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. 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.
Good bookkeeping software with the ability to track unpaid invoices and print an accounts receivable (A/R) aging report is critical to addressing unpaid invoices. We recommend QuickBooks Online, our best small business accounting software. Visit QuickBooks Online to learn more about its offerings.
Pros & Cons of Extending Credit to Customers
|Increased sales: Customers tend to purchase more if they don’t have to pay for goods or services upfront. This can result in more profit for your business.||Risk of not getting paid: Minimize the risk by taking the proper steps to check your customer’s credit history, require an upfront deposit, and stay on top of your unpaid invoices.|
|Competitive edge: Customers may choose to do business with you over a competitor that does not extend credit to their customers.||Time investment to track unpaid invoices: Unlike cash sales, you will have to be organized when it comes to managing your A/R.|
|Customer loyalty: Over time, you will build trust with your customers because they know they can rely on you to provide them with the products and services they need without having the cash up front. This can lead to a long-term and profitable relationship in the future.||Delayed payment: Depending on the payment terms, there will be a delay between the time you provide goods and services and when you get paid. To mitigate this, you can go with invoice factoring companies to get the cash you need.|
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. The two factors you should consider before extending credit are customer payment terms and company credit policy.
1. Customer Payment Terms
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.
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.
When designing payment terms, you have to identify the rewards of extending credit to customers. What is your aim? Is it to boost sales, stay ahead of competition, or collect faster? Giving longer credit terms would encourage customers to buy now and pay at a later date. On the contrary, granting a higher cash discount would encourage customers to pay early to enjoy the discount.
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, whereas new customers might start out with 30-day terms. Read our guide on common invoice payment terms to learn how to select the right terms for your business.
2. Company 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 via email or telephone and following up by writing a collection letter; it might also include engaging the services of third-party collection agencies.
Using 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 wanting to offer credit to customers but needing 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.
Frequently Asked Questions (FAQs)
No, these two are different. Extending credit to customers involves allowing them to purchase goods and services that will be paid at a later date. On the other hand, a loan involves money wherein the debtor should repay the money plus interest to the creditor at a later date.
There is no fixed rule on when to extend credit to customers. The decision to extend credit differs from one company to another, and you should weigh your options and assess the risks involved. If you don’t extend credit to customers, you risk your business losing valuable customers who would look for competitors that give generous credit terms. But if you extend credit, you expose yourself to customer defaults.
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.