All businesses have trading relationships with both suppliers and customers. Suppliers who extend credit to your business by letting you pay for goods or services after you receive them are your creditors. Customers who owe you money for goods or services that you have supplied are your debtors.
The balance between when you need to pay your creditors and when you receive payment from your debtors has a major effect on the cash flow of your business. Getting the balance right is important in determining what cash will be available to your business in the short term, and for identifying the cash, or working capital, needs of your business as it grows.
Managing credit and debt is vitally important to the smooth and effective operation of your business and may even make the difference between your business surviving or failing.
Looking ahead and keeping records of how much you owe, how much you are owed, and when payments are due to be made or received, allows you to forecast your cash flow over several months and ensures that you will have enough money in the bank for regular business payments, such as salaries, rent, and other overhead payments. This can be particularly important if your business is seasonal or if you must pay suppliers several months before your customers pay you.
When the value of what you owe creditors equals the value of what debtors owe you, there is no effect on the working capital needs of your business, assuming payment terms are the same. But if the value of what debtors owe increases relative to the value of credit extended, as often happens when businesses grow, then your need for working capital will increase. If you are able to increase the value of your credit while maintaining the value of your debt, then you can reduce the working capital needed by your business.
There are no firm rules for credit terms, but there are widely accepted common practices. Normally the credit period is based on either the date of the invoice or the month of the invoice. The most typical credit term based on the date of invoice is 30 days—that is, the invoice is due for payment 30 days after the date on the invoice. If you are sending several invoices to a customer in any one month, it is customary to use net monthly terms. This means that all invoices for a particular month are grouped and paid together at the end of the following month. Using net monthly terms greatly simplifies the process for both your business and your customer.
For many businesses, the amount owed by their debtors is the largest single element of their balance sheet. If your business is trading in a business-to-business environment, you may wish to use the services of a third-party finance company, which will make money available to you based on the security of your debtor balances. This service is called factoring or accounts receivable financing, and it can range from providing financing against your debtor list to a full sales ledger and credit control service. Usually, the finance company will pay the business up to 80 percent of the value of an invoice, with the remaining balance due either at an agreed maturity date or when your customer pays the finance company. This type of service is especially useful for fast-growing businesses with a shortage of working capital.
Creditor financing means "borrowing" money from your creditors to meet your working capital needs. Typically, creditor financing is used by retail businesses that sell products or services for cash but buy on credit from suppliers.
Trade suppliers aren't your business's only short-term creditors. This group includes anyone to whom you owe money in the short term—not only trade suppliers but also the IRS, for example, if you are an employer.
How you manage payments to your creditors is important to a successful long-term relationship. In dealing with creditors, make sure that you are:
- professional in your handling of their account, abiding by the agreed credit terms and not wasting creditors' time with poor administration
- honest whenever cash-flow problems make your business unable to meet payment terms
- straightforward in your commercial negotiations. If you ask for better terms, make sure you can demonstrate that your business has grown and that you have a history of good credit.
If you have difficult obtaining credit from suppliers, you can use a credit card to pay for goods. The supplier is paid immediately, and you have some time before your credit card payment is due. Be aware that if you use a credit card, you may end up repaying at a relatively high interest rate.
Providing credit may be an important service to your customers, but it is imperative to set up effective credit control procedures under which you:
- require customers to complete an account application form, giving details about their business as well as credit references
- supply customers with your standard terms and conditions of sale in writing, especially their credit limit and the payment terms
- keep records of quotations and delivery notes, so you can quickly resolve any disputes about what is owed
- set up an efficient accounts administration system, so you can send invoices promptly and follow up with regular reminders
- monitor customers' payments, and when they fall behind, speak to the person who places the orders as well as the company's finance department. If payment is not made, halt supplies and take further action to collect the debt if necessary. Consider withdrawing credit facilities if a customer is a persistently poor payer.
- maintain a debtors list, preferably in balance order, so that you can easily review how much each business owes to you, and how old their debt is. Concentrate your efforts on those customers with the oldest and largest debts to ensure that your time is used most cost effectively.
If your business regularly struggles to pay its creditors because of slow payment from your debtors, this tells you that your business does not have sufficient working capital. Instead of focusing your efforts in obtaining more credit, put more effort into managing your relationship with debtors more effectively, for example, reducing the credit period that you offer.
Scott, David L.
Business Products Credit Association: www.bpca.org
National Association of Credit Management: www.nacm.org
U.S. Small Business Administration: www.sba.gov