Businesses that offer a line of credit to their customers create the opportunity for customers to purchase goods and services when they need them while offering greater flexibility on their payment terms. Here are the pros and cons of extending credit, and how to decide when you should extend credit to a customer.
Pros of extending credit to customers
- It strengthens your reputation. Not every company can offer credit to their customers. Extending credit implies your business has enough financial stability to offer this service, which can increase your standing in the business community and attract more customers.
- It creates more sales. For customers who may not have the funds to pay for your goods and services, credit can create more opportunities to make sales now and allow customers to pay you at a later date.
- It increases customer loyalty. The availability of credit tells customers their business is important and appreciated. Customers who opt to make a purchase by using your credit can be flexible with their own cash flow, which creates a relationship based on trust rather than supply and demand.
- It gives you a competitive edge. Not all businesses can offer a line of credit to their customers. If a customer is deciding between your products and a competitor’s products — and your business is the only one offering credit — they will likely choose to go with your business for the benefit of flexibility. The credit line with your business offers a level of attractiveness over your competition.
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Cons of extending credit to customers
- It can negatively affect cash flow. Your immediate cash flow will be affected based on the amount of credit you offer to customers. If this isn’t a top priority for your business, you could limit your business’s growth and hinder your own financial obligations.
- It might lead to unpaid or overdue invoices. Any customers who end up being unable to pay what they owe could cost your business additional fees for hiring a lawyer or collection agency to collect the money for you. It defeats the purpose of offering credit to customers in the first place if you find yourself in a situation with multiple invoices in collections.
- It necessitates accounts receivable management resources. Your business might need extra resources to handle the work that comes with extending credit. You may find it necessary to hire another employee to handle accounts receivable matters, or you will have to take the time to find additional tools and processes to keep up with collecting invoices. Unpaid invoices will require emails, phone calls, and even letters by mail to address the lack of payment.
[Read more: Accounts Receivable: How to Improve Your Chances of Getting Paid]
Not every company can offer credit to their customers.
When (and how) to extend credit to a customer
Here are a few key steps to follow if you’re considering extending credit to some or all of your customers.
Determine your financial risk
Consider the cash flow interruptions your company can handle if you don’t get paid for your goods or services right away, as well as the potential financial risk if a customer is unable to pay their tab. The risk level can be set by utilizing the daily sales outstanding calculation to determine the health of your accounts receivable.
Develop a thorough credit policy
To gain more trust in your customers’ ability to pay back their line of credit with your business, you’ll want to consider factors like banking references and credit check authorizations for each customer. Drafting an agreement with clear terms and conditions for receiving credit will help set the right expectations with your customers and provide some legal protection for your business if a customer defaults on their debt.
Assess credit worthiness of customers
Before extending a credit line, invest in a credit agency that will allow you to pull credit reports on your customers to determine if extending a line of credit is a good idea right now. The reports will help vet customers properly and determine if they have the ability and willingness to repay debts.
Customize terms for each customer
You can offer a customer with good credit longer payment terms than those customers who have historically missed payments and have lower credit scores. Although the standard is to offer 30-day payment terms, customers with good histories could be offered 60- or 90-day terms if your business can afford it.
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