The How, When, and Why of Extending Trade Credit

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Trade credit is the largest form of short term business financing. In a sense, it’s peer to peer lending — businesses helping each other. Of course, it’s not all altruistic, without trade credit, many of your customers wouldn’t be able to buy from you.

Yet, as in banking, not all customers should be treated equal. New businesses, those in troubled industries, highly leveraged companies, fast growing ones, and even huge well-known buyers like, say, the State of California, warrant tighter credit terms.

Deciding how, when, and to whom you extend credit, is just one part of an overall credit and accounts receivable management system that should include:

1. A formal credit application complete with:

• The legal name of the business and any dba's
   
• Owners' / officer's names and contact information
   
• Names of those authorized to place orders (and any credit limitations)
   
• Years in business
   
• The industry SIC code
   
• A Federal ID and/or Social Security number
   
• The Business form (C corp, S Corp, limited partnership, general partnership, sole proprietorship, Limited Liability Corporation, individual)
   
• Number of employees
   
• Estimated annual sales
   
• Bank references — including the bank manager's name and phone number
   
• Vendor references — you'll want names, addresses, phone numbers, credit limits, and how long they've been a customer from at least three unrelated entities.
   
• Whether purchase order numbers are required for payment
   
• Signatures of the owners/officers of the company.

The boilerplate of the application should, among other things: set forth your right to check references and order credit reports both initially and on an ongoing basis; spell out the penalties for late payment; lay down the process for dispute resolution; and include the right legalese to make sure it will stand up in court.

If you require a personal guarantee — a good idea with a risky borrower — be sure your application process complies with consumer credit regulations.

2. Credit bureau agency checks

An initial credit report from Dun & Bradstreet or similar business rating organization will allow you to see how much credit others are extending this customer, their payment history, general financial health, banking information, and a wealth of other data. Periodic checks will help you spot any deterioration in their condition or payment habits.

3. Payment terms that match the situation

Once you've collected the information you need, you can customize a credit policy that matches the situation. That includes not only setting the payment terms (i.e. time for payment, late fees, finance charges) but establishing a credit limit and sticking to it.

For the riskiest accounts, consider COD (via cashier's check or money order), escrow payment, letters of credit, direct debit, credit/debit card, Paypal, or some other immediate form of payment.

For less risky customers, it's best to follow the standard for your industry.

If you choose to offer a discount for early payment, make sure it's worth the hit to your profit margin. If you have access to a line of credit, it's usually cheaper to use that than to offer a trade discount. For example, on a $1,000 invoice, a 2% discount for payment 20 days early (e.g. 2% 10, net 30 terms), will cost you $20. If you can borrow at 6%, it would only cost you a little over $3 to finance that receivable for 20 days.

On big projects, or ones where you have significant out-of-pocket costs, consider taking deposits or requiring progress payments.

4. Accounts receivable agings

Someone in your organization should be looking at accounts receivable agings on a weekly basis. The sooner you spot a problem, the more likely you'll be able to keep it from becoming a bigger one.

Other "best practices"

• Invoice immediately on delivery and remind your customers of your payment policies on every invoice.
   
• Enforce late fees.
   
• Be on the alert for fraudulent checks.
   
• Stop selling to customers who owe you money.
   
• Be the squeaky wheel. Business owners aren't terribly logical about who they pay when times get tough. The more aggressively you pursue late payments (within the law), the more likely you are to collect.
   
• You may need to obtain a landlord's waiver to legally reclaim goods from a customer's premises if you need to.
   
• If your customer can't pay in full, set up a payment plan and make sure they stick to it.
   
• If all else fails, consider small claims court, formal legal action, or a collection agency services for bad debt.
   
• Credit and collection laws vary from place to place. Be sure your credit application, finance rates and fees, and other practices comply with local laws and regulations.

Remember income is just a number on a financial statement. It isn't worth a dime until you convert it to cash. Make sure you know what cash flow is and isn't.