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When to Extend Credit to Your Customers?

As your SME grows, you are given the question on how to grow your sales further and increase your bottom line. Offering credit to your customers is a good way to increase your revenue by encouraging your customers to spend more and building long term customer loyalty.  When deciding to extend credit line to your client, there are several guidelines to follow on what you should and shouldn’t do. Most importantly, you must make sure that your customer is able to pay, willing to pay, and has a good credit history.

Assessing Credit Worthiness of Your Customers Before Extend Credit Line

Building trust is incredibly important when extending a credit line to a client. It is wise to start with cash sales when first dealing with a client to start to build trust. As you gain trust from sales history with the customer, you can start to navigate way towards extending a line of credit. Developing a thorough credit policy to gain more trust in a client’s background.  This includes:

  • trade references,
  • banking references,
  • credit-check authorization,
  • terms and conditions, and
  • disclaimers

For a small fee that is worth it in long run, you can pull credit reports on your client to determine their credit worthiness. Credit bureaus in Singapore include Credit Bureau Singapore and DP Credit Rating.

After noting your client’s past ability and willingness to repay its debts, you can hopefully determine if you actually want to extend a credit line to such an entity.  If you deem a client worthy of a credit line, then it is best to start with shorter-term credit horizon like 10 days to further determine the ability and willingness to repay you.  Remember that the longer the time horizon for an invoice the riskier it is.  As you become more confident in your client’s payment, you can extend longer credit terms to 30 days.  When extending credit lines to your clients, make sure you have the proper collection services to manage your receivables.

Determine Your Risk Appetite

The next step is determining the amount of risk your business can take through the extension of credit.  How much risk are you willing to take by extending credit?  Make sure your balance sheet can withstand potential loss from credit extension to avoid insolvency.

By using the DSO (daily sales outstanding) calculation you can determine the health of your accounts receivable.  DSO is calculated by

DSO = (Accounts Receivable / Total Credit Sales) x Number of days  

A low DSO means you collect payment amount from transaction in a short amount of time after an invoice is released.  Generally, a DSO under 45 days is considered excellent, given the invoice is net-30.

You can also use the receivables turnover metric to measure how well your company collects its outstanding receivables. Receivables turnover is calculated as

Receivables turnover = Net credit sales/ Average accounts receivable.

A high receivables turnover may suggest that you are effective at collecting receivables.  However, a high receivables turnover may also suggest you are too strict on your lending policy and that you are turning away clients which may be reducing your bottom line.  You can track receivable turnover historically and adjust your lending policy accordingly.

Planning for Cash Flow

Due to the nature of credit, your business may run into a cash crunch when you are short on working capital. That is why it is best to plan cash flows using a cash flow forecast. When you need short-term capital, you can sell unpaid invoices on an online invoice discounting platform, like InvoiceInterchange, where you can receive fast invoice finance in less than 24 hours.

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