This article is part of a larger series on Bookkeeping.
Extending credit to customers allows them to purchase goods and services and pay for them later on. Offering credit is often a win-win for both merchants and buyers and having a formal credit policy is among the most important best practices for managing accounts receivable. Customers have more purchasing power and tend to buy more if they aren’t limited to the cash they have at the time of the sale. Extending credit can benefit your company by establishing trust with your customers and increasing customer loyalty.
To establish an effective credit policy, it’s important to communicate your credit terms clearly and do your due diligence in terms of only lending to credible customers. Invoice factoring might be used in conjunction with customer credit to facilitate cash flow.
Pros & Cons of Extending Credit to Customers
Extending credit to customers can bring you increased sales, a competitive edge, and stronger customer relationships. However, you run the risk of not getting paid. The key is to stay on top of unpaid invoices so they don’t become delinquent.
Factors to Consider When Extending Credit
Every business has customers who are more loyal and trustworthy than others. Fortunately, you can ultimately determine which companies you want to extend credit to. Two factors you should consider before extending credit are customizing the payment terms for each customer and creating a credit policy.
Customize the Payment Terms for Each Customer
If a customer has good credit and has historically paid their bills on time, it’s likely that they’ll pay you on time as well. However, if a customer has poor credit or a past history of delinquency, you may want to investigate further by looking into their financial history. A credit report will cost between $29 and $229, depending on which reporting agency you use. Check out our business credit report guide to learn more about the credit agencies, how to pull a credit report, and what to look for.
After reviewing the credit report, set payment terms based on the information you discover. Traditionally, customers with good credit will receive longer payment terms than customers who have had issues paying their bills on time.
While the industry standard is to offer Net 30 payment terms, you can choose to offer different terms. Your best customers might deserve 60- to 90-day terms while new customers might start out with 30-day terms. Look at our invoice payment terms guide to learn how to select the right terms for your business.
Create a Credit Policy
Before extending credit to customers, you need to have a documented credit policy in place. Your credit policy should address payment terms, penalties, interest for late payments, and the collection process for delinquent invoices.
In addition, a list of acceptable payment methods, along with detailed instructions on how to remit payment, should be included. You should review the policy with your customers and have them acknowledge that they agree to the terms prior to providing products or services on credit.
A credit policy should include:
- Contact information: Include detailed information on how the customer can reach you, which includes your business telephone number, email address, website, and physical address―unless you have a home office
- Payment terms: This is when the payment will be due, such as Net 30 or 2/10 Net 30
- Interest and penalties for late payments: Detail what interest rate or late fees will be charged and when these charges will kick in, such as two weeks after the due date or in one month
- Acceptable forms of payment: Let the customer know if you accept cash, credit or debit cards, checks, automated clearing house (ACH) transactions, or wire transfers; for credit and debit card payments and wire transfers, be sure to include instructions on how customers can make these payments like online or telephone
- Remit to address: Include the mailing address where customers can mail checks
- Delinquent payments: Indicate when a payment is considered delinquent, such as 60 days after the invoice due date
- Collection process: This is the process you’ll follow to collect payment on delinquent accounts, which may involve you requesting payment from the customer via email or telephone and following up by writing a collection letter; it might also include engaging the services of third-party collection agencies.
Use Invoice Factoring to Help With Cash Flow
Extending credit to customers can help your business grow in the long term, but cash flow gets a bit messy when there’s a time lag between purchase and payment. Invoice factoring is one way to plug the gaps in cash flow. It advances your capital right away in exchange for assigning unpaid invoices to the factoring company. It’s a good solution for businesses that want to offer credit to customers but need help in stabilizing their cash flow.
Invoice factoring companies typically advance 70% to 90% of the invoice value upfront. The cost of your capital being tied up in the invoices is often more than the fees charged by the invoice factoring company.
Recourse vs Nonrecourse Factoring
One of the most important conditions to consider when negotiating an invoice factoring arrangement is whether it’s a recourse or nonrecourse factoring arrangement.
- Recourse factoring: This allows the factoring company to seek repayment of its advance if your customer fails to pay its invoice. With this type of arrangement, if the customer fails to pay, you would be responsible for paying the invoice.
- Nonrecourse factoring: The factoring company would be responsible for the invoice if the customer fails to pay it. Most nonrecourse agreements apply if your customer can’t pay due to insolvency, which usually means bankruptcy. Some factors have more flexible definitions of insolvency than others, such as if a customer closes its doors without declaring bankruptcy.
We selected FundThrough as one of the best invoice factoring companies, which is partly due to its quick application and funding process. For more information about FundThrough and our other recommendations, check out our article on the best invoice factoring companies.
For many small businesses, extending credit to customers is essential to business growth. When developing a credit policy, set clear terms, track payment deadlines, and only extend credit to customers you trust. If cash flow is a concern, consider using invoice factoring to support your cash flow when you extend terms to customers.