One summer, a young girl set up a lemonade stand at the end of her driveway. After several weeks, she had done very well, selling an average of 20 glasses of lemonade per day. At $0.50 per glass, she had average daily sales of $10.00. Not bad at all! But she noticed that many people told her, “I’d love to buy some lemonade, but I don’t have any cash with me.” And they continued on, without buying any lemonade.
Then one day she thought she might be able to sell more lemonade if she let these people have the lemonade today, as long as they agreed to pay her the next time they came by. Sure enough, most of those same people agreed to buy the lemonade and pay her for it the next day. After several weeks, her sales have increased to 30 glasses and $15 per day! Wow!
What a great business decision! She increased sales by making it easier for her customers to buy from her!
Using credit to buy something is a common practice for both consumers and businesses. Simply put, “credit” refers to the practice of purchasing something now, and then making your payment some time later. As an easy example, consumer credit cards are used millions of times each day to make a wide variety of purchases, but actual payment isn’t made until later when the statement arrives in the mail. Similarly, businesses use credit to simplify their purchasing process and make better use of their cash by delaying payments.
Of course, in order for either the consumer or the business to do this, the credit card company or the selling business must be willing to extend credit to their customers to begin with. So, credit really boils down to a matter of faith that a customer will pay as promised. This blog will discuss the strategic factors that affect how a business decides to offer credit to its business customers. We will cover the tactical decisions in establishing a credit policy in a later blog, and we’ll let the credit card companies worry about consumer credit.
The main purpose of extending credit is to increase sales.
The first question business owners should ask themselves is, “Will extending credit to my customers help grow sales?” Or, at a bare minimum, “Will extending credit help me keep up with my competition?” If the answer to either of these is “No,” then extending credit really doesn’t make any sense. But, if the answer is “Yes,” then we can move forward to additional factors to consider in creating a credit program.
But before we do that, a simple, yet critical point to make here is that extending credit is an optional business practice, not a requirement like filing taxes or other regulatory items. Although, extending credit may sometimes feel like a requirement if all of your competitors are doing it. And, in many industries, this is the reality.
How do I begin to offer credit to my customers?
Once you have decided that offering credit to your customers will benefit your business (i.e. it will help grow sales!), it’s important to understand how credit benefits your customers. Remember that a commercial transaction is an exchange of value. In many transactions, this exchange is immediate, like when you pay cash for a glass of lemonade. The use of credit, though, affects the timing of the exchange of value. Both parties benefit from this shift in timing. The seller gets a sale that he or she otherwise may not have made. And the customer benefits from an easier purchase and the ability to pay later. In many cases, customers will make multiple purchases, and pay for all of them at once, at a later time. This makes buying and paying for materials more efficient and easier to manage for your customers.
Some other important questions to consider include:
What are the elements of a credit policy?
Once you’ve carefully considered whether you need to offer credit, you can proceed to the details. This is where it’s important to develop and clearly define aspects of a formal credit policy:
What is the cost of extending credit?
Developing, or more importantly, executing a credit program is a serious undertaking. And, it’s not without its costs. But since the purpose of extending credit is to increase sales, the benefits should outweigh these costs. Nevertheless, business owners should be keenly aware of the costs associated with their extending credit to customers. Here are some cost considerations to think about:
Whether you are new to establishing a credit program or you have an existing one, consult with qualified financial professionals to review the considerations provided above. Whereas an effective, carefully developed credit program can provide significant benefits to your business and value to your customers, a poorly-conceived or managed program can have disastrous consequences.
CFO Simplified is your strategic financial partner to drive growth, profitability and value into your business. For more information and examples of how CFO Simplified has helped clients achieve these objectives, please review the services offered and case studies available on our website.
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