Offering credit to customers is an alternative to having your customers pay with cash or credit card at the time of purchase. When you offer credit to customers, you are basically acting as the credit card company and letting your customers pay you back in the future. The credit terms are completely up to the company, but most companies would opt for 30 or 45 day payment terms.
There are a number of pros and cons to offering credit to customers. The company’s tolerance for credit risk is the most pivotal factor when considering whether or not to extend credit to customers. The visual below outlines the pros and cons (advantages or disadvantages) that the company should evaluate:
Pros (Advantages) of Offering Credit
1) Expand sales opportunities: By offering credit to customers, this may allow the company to reach a whole new customer base. Certain customers may not be able to pay cash at the time of purchase due to their cash conversion cycle and internal working capital needs. By extending credit to these customers, they may now be able to buy from your company.
2) Customer loyalty improves: By allowing customers to pay on credit, this might increase the chance that the customer continues to use your company as a vendor. Offering credit to the customer is a sign of good faith and shows your willingness to trust that they will make payment in the future. This is even more important if your credit terms are more favorable than your competitors.
3) Match terms of competition: If your competitors allow customers to pay on credit, then your company may have to offer this option just to remain competitive. Every industry or sector is different, so extending credit could be crucial in some sectors/industries and less important in others.
Cons (Disadvantages) of Offering Credit
1) Bad debt may exist: When you offer credit to customers, you allow them to pay their bills in the future. However, if they don’t pay you in the future, that results in bad debt for the company. If the product you sell has a high cost of goods sold, then bad debt can be very costly. If the product you sell has a very low cost of goods sold (think about SaaS products), then the impact of bad debt may not be as costly. There are controls a company can implement to reduce the risk of bad debt:
2) Manage accounts receivable: This should not be taken lightly. Depending on the number of customers the company has, managing accounts receivable can be a full-time job for an employee. When you offer credit to customers, you have to send invoices, follow-up to demand payment, and ultimately process the invoice. So even if you start extending credit to customers and that improves sales, you might have to hire a new employee with a salary of $30,000+ per year!
3) Cash flows negatively impacted: While a company can recognize revenue when a sale occurs, that doesn’t result in cash flow for the company if credit is offered. The company would record an accounts receivable, and if accounts receivable continues to increase, that can result in negative cash flows. An increase in accounts receivable means that the company has not yet received cash from customers that it may need to fund other needs of the business like paying their suppliers or purchasing additional inventory. As a result, the company may have to inject the business with cash. This cash can be obtained from equity owners or by borrowing money from a bank (i.e. debt). Remember, an increase in days sales outstanding results in an increase to the cash conversion cycle in number of days. The company wants the cash conversion cycle to be as short as possible!
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