Early-stage companies are glad just to get orders for their products. They see every prospect as a link in the chain that brings them ultimate success. It usually takes them a few bites into a rotten apple before they realize that one of the standards that they need to set is a credit policy that provides them with reliable customers that will end up paying their bills. Larger, well-established companies developed solid credit policies as part of their standard operating procedures. Someone wants to do business with you, they submit to a credit check. When you are comfortable that they’re able to pay your invoices, you give them a credit line, allowing them to buy your products or services.
In spite of solid credit policies, companies still get blindsided by customers that fail to pay their bills. Every company that looks at their business strategically, plans on a certain amount of bad debt. Nobody wants bad debt, but the reality that some bills aren’t going to get paid is part of good business planning. But the key is to do what you can to provide a fence around your receivables to reduce, if not totally eliminate write-offs. But not every risk is something that you can preplan for.
One only needs to look back to our recent past during the Great Recession of 2008. Many companies were caught short when their customers weren’t able to pay their bills and there was a domino effect that crippled many businesses. For instance, I worked with a manufacturer of new and replacement windows that had quite a few small home builders as customers. The manufacturer had been having a difficult time, but was working their way out of a hole. Then the recession hit. Home sales plummeted. Remodeling came to a halt. Construction of spec homes stopped, and many small home builders went out of business. The company, which had been doing OK, suddenly found that their accounts receivable, which supported their line of credit, had gaping holes in it. Invoices started to age out, and fall off the edge of their borrowing base. Credit line availability evaporated, and the company was suddenly short of cash, and at risk of going out of business.
Companies with established credit policies have great similarities. They are larger, with a stable customer base, and often have long established credit policies. Once a policy is established, there is little impetus to go out and change it because it was likely achieved after many frustrating conversations around the conference table to get everyone to agree. Finance wants tighter restrictions to protect collections, while the sales department wants more lenient policies so that they can push sales. Once those two warring parties come to agreement, nobody wants to open the topic again.
After 10 years of growth, the economic climate has once again changed. While some businesses have been able to take advantage of the economic turmoil, many businesses are struggling for customers. Banks are starting to pay fresh attention to their loan portfolios and the “pretend and extend” policies of 2020 are in the rear-view mirror. Supply chain issues have suddenly brought new issues to the fore and will likely have an impact on consumer sales over the next six months or longer. Now is not the time to sit on the sidelines, letting policies that were established years ago drive decision making. Re-examining your credit policy might certainly have an impact on sales but will undoubtedly provide some additional security to your bottom line. Your business needs to do two things:
- Evaluate whether your existing credit policy is still relevant in light of the current economic environment.
- Determine whether your longstanding customers should be reviewed to see if their credit worthiness has changed.
Here are some steps that you should undertake to protect your accounts receivable:
Realistically examine your credit policy.
- Does it still provide the protections it once did?
- When was it established, and how has your business changed since it was first written?
- It is likely that not only has your business changed, but the economic environment has changed dramatically as well.
- Write a new policy based on the current environment and set a schedule to provide continual review of relevancy.
In the new economic reality, should new customers be rated differently than in the past?
- Review of their banking relationship
- Size of credit granted them by other suppliers
- Review their financial reporting
- Examine their accounts receivable – are their customers paying on time, and does their customer concentration create risk for them that ends up transferring to you?
Give your own customers a fresh look
- When did you last review their credit worthiness?
- Apply Pareto’s Rule – Time is a valuable and limited commodity. With reduced staff levels, concentrate your efforts on your largest clients.
- Review not just their credit history with their current suppliers and bank, but take a deeper dive into their businesses.
- Get current financial statements, and review not just their profitability, but make a decision on their financial risk profile. What is their customer concentration? Where is their cash coming from – credit line, sale of inventory, accounts receivable collections?
The days of a stable economy will hopefully return, but now is not the time to reminisce about the good old days. Mature businesses have always looked outside the norm to find not just opportunities to expand their market, but also to protect their assets. It’s common for companies to explore and establish alternate sources of supply, cross train staff, and establish product lines that are counter cyclic. But internal policies need to be reviewed regularly as well.
Just as this time of the year brings the typical drive to create a budget that reflects what you hope will be next year’s sales and profitability, shouldn’t it also be a time to reexamine the policies that are at the core of how your business operates? Regulatory agencies and the courts provide a necessary direction for accounting procedures, human resource management, and contractual relationships. But the review of your customer relationships is no less important. Collection of accounts receivable may be going fine, but it can certainly create a different sense of urgency in short order. Take the time to make sure that the processes and procedures that drive your cash flow are up to date and relevant in the current economic reality.
Written by Lawrence Chester.
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