It’s a given – extending credit to customers will result in a sales increase. Marketing a creative payment strategy in your credit plan may result in a competitive advantage. But will the increase in sales achieved through your credit plan result in increased profits? It should. The objective of credit management must be to increase profits by minimizing losses (bad debt) without adversely affecting the volume of sales.
Accounts receivable is probably the largest single asset on your balance sheet. Turning it into a profit center requires a carefully planned and managed credit system.
• The collection of accounts receivable becomes a disruptive force in day-to-day business operations.
• The costs associated with collections directly decreases profitability. (This includes often overlooked “hidden” costs such as increased labor required to contact/collect and track past due accounts, the cost of additional working capital as a result of decreased cash flow, the cost of mailings, collection services expense, the accounting costs associated with compiling and writing off bad debt, etc.)
• Bad debt directly decreases profitability. Uncollected accounts receivable results in a loss that is never recovered.
The bottom line: Failing to effectively manage accounts receivable can dramatically and negatively impact bottom line profitability.
The inability of a business to utilize its money (“working capital”) results in the business being held hostage by its own poor accounts receivable policy and procedures. In reality, a company devaluates itself when it does not control accounts receivable effectively.
The Options of Change – In-House or a Third-Party Lender
Management has the option of changing the company’s accounts receivable into a producing asset rather than watching it slowly evolve into a liability to business operations. By implementing a credit program that maintains stringent criteria, accounts receivable becomes a term-payment plan (with interest), rather than a debt owed. In essence, the company changes from a nonprofit, interest-free lending institution to a “for profit” financial loan institution.
In-house Credit Program
Electing an in-house approach mandates properly managing the credit plan with established policies and procedures, thereby reducing non-captured costs from the original sale (caused by accounts receivables being extended). Failure to effectively manage accounts receivable incrementally decreases profits by the additional cost to collect the money due.
Briefly, an in-house balanced, profitable credit plan must include a review of the potential credit customer’s credit report and credit references (to evaluate credit risk); develop a credit policy that will stimulate sales, but not increase losses; create “in- house” credit accounts tracked by accountable personnel; and implement an aggressive, yet professional, diligent collections process. A well managed credit plan will not have an adverse effect on profits. On the contrary, its cost-effective procedures will actually boost profits.
There are numerous industry-specific accounting software systems that offer a credit and collections module to assist in the logistical part of the credit-collection process. It is highly recommended that any company considering an in-house credit program incorporate this type of software as part of their approval-monitoring-collection efforts.
Third-Party Lender Program
In addition to the local lending sources available to companies, certain leading industry financing sources exist, such as GE Commercial Finance. The advantage in using a nationally recognized financing source comes from their understanding of industry business cycles, the specialized programs they offer (such as asset-based revolving credit facilities and inventory financing), and their structured floor plan programs.
The company effectively becomes the agent or introducing party of these third-party lenders to its customers. The less participation in the process by the company, the less likely the company will share in any interest income earned by the lender.
The negative to using a third-party lender is that fewer of the company’s customers will probably qualify for financing.
Warning: Any customer declined by a third-party lender should be more closely scrutinized by the company as it relates to activity in their open account. These accounts should be flagged as representing a potentially higher credit risk and managed accordingly.
The Advantages of Change
The advantages to any company electing to implement either an in-house lending program or a third-party lending program include:
• Increased customer purchasing power = additional sales. Most small business customers are cash poor and cannot carry the levels of inventory they desire, or at least the minimum required levels.
• Reduced inventory requirements by incorporating business customers in satisfying local market demands.
• Accelerated sales cycle by encouraging preseason customer stocking activity.
• Increased potential market share.
• Aid in building new (and enhances existing) customer relationships.
• Increased incremental sales.
• Reduced conversion cycle from inventory to accounts receivable to receipt of cash payment.
• Increased income and profits from managed credit plan financing.
• Reduced potential of a “forced after-the-fact” financing of sales.
• Avoided credit risk from extending open account terms.
• Realized predictable cash flow on all pre-approved orders.
• Increased operating efficiencies by reducing the number of orders and shipments (but increasing the size of each), reducing counter traffic and the number of pickups, and reducing the number of invoices required to be processed.
Credit as a Positive Force in Stabilizing and Growing the Business
A credit strategy is used to increase customer traffic as well as establish a major competitive advantage over other companies that are not inclined to profit from this approach. Providing credit is, in and of itself, a powerful marketing tool to attract customers. This says to the cash distressed business customer who needs inventory, “As your vendor, I care about your needs, and I am willing to work with you.”
Trust can be built and goodwill generated with these cash distressed business customers. Companies utilizing a credit plan would be positioned to develop profitable long-term relationships with them. Satisfied customers are the best possible type of advertisement, as well as an investment in a company’s future. They are also the key to capturing an ever increasing market share. Building a customer base in this way will result in greater stability since customers typically select a vendor with whom they have credit established when contemplating future purchases. Remember: Two key goals of a balanced, profitable credit plan are to increase customer stability and grow the business.
As more credit business customers make recurring cash payments with interest, a constant, planned and predictable flow of cash will emerge, replacing the old irregular pattern previously experienced from “cash only” customers and poorly controlled accounts receivable. This cash flow stability is a direct result of a balanced, profitable credit plan. The stable influx of cash will enable the company to make informed and intelligent business plans for the future. In other words, this will allow the company to manage the business instead of juggle bills.
Another benefit of establishing a credit plan is the reduction of the company’s bad debt. Good credit customers tend to pay their bills in a timely manner when their purchases are spread over many payments. Planned payments benefit both the company and its customers. They will allow the business customer to maintain the inventory necessary to ensure their cash flow, so they can make the necessary payments to their vendors.
Credit management is directly related to operations, quality, sales and accounting. Many times, internal policies and procedures in these manageable areas are directly or indirectly responsible for providing customers excuses for slow paying or not paying. Lack of accountability, poor quality, poor workmanship, lost paperwork, no follow-up, and/or no follow-through will lead to a decrease in sales and a decline in profits. A balanced, profitable credit plan will be a driving force in upgrading general policies and procedures in operations, quality, sales, and accounting. Internal policies will be forced to change in order to meet the demands of the credit plan and the needs of credit-based customers. Upgrading these policies and procedures will have an overall positive effect on the company. Ultimately, a credit plan (along with changes in operating policies and procedures) will minimize risk and stabilizing the business financially.
Your choice …
Failing to effectively manage accounts receivable can have a dramatic, negative impact on bottom line profitability.
By designing and managing a balanced, profitable credit plan (including an evaluation of customer credit risk, creating a credit policy that will stimulate sales, charging interest on payment plans, and diligent collections practices), both sales and profits will increase.
Formalizing a credit plan and managing it, will produce increased sales, customer base growth, decrease or eliminate losses, increase profits, and have a stabilizing effect on cash flow as well as overall operations. Credit, collections and accounts receivable add to the profitability of a company when properly managed.
By instituting and effectively managing credit plans it is possible to turn historically negative segments of the business into profitable areas and ensure success in the marketplace; or don’t, and succumb to the pitfall of being one of the many companies who inevitably extend credit whether they intend to or not … your choice.
© 2004 Kenneth Sweet - Kenneth Sweet, JD, is the Executive Director of Management and Tax Consulting at the largest privately-held business development company for small to medium size business in North America, and a leading authority on small business.
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