Quality checking your customers

                                                                                                                                                       14.10.2011


Selecting the right type of customer is crucial to ensure small business survival. Conducting routine credit checks on your customers before entering into a trade credit agreement is one of the best preemptive cash flow management strategies.

In many industries, the question isn't whether you will grant trade credit to your customers, it is how you will go about doing it. This is especially true if your business is new or if it deals with large customers, in which case granting credit is unavoidable.

This means it's critical that you establish sound policies and procedures for checking the credit quality of customers before granting them payment terms. Otherwise you could end up spending inordinate amounts of time and money chasing after accounts receivable that are 30, 60, or 90 or more days past due. In many cases you won't get paid at all.

Depending on the size of the invoice, nonpayment can be devastating to a small business. It can wipe out your profit margins and may even drive you into bankruptcy. But nonpayment is not the only risk of granting credit without conducting a thorough credit check. Payment delays can also prove costly by disrupting your cash flow.

The typical small business lives and dies by its cash flow cycle, which is the lag between the time you spend cash to buy materials, equipment, and inventory and pay employees and the time when you collect and deposit accounts receivable from customers. Late-paying customers can have a disruptive and potentially devastating impact on this cycle.

For example, let's assume you've granted one of your larger customers a net-30-day payment terms. After a few months you realise that the customer has been paying in closer to 60 days and their outstanding receivables balance is closer to $20,000 than the $10,000 in trade credit you agreed to. As a result, your company's working capital comes up short at the end of the month and you are forced to tap a bank line of credit for $5,000 to meet expenses.

But what if you can't access a line of credit? Maybe you can get a cash advance from a business credit card or sell some of your outstanding accounts receivable to a finance company or factor. But these options tend to be expensive, and they don't solve the core problem: getting late-paying and uncreditworthy customers to pay their invoices on time.
You can avoid falling into this trap by drafting a formal credit policy that details specific procedures to be followed before you'll grant trade credit and payment terms to a customer. In drafting your credit policy, pay especially close attention to the ebbs and flows of your cash flow cycle to ensure that you will always have enough cash on hand to meet your monthly expenses.

Start by measuring your day's sales outstanding, or DSO. It will tell you how long it is currently taking you to collect your accounts receivable. Next create an accounts receivable aging report so you can see the payment status of each customer (current, within 30 days, within 60 days, etc.) and the amounts due.

Based on this data, you can draft a credit policy that grants payment terms in such a way that ensures your cash flow remains consistent throughout the month -- and you don't run out of capital when you need it most.

Don Sadler  allbusiness.com

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