Published on 7 May 2024
The pros and cons of extending credit to customers
When you extend credit to a customer, you allow them to obtain goods or services before they pay for them. You are trusting your customer to pay at a later date.
This can be a win-win situation. Extending credit can attract new customers and can create loyalty and trust among existing ones. Both new customers and loyal customers means more sales.
However, before rushing headlong into extending credit, it is important to acknowledge the potential risk involved. The European Commission has reported that one in four bankruptcies are due to invoices not being paid on time.
Summary
Key takeaways
- Extending credit can be a way of boosting sales
- When managed carefully, it can be a win-win situation
- There are inherent risks in extending credit
- Businesses should be fully aware of the pros and cons before extending credit
The advantages of extending credit to customers
Customer attraction
Extending credit shows that a business is financially stable and reliable.
Customers are also attracted by credit because it gives them more flexibility and greater purchasing power. If credit is available, many customers will make a purchase or will purchase more than they would if they were limited to the cash they had at the point of sale.
Competitive advantage
The ability to extend credit may give your company an edge over your competitors. Not all businesses are financially capable of extending credit. If all else is equal, a customer hesitating between two suppliers might opt for the one offering credit
Customer loyalty
Credit can also boost loyalty among existing customers. By offering credit, you are showing them that they are trusted. In return for the trust, you are likely to build loyalty among the customers, and loyal customers are more likely to make repeat purchases.
Increased sales
Credit can increase sales both among new and existing customers. The ability to pay on credit encourages customers to make purchases even when they do not have the cash immediately available. Loyal customers with an established relationship are also more likely to make repeat purchases, taking advantage of the flexibility of credit lines when they need to.
Better Inventory and Resource planning
Another advantage of extending credit to customers is that you get to have a better understanding of your available stock and resources. By accelerating the sale of a good or a service, without waiting for the customer to pay, you can make better use of idle resources and generate better flow in your inventory.
The disadvantages of extending credit to customers
Delayed payments
The obvious disadvantage of extending credit is that there is a delay between supplying the goods or services and receiving payment for them. Depending on the payment terms, this may be Net 30, Net 60 or even Net 90 days after the date of the invoice.
Cash flow issues
This delay in payment has an obvious impact on cash flow. The cash from the sale may not be available until several weeks or months later.
In some cases, customers may be late with payments. Late payments, also known as “delinquent payments”, are an unfortunate fact of life for many businesses. The European Commission estimates that one in two invoices are settled late.
In the worst cases, a customer may not pay at all.
Administrative costs
With good financial management, the worst risks can be mitigated. However, good management comes at a cost. Invoices need to be generated and sent. Credit checks need to be carried out. Payment terms need to be established. Accounts receivable need to be monitored. Late payment reminders need to be issued.
Some of these tasks can be carried out automatically by proprietary software. This also comes at a cost and staff need to be trained to use it. For larger companies, a dedicated member of staff may be required.
Credit risk
By its very nature, extending credit involves risk. While good financial management can mitigate this risk, it can never be eliminated entirely.
When all else fails, you may turn to a professional to help you recover an unpaid debt. Factoring services, debt collection agencies, and lawyers’ fees all involve a cost. This obviously dilutes the purpose of extending credit in the first place.
A balancing act: finding the right credit policy
A balance needs to be struck between extending credit and managing risk. This balance is not the same for every company. Larger companies may be in a position to take greater risks. The effect of non-payment on a small company can be catastrophic.
Your credit policy must be tailored to meet your business model and your customer base. If you decide to extend credit, you must have clear payment terms, credit limits and payment schedules in place. A solid credit management strategy is essential.
Credit management strategies
A good credit management strategy can help you mitigate risk. The main purpose of a credit management strategy is to reduce the probability of the company losing money if borrowers default on their repayments. By taking steps such as carrying out credit checks and taking out credit insurance prior to extending a credit line to customers, you can identify and reduce the associated risks.
Credit checks
Before extending credit to any customer, it is important to check their creditworthiness. Does the customer have a good track record when it comes to repaying credit? Is their business financially stable? Do they have the income to cover repayments? Do they have sufficient collateral or capital to repay the credit if their business takes a turn for the worse? How reputable is the customer in the wider business community?
Credit insurance
Credit insurance is one way of protecting yourself against the vagaries of the business world. Trade Credit Insurance provided by Allianz Trade covers your accounts receivable against unexpected risks such as customer bankruptcy, changes to import and export regulations and so on.
It can help you safeguard your cash flow and avoid bad debts.
Debt collection
Automated systems can help to identify payment deadlines and issue payment reminders. For a customer who has simply overlooked the deadline, a friendly reminder is often all that is needed.
Occasionally, a late payment may indicate that your customer is experiencing difficulties. Your credit policy should be flexible enough to allow you to renegotiate the payment terms, while firm enough to protect you against the risk of non-payment.
When reminders and renegotiations fail, professional debt collection agencies can help. For a fee, they take over the debt collection process. This can free you up to focus on your core business and take away the stress of chasing late payme
Regulatory compliance
Legal frameworks and regulations are in place to protect businesses, particularly small businesses, against the risks associated with extending credit.
The European Commission recently announced proposals for a new Regulation to revise existing Directives on late payments. The aim is to make B2B transactions fairer, and to protect SMEs against the risks associated with payments not being made on time. It should also encourage SMEs to make more widespread use of digital technology and improve their financial literacy.
Conclusion
Extending credit can be a great way of attracting new customers. It can build trust and loyalty among existing customers. When managed carefully, it can be a win-win situation. Customers can access goods and services without having to pay for them immediately, and you increase sales.
However, even with the most loyal of customers, there is always a risk of non-payment.
By establishing a comprehensive credit management strategy, you can anticipate, measure and mitigate risk. Carrying out credit checks, establishing clear payment terms, monitoring credit and efficiently collecting debt are ways of safeguarding your business against the risk of non-payment.
Allianz Trade can advise you on building a good credit management strategy and the benefits of Trade Credit Insurance.