Many small businesses extend credit to their customers as a matter of course without evaluating the cost and consequences of doing so. In most cases you will want to continue selling to your customers on credit but you should understand what it costs you, take reasonable steps to reduce this expense, and consider some alternatives.
The costs of extending credit fall into three broad categories: administrative, financing and risk.
Administrative costs include labor and direct expenses (such as paper and postage) associated with billing your customers, collecting past due invoices and processing payments. A Fidesic Corporation study found that the cost of paper billing and processing checks received for payments was $8.44 per invoice for smaller companies – approximately 90% of this cost was labor. If you issue a lot of small invoices this cost could significantly erode your margin.
You can potentially reduce administrative costs through technology. First and foremost, you should use a business software system to create invoices – don’t generate them manually. You may have an industry-specific application that can produce invoices and every small business accounting software package (QuickBooks, Peachtree, etc.) has this capability. Another way technology can help is by sending invoices and accepting payment electronically. This could be as simple as emailing your invoice as a PDF file which eliminates printing and postage costs. Alternatively, you could use a web application to present invoices and accept payments the way many utility companies do.
The size of your accounts receivable balance drives the size of your financing costs. There are interest costs if you have to borrow to get the operating cash represented by these receivables. If you have a bank line of credit this could be at a rate of 6% APR — or more. If you have available cash there is the opportunity cost associated with the funds tied up in receivables – how could you have invested that capital to grow the business?
You can reduce financing costs by being more effective in collecting your outstanding invoices and how you handle your Accounts Receivable Management. Reduce Days Sales Outstanding (DSO) and your financing cost comes down. When applicable, collection automation software like Lockstep Collect can reduce administrative effort and reduce outstanding receivables by 10-20%, producing additional savings. Also, don’t forget to bill promptly and accurately. Companies that issue invoices monthly can be extending their DSO by 10-15 days since the clock doesn’t start on payment until a customer has received their invoice.
Also consider the cost of credit by customer. A customer that typically pays in 30 days costs you less than one that pays in 90 days. Take this into account when evaluating pricing discounts and planning collection activity.
There is always a risk that an invoice will never be paid and must be written off but with proper Accounts Receivable Management you can reduce this risk. According to CreditPulse, the average Bad Debt Allowance is about 4% of credit sales but it varies greatly depending on industry ranging from about 1% for oil & gas to over 8% for service businesses. Some people also include unauthorized deductions as part of this cost element – for example, that freight charge your customer deducted but you had to pay goes straight to your bottom line.
You can reduce risk by doing a better review of applications for credit from new customers and monitoring customer payment trends and other developments over time for existing ones. Further, you need to evaluate whether deductions are warranted and if not – bill them back. Finally, engage outside collection agencies sooner. You will give up a substantial percentage of the value of an invoice – if it’s collected — but 50% of something is better than 100% of nothing.