Banks are experts in lending; your company isn’t. I know that sounds really simple but the fact is that companies like yours lend the use of your “money” to their customers all the time by allowing them to purchase goods or services on credit. The reason is simple: in the short term, your customer can buy from you on credit, use that product to make money and then repay that money back to you.

At least that’s how it’s supposed to work. Unfortunately, due to their banks restricting access to cash, your customers might now buy your product on credit, get paid and then use that money for something else rather than paying you. Now you’re a banker, because that’s what a bank does. The only difference is that the bank has complete financial information on your customer and secures their assets before loaning out money. You, most likely, are just looking at other creditors’ actions and matching everyone else’s offers. 

Often when customers “borrow” from you, you think you’re helping by providing them all this free credit. You’re trying to help the customer, but you’re putting your own cashflow in jeopardy because you go into the deal not understanding the risk and then end up borrowing the money to finance your customers: some of whom will never be able to repay you.

What should you do if you’re caught in this dangerous cycle? Increasing your due diligence in extending credit is the most obvious solution.  Another is to stop shipping to those who are significantly past due (twice terms or more). Even if you don’t do the due diligence up front, you can insist that they have to pay you on time now. This is the model the utilities companies use. They’ll let you use their utilities for a month or two, but then if you don’t pay, they’ll shut you off.

If you want to do more, alter your sales commission structure so that it pays Sales when the money comes in, not when the sale is made. Another strategy is to service charge customers for past due balances.

You need to understand that extending free, uninterrupted credit is not actually helping some of your customers. Trade credit is not a substitute for bank credit. You are taking all the risk without enough reward. There’s a reason why you aren’t in the banking business; you’re in the trade credit business.  

Many mid-sized businesses can name their top ten customers by sales volume but have no simple way to determine their top ten biggest credit risks. If you’re in one of these companies, you may feel it’s inevitable that you’ll have to write off a certain percentage of sales as bad debt. Mind if I shock you by saying it’s possible to create a credit department that has no write-offs? It is.

We have a client whose gross margins are about 2%; they are in a high risk industry and they invited us in to design a credit system with zero tolerance for write-offs. One bad credit decision could wipe out their year’s profit. Your business probably doesn’t need to be that strict, but I want to emphasize that it is possible to have very low or zero bad debt in your company. Most companies I talk to don’t understand that they could get to zero if they wanted to.

How do you do this? Start by having every company that buys from you formally apply for credit. Smaller companies and those growing quickly tend to allow anyone to order from them without even asking what the legal name of the entity is. Often we only find this out by looking at the checks where the legal name must appear. If a lot of your business is not done on contract, you need to have the customer sign YOUR contract, your credit application, to at least put them through a process that collects basic information about their company. Essentially you want them to apply for credit terms, though you may not describe it that way.

You don’t have to tell your customers, “We want you to apply for credit.” Often we describe the credit application form we use to collect information as a “customer profile.” For both new and existing customers, it’s easy to say, “Could you please fill this out so we can get you set up in our system?” or “We’re updating our files for 2010 and we’d like you fill out this profile to make sure we’re up to date.”

Once you have this information, it’s your credit department’s job to analyze the risk and recommend how much you should take. By knowing the amount of risk your customers represent, you can make stronger choices. For high risk customers, don’t give them the best deals and pricing, and consider not shipping to them when they become past due. You don’t need to refuse to sell to high-risk customers, but you can ask them to pay cash, use a credit card, partial down payment, or a Letter of Credit for security.

As in the example I mentioned at the start, you need to realize that the lower the margin, the more due diligence you need before you extend credit to a customer. You may want to segment your customer list and take more risks only where the margins are higher (perhaps on services, which tend to be higher margin than products).

How did our client reduce their risk to zero? All of their customers sign a credit application and they have very short terms. They don’t allow any account to buy on credit without verifying bank balances, and they call all customers when invoices age just a few days past terms. Your business probably doesn’t need to be this strict, but by having current information from all your customers, you can make wise decisions about how much credit you can afford to extend to them.