, the most obvious source of information is past behavior.
• Define your credit terms
Specify the length of time you are willing to extend credit to your customers; the size of the cash discount, if any, that you will be offering for early credit payment; and the time within which customers must avail themselves of the discount or lose it. The usual format of the credit term is the cash discount followed by the discount period, then followed by the normal credit period. For example, if your company offers customers 2 percent cash discount if they pay within 10 days—otherwise they pay in full within 30 days—then the credit term is 2/10, net 30.
Early payment is attractive to customers because it helps them to avoid the higher cost of paying the net or full amount at the end of the credit period. Offering discounts can also be attractive to you, the seller, because discounts help to lower your cost of funds tied up in accounts receivable.
The type of credit terms you offer partially depends on the industry you belong. Each industry has its own standards on providing credit, but you may help boost sales by setting a different credit period, discount rate, or discount period from the norm. However, expect your competitors to react to it.
You must define your credit period as a fixed number of days after the date of order, invoice or shipment. Avoid tacking your credit period to events over which you have no control, such as the date your invoice is received or the time your goods arrive in their destination. In other words, spell out your due date clearly. If it’s the 29th of the month, then it’s the 29th of the month.
• Know how to invoice
Ensure all information (terms of payment, due date, etc.) is available and accurate before you invoice. You must start invoicing as soon as you can so it will reach your customer quickly. Customers don’t pay without the invoice.