The End of the IOU - Minimizing Bad Debts

As a general rule of thumb, any business can expect to write off between 3% and 5% of debt as bad. That's if the business's receivables are managed properly. If not, that percentage will be much higher.

For any small business, especially one that's in its first couple of years of operation, cashflow is a paramount consideration. Many small businesses fail simply because they run out of cash during this period. So don't throw away money that's owed to your business just because its collection is unpleasant. The very survival of your business may depend on this cash.

In this article we consider whether you should extend credit and, if so, what processes you should implement to maximize your chances of getting paid.

Should you Extend Credit?

You might want to have a strict payment-up-front or on-delivery payment policy, but the realities of today's business environment are such that, in order to remain competitive -- and make a sale, you may have very little choice about your policy.

Assuming you have no real alternative other than to extend credit, the establishment of a policy about the extension of credit will be essential to your business's success.

How rigorous your policy is will depend on how much money you make on each job. If you perform a service or sell products worth several thousands of dollars, you're obviously going to be more concerned about the creditworthiness of your customer than if you're only talking about a $50 sale.

So what are the considerations you should take into account for major orders?

1. Character

When you consider the character of your customer, focus on the willingness of the customer to pay debts.What do you know about your customer? What is the history of the business, and how experienced is its management team? Does the firm have a history of litigation for unpaid debts? Does it (or any of its principals) have a history of insolvency?

2. Financial Capacity

Here we're concerned not with the customer's willingness to pay debts, but with its capacity to do so. So find out about the financial position of your customer before you decide to extend credit.

How do you get the information you need to determine your customer's character (willingness to pay) and financial capacity (ability to pay)? Ask for this information in an Application for Credit form that you develop for this specific purpose. Any prospective customer who's reluctant to complete such a form should be treated with caution. Any reputable organization will understand your concern to only extend credit to creditworthy applicants.

And don't just accept at face value the information that you are provided with. Carry out credit checks (try Equifax in the case of individuals, and Dun & Bradstreet for corporate credit checks). Also check with your customer's bank and, two or three of their customers. You should ask for credit referees such as these on the Application for Credit form.

If the result of any of these enquiries is even slightly negative: be cautious. And if you're just not comfortable enough to extend credit to a particular customer, don't. Don't be coy here. This is your business's livelihood you're dealing with. In such cases, require payment prior to shipment or prior to the performance of services.

Extending Credit

Once you have decided to extend credit to a particular customer, make sure your supply terms are crystal clear.

Your supply agreement should cover:

1. In the case of the provision of services, what services are you to perform for the customer? In the case of sale of products, what are you selling? In other words: what is the subject matter of the contract?

2. The fee for your services or price for your products.

3. When delivery will occur.

4. When ownership of goods will pass. If you're shipping goods to your customer, consider including a retention of title clause in your supply terms. This clause will have the effect that ownership of the goods will not pass to the customer until payment is made. This means you can, at least in theory, repossess the goods if you don't get paid.

   Note this will usually only be effective if the goods can be specifically identified as belinging to you. If the goods in question could have been sourced from any number of souppliers and can't be identified as having come specifically from you, a retention of title clause may offer little real protection. However, if you sell goods that are identified with serial numbers, or you're the only vendor of a particular product, such clauses are effective.

5. When payment is due. In the case of major jobs, consider requiring part payment up front with the balance due on completion, or in stages throughout the project.