Developing a Credit Policy

Five Factors to Consider when Deciding Whether or Not to Extend Credit

Customer paying barista with credit card in cafe
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Developing a credit policy is something a business eventually has to face. One of the basic decisions you have to make when starting a business is whether or not you are going to extend credit to other businesses and consumers. This is a decision to be taken very seriously as it will impact your cash flow and even your profit.

Here are six factors that you should consider when developing a credit policy and that should influence your decision whether or not to extend credit to customers.

You should grant credit only if the positives of doing so outweigh the negatives. Often, this is difficult to determine.

  1. The Effect on Sales Revenue

    The reason you would grant credit in the first place is so your customers can delay paying you. This is convenient for your customers and will probably win customers for you, but it is not so convenient for you and your bottom line, at least on an immediate basis. Sales revenue from the sale you made to your customer will be delayed for either the discount period or the credit period, or perhaps longer if the customer is late in making the payment. The upside is that you may be able to raise your prices if you offer credit.

    You have a trade-off. The possibility of more customers and higher sales prices if you offer credit in exchange for possible delayed and late payments. Unfortunately, it's hard to quantify this.

  2. The Effect on Cost of Goods Sold

    Whether you sell products or services you have to have them available and, in the case of products, in stock, when a sale is made. When you extend credit, that means paying for that product or service in order to have it in stock but not getting paid for it immediately when it is purchased. Even though you will eventually get paid, your business has to have enough cash flow to compensate for the delayed payment. In addition, you lose any interest income you might have earned on that money.

    Again, you have a trade-off. This time it is more customers and higher sale prices in exchange for lost interest income and temporarily lower cash flow.

  1. The Probability of Bad Debts

    If a company makes all its sales for cash, there is no possibility of bad debts or debts it cannot collect. If any percentage of the company's sales are on credit, there exists the possibility of bad debts or debts you, as a business owner, will never collect. When you are developing your credit policy, you should allow for some percentage of your credit accounts that will never be paid.

    The trade-off here is that some percentage of your credit sales will never be paid. You have to decide if this factor is worth more customers and higher sales prices.

  1. Offering a Cash Discount

    Particularly when you offer credit on a business-to-business (B2B) basis, most companies offer other businesses a cash discount. In other words, if the business pays the bill within the discount period, that business gets a discount. If they don't pay within the discount period, then they must pay within the credit period or the original period within which the bill is due.

    Cash discounts are often stated like this example: 2/10, net 30. If those are your credit terms, it means that you offer a 2% discount if the bill is paid in 10 days. If you don't take the discount, the bill is due within the 30 day credit period.

    Is getting your money in 10 days worth the 2% discount that you offer? That's the trade-off you have regarding cash discounts and whether you should offer them.

  2. Taking on Debt

    If you, as a business owner, decide to offer credit to your customers, chances are you will have to take on debt to finance your accounts receivables. As a small business, you may not be able to afford to sell your products or services without immediate payment unless you have a good working capital base. If you have to take on debt, you have to factor in the cost of short-term borrowing as part of your decision to offer credit.

    Offering credit to your customers is a big decision with wide-reaching effects for your company. You have to consider the factors above and more. Will offering credit result in repeat business? Do you have the time and resources to collect late payments? Make this decision wisely.