Should I set payment terms for my customers?
The short answer is definitely, because non-payment by customers is one of the biggest causes of business failure so you need to set and enforce the payment terms. However, before granting credit you need to consider three things:
1. Is it necessary to provide credit and what are the reasons for granting credit?
Some reasons to grant credit include:
- To increase sales – allows customers to purchase now and not have to wait until they have cash
- To increase profits – a portion of a business’s costs are fixed (rent, salaries, electricity, etc) so by increasing sales you increase profits
- To increase market share – if your sales are growing someone else’s may be declining in which case you are gaining market share from them
- To match what competitors are offering – if you offer a similar product to your competitors, but do not provide goods on credit, your customers may well move to your competitors
In some industries the granting of credit has become a separate source of revenue and an additional value offering to customers. Examples include clothing retailer Edgars, furniture retailers Ellerines and Joshua Doore, and motor vehicle manufacturers BMW, Mercedes and Toyota.
2. How will you decide who can buy goods on credit and who can’t?
Once you have decided to grant credit you then need to establish a credit policy which sets out:
- How you will assess the creditworthiness of the customer – essentially you are assessing the likelihood of the customer repaying you. Criteria to look at include:
- Character – willingness to pay
- Capacity – ability to repay
- Capital – the financial strength or resources of the customer
- Current economic and business conditions
- Credit history of the customer
- Collateral held against non-payment
- The setting of credit limits for different customers
- The credit period
- Interest rate to be charged on overdue accounts
- The procedure to be followed on overdue accounts
- How bad debts will be treated
- What discounts will be offered for early payment
3. What is the cost of providing credit versus the cost of not providing credit?
Like most things in business, there is a cost to providing credit and there is a cost to not providing credit. These costs need to be weighed up against each other.
Costs of granting credit
- Loss of interest if the money had been received at the time of the sale and invested or used to reduce the bank overdraft
- The opportunity cost of not being able to use the cash
- The actual cost of assessing a customer’s creditworthiness, keeping records and collecting debtors.
- Bad debts
- Discounts for early payment.
Costs of not granting credit
- Loss of customer goodwill
- Loss of potential sales to competitors
- Convenience as debtor payments will often be transferred electronically into your bank account so there is less risk from handling cash and no need to take cash to the bank.