A Small Business Owner’s Guide to Extending Credit to Customers

You made the made the sale! Put it in the books, deal closed, right?

Well, maybe.

The deal might have closed, but that doesn’t mean you’ve actually made any money. Once you deliver your product or perform your service, and deliver the invoice, now you have to collect on that invoice.

On paper, collecting on an invoice seems simple. You delivered the product or service to the customer along with an invoice which states the work performed, the associated costs and the due date for the payment. Now it’s your customer’s turn.

While simple on paper, this basic and fundamental business process known as accounts receivable can help boost a business’ ability to transact more business, but it can quickly become a pain point if it’s not managed effectively.

Money owed to a company for work performed is known as accounts receivable, often called “AR” for short. On a balance sheet, accounts receivable are categorized as an asset since they (in theory) will become cash in the future.

As the definition indicates, accounts receivable arise when a business sells its good or service to a customer on a credit basis—i.e. the customer is not required to pay at the time the good is delivered or the service is rendered. Transacting business on credit can make it easier to secure new work. Customers get the benefit of obtaining the good or service now, but not having to pay for the good or service until later. While this may help close more sales, offering credit to customers does create some risk for the business.

The most obvious risks to maintaining accounts receivable is the risk that you might get paid slowly or—worse—not paid at all. While you can book a sale on your income statement, you must also increase the amount due from customers. While accounts receivable is reported as an asset, if the accounts receivable is not paid, it becomes a “bad debt expense.” The bad debt expense is recorded as a bad debt/credit loss on the income statement and a simultaneous reduction of the accounts receivable asset.

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Accounts Receivable Can Be a Wrench in Your Cash Flow

“Better late than never” may seem like an acceptable approach to collecting accounts receivable. However, delays in collecting accounts receivable can run a business into the ground. Consider the following hypothetical:

Your construction company closes a big deal that drives enough revenue to help you hire a few employees, and lease some office space. You charge an initial down payment, with monthly payments due in equal amounts over the next two years. The down payment allows you to make payroll for the first quarter and pay rent for a few months.

After you move into your space, the customer hits financial trouble and stops making its monthly payments. Unfortunately, you already moved into your new office—rent and utilities are still due every month. You also hired employees and payroll is due every two weeks. The customer assures you that they are closing a new round of financing within six months and it will resume payment at that time.

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But what if that financing doesn’t come through? You’re left with recurring expenses you can’t pay. Accounts receivable is one of the biggest cash flow problems that businesses run into—it’s even driven some close their doors.

Even Apple Acknowledges Accounts Receivable as a Risk

Unfortunately, risk associated with accounts receivable is something a business never outgrows. As described in the earlier hypothetical, bad or delayed accounts receivable could result in missing rent payments or missing payroll.

Don’t be tempted to think you can simply sell your way through accounts receivable risk. Consider Apple, currently number three on the Fortune 500 list. As a publicly traded company, Apple is required to list “risk factors” in its annual report each year to inform investors of risks that could impact that company adversely.

Of all the “risk factors” that could impact a global technology giant like Apple—e.g. macro-economic conditions, the rapid change in technology, sufficient component supply, etc.—Apple lists Accounts Receivable as one its top 27 risk factors in its most recent annual report:

“[Apple] is exposed to credit risk on its trade accounts receivable….While [Apple] has procedures to monitor and limit exposure to credit risk on its [Accounts Receivable]….there can be no assurance such procedures will effectively limit its credit risk and avoid losses.”

Apple is a perfect example of the business potential and risk accounts receivable presents. When describing the accounts receivable risk factor, Apple indicates that it relies on retailers and distributors for revenue generation, i.e. retailers and distributors buy from Apple on credit. What is the expense of that credit? The same annual report mentioned above reported Apple’s accounts receivable at over $15 billion in 2016.

Customers Owe You Money—Now What?

Many businesses offer incentives to encourage timely payment of invoices. Early pay, and pre-pay plans offer customers a discount on the entire invoice if customers pay in advance or in a certain amount of days.

A common early pay discount structure will look something like “2% 10, net 45.” What this means to a customer is the standard window to pay for the good or service is 45 days. However, if the customer pays within 10 days, they receive a 2% discount on the invoice. Businesses get a double benefit from offering such terms. First, the business increases the chances of getting paid in a more timely fashion. Second, if the customer is able to pay within 10 days for the discount, that customer is more likely to be repeat business for the early pay benefit.

Another common incentive to customers is the option to pay a year’s worth of monthly installments upfront. This incentive model is very common in ongoing service industries (e.g. lawn care, insurance, maintenance, etc.) and growing IT-as-a-Service industries (e.g. cloud-based software, business applications, etc.).

Getting Paid Comes Down to One Word: Clarity

Whether payment terms offer an early pay incentive, or you simply want your customers to have a firm understanding of binding payment terms, it is a best practice to include payment terms in your contractual language. Incorporating the common payment term language illustrated above into any number of contractual mechanisms can bind customers to your desired payment terms.

The goal when it comes to payment terms is clarity. It’s one to bury the stipulations in a 10-page contract, it’s another to have the discussion over the phone. People like doing business with companies that are transparent and upfront. Make sure you’re doing your part to collect on accounts receivable.

• Include payment procedures in your contract, purchase order, supplier and invoice. Make the information available to your customers in as many ways as reasonably possible.
• Discuss the terms in person or over the phone before you start the work. Everyone should understand how much is due and when it will be paid.
• Make sure you’re talking with the person responsible for the payments. Your point of contact may hand over the terms to someone in accounts payable. This is the person you want to have a dialogue with.
• Address late payments before they happen. Explain any late payment charges or collection fees and when they will be incurred.

Clear communication with your customer and a legally enforceable method of binding both parties to such terms are essential to incorporating an effective accounts receivable strategy.

Mind the Gap, with Short-Term Financing

How do you manage the gap between the needed working capital fulfilled by the sale of goods and services, and the delayed collection of payment through an accounts receivable strategy? There are certainly options. Banks often extend revolving lines of credit secured by amounts due under accounts receivable. Many businesses remain debt-free in the long run simply by funding working capital over short intervals with the credit facility and then paying down when accounts receivable is collected. Over time, businesses can build a credit reputation that will allow for larger financing approvals should larger capital investments be needed.

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Flexible payment options can also help you collect earlier. The historical trinity of payment options (e.g. cash, credit, check) should probably be table stakes for a modern business. Technology continues to expand payment options through ease of use for the customer. Mobile apps, text payments, and auto-draft are all technologies that have evolved so that customers can pay with as little hassle as possible. Today’s mobile customer base expects to pay in any method the mobile market has developed. The more flexible you can be in receiving payment, the more likely you are to get paid.

Accounts receivable is a powerful business tool that businesses, small and large, have used to attract customers and grow opportunities. While the power behind an accounts receivable strategy is clear, accounts receivable presents risks that a company can never truly avoid. Before jumping into an accounts receivable strategy, it is vital that a business weigh the risks and adequately hedge against such risk with reserves and projected bad debt accruals if at all possible.