How To Structure Credit Policies and Procedures In A Small Business

hand-with-money-1435431-mAs you grow your business, one of the things you should consider is having credit policies in place for existing as well as new clients. In this episode of, Bernard Roesch shares some benefits of offering credit to certain clients and some situations you should be aware of to make sure that offering credit doesn’t hurt your business in the long run.

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Benefits Of Offering Credit In Running A Small Business

Interviewer: So, Bernard, before we get into some of the specifics of credit policies, can you explain why it’s an advantage for a small business to actually offer credit to clients?

Bernard: Well, there’s essentially two reasons why you typically would want to offer credit to your clients.

Developing relations with new clients – One is in a situation where you’re developing a new relationship with at client.

  • You have to realize the client may not know everything about you, so you may have to prove yourself in some way.
  • By extending credit terms, you make it easy for the client to agree to do business with you.
  • They have a little bit of a time window to assess the quality of the goods that you ship or the type of service you provide.
  • That enables the client to be comfortable, yes, they’re going to go ahead and do business with you.

If everything goes well, then they’ll be comfortable paying you, as opposed to: they write you a check right away, they don’t really know you and then you’re going to be shipping the goods or producing the services. That’s the first reason.

Cash flow requirements of customers – The second reason is customers themselves might have cash flow requirements.

  • They may be purchasing some goods or services from you, but then, in turn, this will go into a product or a service that they sell.
  • They will need to get paid in order to have the cash to pay you.
  • It’s sort of a chain: if you insist on having payment up front, on a credit card or a pre-payment, it will be harder for your customer or client to do what he wants to do with respect to transacting business, because there will have to cash out before they can actually get cash in from their own customers.
  • So by extending credit, you make it a little bit easier for them to run their own business,
  • Therefore you will be more attractive as compared to other suppliers that may not offer credit.

How To Determine a Balanced Credit Structure

Interviewer: Using the example of extending credit to new customers and new clients, can you give us a specific example of what those credit terms may look like? For example, on an initial project of maybe $5000 that would be completed over a thirty day period;

  • What types of credit structure would you recommend in that case? and
  • What are some limits you should have in place so that everybody wins in the long term?

Give us an example with a $5000 project over 30 days.

Bernard: I think it’s always good to ask your customer to make some kind of payment to demonstrate interest and commitment. In my own particular case, I love to always have a little bit of a payment up front just to demonstrate commitment.

  • Let’s say you want to ask $500, or $200, or a thousand just to get started.
  • Then, at that point, you would want to extend some terms with respect to how quickly you will bid out.
  • Say, once I have a third of the project completed, then I will bill you for that third in that thirty days.
  • Another third, after you’ve done two-thirds of the project, another thirty days.
  • And for the final payment, you would give thirty days, forty-five days from completion just to put the client at ease that, yes, everything will be completed satisfactorily and everything else.

So, you want to bill promptly as appropriate;

  • But you want to give a little bit of flexibility to the customer or client to make sure they are comfortable, now that they’re going to be parting with their money that you’ve delivered everything that they wanted.
  • At that point, you want to collect, when you’ve demonstrated that you’ve done the job, you’ve shipped the goods.
  • At that point, the money is due to you.

Interviewer: So you mentioned getting a certain percentage up front. In your experience working with different businesses and also working with a wide range of vendors;

  • What percentage seems to be a reasonable percent to ask for up front for both sides of the deal, basically for the client and also for the vendor?
  • What is a good percentage to ask for up front on the same example, the $5000 project?

Bernard: Well, it depends on the type of business and transaction, but it has to be something, to me, that is

  • Substantial enough so that it demonstrates commitment on the part of the customer or client that is purchasing what you’re selling,
  • But it can’t be so much that it now becomes unbalanced. Now you have all the money on your side and no incentive to complete and deliver what you have.

Take, as an example, the contractor that is going to refurbish your basement.

  • The contractor is going to ask for some money up front just so that they know that you’re serious about doing the basement.
  • But if they’re asking to be paid 100% of the work upfront, then you’re going to say “wait a minute, why should I do that?” Unless it’s a very competitive situation.
  • You want to keep the money flow balanced so that it’s reasonable both on the supplier and on the customer’s part.

Interviewer: I think that definitely makes sense.

Potential Problems With Extending Credit

Interviewer: Let’s turn the tables a little bit and talk about potential problems that can come up when you start to extend credit to clients.

  • What’s an example of a disaster or a really difficult situation that can happen if you’re not careful with how you actually structure the credit policies that you have in place in your business?

Bernard: What I see at times that turn into disasters is what I call the incremental situation, where;

  • You do a portion of the job and you start billing.
  • Your customer does not pay you right away.
  • Then you say you’re going to continue and do the work and
  • Because of one thing leading to another, you’re not able to assess your overall exposure in terms of total amount owed.
  • At some point, you’re going to have an outstanding amount much larger than you can afford to lose.
  • That’s where you get into a disastrous situation.

So sometimes it’s not necessarily the terms or how late the customer is, but really, what is the total exposure you have with that particular customer.

  • That exposure might be too large if the amount that you have outstanding is more than you can lose or if the cost doesn’t justify the amount outstanding.
  • For instance, if I’m selling services and it’s just my time, there’s no real substantial out of pocket cost, maybe I can be aggressive in terms of how much I can have outstanding.
  • But if I’m selling hard goods, let’s say I’m selling computers and my cost margin is only ten percent, then I have to be much, much more careful as to how much credit I would extend to my customers, because I’m paying my suppliers, I’m paying hard cash for the service or the goods I’m delivering.
  • Therefore, if I was going to lose that money, I’d hurt much more than if it’s more of a soft cost that goes into the service or product.

Things To Consider When Making Changes in Your Credit Policy

Interviewer: So let’s talk through if you need to actually make changes to an existing credit policy that you have in place with a client, what are some of your options there to make sure that you don’t alienate the client in trying to change the terms after the deal has been kicked off?

Let’s assume that this is a construction-related deal like you talked about earlier. Share with us basically;

  • What you can do if there are some unforeseen circumstances that come up that force you to need to change that credit policy.
  • How should you go about doing that with a client?
  • What do you need to explain to them?
  • What are some of the options that you should consider at that point to change those in an amicable way?

Bernard: Well, the main thing, as you said, is amicable.

  • You want to preserve that relationship with your client and you want to explain to the client or the customer why you’re changing your credit terms or your credit policies.
  • You can explain that you have higher costs or that you’re incurring certain unexpected changes in the job.
  • I think that if you can explain why you’re doing certain things, the rationale for it, if the client can accommodate you, the client may very well be able to accommodate you.

Interviewer: Perfect. I think this has been really helpful on a topic that I think a lot of business owners don’t necessarily think deep enough into.

Summary And Next Actions

Interviewer: So, to summarize what you’ve shared today;

Offering credit can be an advantage – The first thing is that offering credit can be an advantage to you as a business.

  • New clients and new customers are going to be more incentivized to try your services, since they haven’t worked with you before, But you’re being reasonable with them to basically ask a small percentage up front and be paid along the way, rather than asking to be paid everything up front.
  • On the flip side of that, you mentioned that existing clients and customers may have cash flow needs of their own that require you to provide them with some sort of credit.
  • For example, if they’re using your products in products that they manufacture, then that credit policy is going to help them basically have realistic cash flow on their end, which I know we’ve talked about in other episodes.
  • An example you talked about is doing a small percentage up front to kick off a project, then doing milestone payments with net 30 terms, which means the payment would be due 30 days after it’s actually invoiced.

That’s definitely a pretty traditional way to structure credit terms and something that will help you basically have a clear process in place with your clients.

Structure credit policies carefully – The last thing that you mentioned, which I think is really important, is to structure these things carefully.

  • If you’re doing milestone based payments, you mentioned that it’s very important to be careful and limit your exposure, especially if the client or customer starts missing or delaying certain milestone based payments.
  • You want to be careful that the incremental work that you’re doing doesn’t put you in a position where you’re overexposed, especially if that client ends up not being able to pay at the end of the day.
  • And you also mentioned that, if changes are needed, explain it to the client and just explain the situation that’s going on and what you would propose.

That’s definitely a reasonable way to change credit policies or change the deal if it needs to be changed.

For more information, visit Bernard has a lot of resources on the site of how to structure your business from a financial perspective and also how to operate your business so that you’re making the right financial decisions to grow your business.

Thank you so much for your time today, Bernard.

Bernard: You’re welcome.


Bernard Roesch About Bernard Roesch

Bernard Roesch is co-founder and Managing Partner of Mission Consulting. Bernard’s background in the early years of his career was spent in the manufacturing sector, making his QuickBooks perspective a unique one – he understands the intricacies of a complex environment and then applies his strategic skills accordingly.