Extending Credit

Given that this nation was founded on debt, and that debt has recently become a national way of life, it is no surprise that extending credit to customers is a fact of small business life. It thus becomes very important to decide who will get credit from your business and who will not. This page focuses on how to approach the problem of extending credit to other businesses. There are some additional pages concerning the Equal Credit Opportunity Act (a law which your business will probably have to comply with)

First of all, you need to get the following information from a business seeking credit.

1. Business/applicant's name
2. Type of entity (i.e., partnership, sole proprietorship, S-corp, etc.)
3. Address of business and length of time at that address, former addresses and length of time at those addresses.
4. Phone number of business.
5. First, middle and last name of owner(s) and/or officers of the business.
6. Banks where business accounts are kept, including phone number and address.
7. Credit references (can be other businesses offering applicant credit, business credit cards, personal credit cards, banks, or any other credit-offering institution which will vouch for the business or its owners).
8. Applicant's accountant. If there is no accountant, this should make you a little wary--it indicates that either the business cannot afford one or that they do not want one.

Since most of the businesses you deal with will probably be operated by the owners of that business, you should obtain the following information about the owner.

1. Owner's name.
2. Owner's address and length of time at that address, former addresses and length of time at those addresses.
3. Balance sheets describing the owner's net worth.
4. Phone number of owners.
5. Banks where personal bank accounts are kept, including phone number and address.
6. Credit references (i.e., personal credit cards, banks, etc.).
7. Employers (both current and former), along with the employer's address and the length of time employed.
8. Marital status, along with the name and address of spouse's employer.
9. Monthly household income (total).

All of this information, once collected, will form the basis for your investigation of the applicant and your analysis of whether to offer credit. You need to verify the accuracy of the information given by the applicant. This can be done in a number of ways. There are firms specializing in collecting information on the credit ratings of businesses, Dunn & Bradstreet is one of the better known ones. Other businesses which have dealt with the applicant-business in the past, particularly other suppliers, is another good source of information. And for overseas businesses, the United States Department of Commerce can help obtain credit information on the applicant-business. Also, if the business is one where the owner(s) actually operates the business (as will be the case in most small businesses), then you can check into the credit history of the owner(s) with a credit bureau such as Trans Union, Experian, or Equifax.

After you have determined that all of the information given by the business-applicant is true, now comes the business judgment time. (Note that if some of the information was not true, you probably need to decline credit.) You need to look at the business opportunity offered by extending credit and measure it against the risk that you will not get paid in the future. Arguing for offering credit will be the possibility of repeat business, increased sales, etc. But do not mistake an increase in sales for an increase in profits, so be judicious in offering credit and only take risks on people and businesses where you believe that the reward justifies the risk. It is decisions like this that make the difference between successful business people and business failures, so think about it carefully.

Before giving credit: You need to make sure that both you and the other side are perfectly clear on the terms of the deal. And then put it in writing! The credit terms can be fairly simple and, in fact, should be simple. The credit terms can be placed on the invoice for the goods or services provided. There are some standard abbreviations used as kind of a shorthand by businesses offering credit to another. You should use these on your invoices as well as having some short written arrangement detailing the credit terms in plain English. Remember that it is vital for your invoices to be clear, correct and timely. This helps you establish the proper billing time cycle. Any delays or nonpayment due to invoicing error or misunderstanding are probably going to ultimately come out of your pocket!

Obviously, the terms you offer other businesses can have an effect on your sales if other businesses perceive your terms as better or worse than your competitors, so you should know what the standard terms for the industry are. Whether you hew to these standards or not is a business decision you need to make.

Regardless of the terms you offer, you should ask for a portion of the money due up front. This both insures that the buyer is serious and show that the business actually has some money. You may also want to get a credit card number and signed sales slip for the full amount of the order so that if the business fails to pay up by a specified date, you can put the sale receipt through and try to get payment that way.

After credit is given: Once the credit is given to another business, eternal vigilance becomes the price of your solvency. You need to watch your accounts receivable closely. Start by keeping track of your average collection period. Average collection periods are calculated by dividing the total accounts receivable (what people owe you for previous sales) by the average daily credit sales. (Average daily credit sales can be calculated by merely taking your business's total sales on credit and dividing them by 30.) In formular form, it looks like this:

Monthly sales on credit/30 = X

Accounts receivable = Y

Y/X = collection period

Your average collection period needs to be compared against the average for your industry. If you are higher than the industry, it is time to reevaluate who you offer credit to and on what terms. If you are lower than the industry, keep up the good work.

Collecting on bad debt: So people will not pay their bills, huh? Maybe it is time for the brass knuckles and late-night phone calls threatening harm and horror? We would recommend a different, less criminal alternative. First off, have some sort of penalty for debts that are over thirty days past due. Interest charges of 1-2% a month is one common method of doing this. High interest rates help businesses focus getting a check in the mail. Another technique is calling the debtor-business and asking them when you can expect payment. This must be done very diplomatically since they are a customer, after all, and you do not want to alienate a customers who may have just overlooked your bill. (On the other hand, if your customers do pay for your sales/services, you go out of business, so your diplomacy must be a firm diplomacy.)

Telephone calls are even more useful since you may be able to get some information about the business and the likelihood of payment. It is more difficult to blow off a person in conversation as compared to a letter. Note that you are more likely to get somewhere with a debtor if you come across as a creditor who expects full and complete payment, while still understanding any present financial difficulties the debtor may be experiencing. You goal should be, however, to get some sort of payment every time you call. So ask how much they can send, even if it is not the full amount, at least something will be on its way. NEVER AGREE TO ACCEPT A REDUCED AMOUNT IN FULL SATISFACTION OF THE ENTIRE DEBT UNLESS YOU ARE ABSOLUTELY SURE THAT THERE IS NO WAY TO COLLECT THE FULL AMOUNT.

If the letters and phone calls fail, it is time to resort to either a collection agency or the courts. Collection agencies will take a 25-50% cut of any debt collected after they become involved. Courts may be a better idea if the debt is fairly small or the debt is fairly large. If it is small, small claims court may get you a judgment against the debtor without much effort. It the debt amount is large, an attorney may be able to help you get a settlement payment or a judgment against the debtor. If the debt is too large for small claims court, but too small to justify the expense of an attorney, go to the collection agency. You should stay on top of late accounts because as the overdue account ages, the likelihood of payment decreases. Initial collection procedures of sending a polite letter should occur within fifteen days of the debt being overdue, and then every fifteen days thereafter.