Customer Credit Made Simple: A Guide for Small Businesses

This article was contributed by Aishwarya Pramod. Aishwarya is one of our Girl Boss Advisors. Her hard work and mentorship make our Girl Boss pilot possible!

As a financial analyst, I’ve had the opportunity to evaluate over a hundred small businesses. I found one surprising struggle that was common across most of them. I’ll tell you what it is, but first, consider this premise:

Nisha’s Big New Customer

22-year old Nisha runs a small ice cream business from her home kitchen. Every week, she sells 50-70 cups of ice cream to people all over Mumbai. Customers love her ice cream!

One day, a local restaurant— the Masala Diner— contacted her and ordered 20 litres of ice cream. Nisha hadn’t heard of the Masala Diner, but she was thrilled! This was her biggest order to date. It was also her first order from a restaurant— until now, all the customers had been individuals.

Nisha’s home kitchen is too small to make 20 litres of ice cream, so she’d have to rent a commercial kitchen space for a day. She’d also have to pay someone to help with delivery. This wasn’t a problem for Nisha – the order would still be profitable once she got paid. But The Diner said they would be able to pay her only two weeks after she delivered the ice cream.

So, what do you think Nisha did? Well, I’ll give you two versions of the story.

Version 1: Accept the customer’s terms

Nisha couldn’t refuse such a big order. She did not mind getting paid two weeks after delivery.

So, she spent her own money on renting a kitchen space, paying a delivery person, and buying ingredients. She delivered the ice cream and waited for payment. 

But even after three weeks, the Diner still hadn’t paid her! She texted, phoned, and finally went to speak to the owners. To her shock, the owners said that they had no money to pay her! They said that many of their suppliers had been waiting much longer for payment, so they’d have to pay those people first. They’d try to pay Nisha as soon as possible, but couldn’t promise anything.

Version 2: Investigate, evaluate and negotiate

Nisha did not say yes or no to the Diner immediately. She decided to find out more about them first. She’d never visited the Diner, so she walked by it the next evening and took a peek from outside. There weren’t many customers and it looked a little run down.

She also knew that her uncle supplied fish to the Diner, so she asked him about his experience with them. He told her the Diner wasn’t doing too well. For an entire year, they had been delaying payments to him.

Nisha decided she couldn’t risk allowing the Diner to pay after two weeks. She went back to their manager and explained that she’d need to incur high upfront costs to fulfill their order, so could he please pay her in advance? The manager stood his ground and was hard to convince. So, Nisha offered a 5% discount if he paid her at the time of delivery. Finally, he agreed.

Soon, Nisha delivered her ice creams, got the cash, and made a tidy profit.

The Takeaway: Evaluate Customers Carefully Before Extending Credit

A “credit period” is the time interval between the purchasing of a product and  when the customer’s payment is due. Version 2 of the scenario was of course a much better outcome for Nisha, as there was no credit period.

In any business, there is always a risk that customers simply won’t pay you, or will pay only after long delays. This is one of the biggest reasons why small businesses shut down.

If a customer asks for a credit period, don’t accept immediately. Analyze their ask carefully, especially for large institutional customers who make up a big chunk of your revenue.

Here are my tips for how exactly you can assess these customers. Note that these tips apply primarily to institutional customers, not individuals.

Assess their reputation in the market

Talk to others who’ve either worked with, purchased from, or supplied  your potential customer. Is their business doing well? Have they been making payments on time? Are they reliable?

Negotiate and incentivize

If your customer asks for a credit period, ask them why they need it (politely!). Is it simply a matter of internal policy? Is it because they don’t get paid immediately by their own buyers?

Try meeting them in the middle by asking for at least half the amount upfront, and the other half after delivery. Consider providing small discounts for advance payment. However, if the customer’s market reputation is poor, you may even ask for payment in advance of delivery.

Build trust-based relationships over time

Once customers have proven themselves reliable, and you feel comfortable, you can slowly increase their credit period. Good customer relationships are critical to business and mutual trust is one way to build them. You can even weather storms alongside your trusted customers.

For example, let’s say that one of your trusted customers has been hard hit by the COVID-19 pandemic and has been forced to delay payments to you. However, you know that they have a solid plan to turn their business around in the next few months. If you are convinced that they will recover from the slump, you can choose to give them some more time to pay, and provide them with uninterrupted goods or services, until they recover.

Analyze your own upcoming cash outflows

Sometimes, you know that you will need a lot of cash soon. For example, suppose that every December-end, you need to pay office rent for the following January through June. In that case, you may not be able to accept large orders in November and December, where customers want to make the payment only in the new year.

Measure customer delays and review them regularly

You can use simple software such as Microsoft Excel or Google Sheets to maintain lists of customers, orders, amounts and due dates. The table below is a sample of what your report could look like. Update these numbers regularly and analyze them at least every month, if not more often.

Send regular reminders and follow-ups

It’s a good idea to send a polite reminder to customers shortly before the due date for their payment. Once your customer base grows, you can set up automated emails, texts or even phone call reminders. Your email and text reminders should have payment links, so customers can pay you easily without postponing it.

If a customer misses a due date, act fast! Follow up consistently and ask about the reasons for the delay. Ask them by when they will be able to pay. Note down the date that they tell you (called a promise-to-pay date) and remind them again shortly before that date. 

In the worst cases, you can withhold further services to that customer until outstanding dues are cleared.

It is possible to take legal action against customers who purposely refuse to pay despite having, even though they have enough money. However, the effectiveness of legal procedures differs greatly from country to country.

Conclusion 

In conclusion, it can be crucial to learn to evaluate your customers. It’s great to have large customers who place large orders. They help your revenue grow by leaps and bounds. Logistically and operationally too, it is easier for a business to manage a handful of big customers rather than dozens of small customers.

However, large orders come with large payment risks. If even one big customer defaults on their payments, your cash inflow could take a critical hit. So, depending on what your business is, you should make sure to pursue different types of customers – individuals and businesses, big and small, those who place large orders, and those who place small ones.

Be careful about allowing untested customers to have a long credit period to pay you. If you don’t feel comfortable taking this risk, you should be prepared to walk away from the order, or even let the customer go completely.