How Offering Open Credit Can Increase Your Profit
Some big companies have large departments dedicated to evaluating and managing risk. For small companies, managing risk is a matter of quantifying your rewards for business functions that may result in a loss, such as offering open credit to your customers. Further, it means taking steps to mitigate the risk of loss.
Use the steps below to increase your profitability by offering credit while keeping risk at an acceptable level.
Determine Your Revenue Potential
Your first step is to estimate your potential increase in sales by offering open credit terms. Do this by categorizing the four types of customers.
- Customers who would definitely increase the amount they bought if you offered credit to make purchases.
- Customers who might purchase more if you offered credit. Consider customers who are buying a portion of their supplies from another supplier, and whether offering credit would incent them to move their business to you.
- Customers who would not use an open credit line. Some people prefer to do business without taking on debt, even short-term. Other customers already buy all their supplies from you. While they might take advantage of credit terms, sales would not increase.
- Potential customers. Consider the customers you would attract by offering open credit. This is probably the hardest category to quantify. Make an educated assumption using response rates to past marketing promotions that attracted new customers. Consider your market share compared to competitors that offer open credit. You can probably come up with a close estimate.
Using the categories above, add up your potential increased revenue based on your estimates for customers who fall in categories 1, 2, and 4. Don’t worry yet about their capacity to pay.
If you have no idea how much your revenue would increase, use a conservative estimate of 10 percent. This is a statistic reported by Consumer Reports that estimates the average credit purchase amount compared to the average cash purchase amount.
Assess Your Risk Capacity
Risk management is all about comparing the risk-to-reward ratio. You’ve already estimated your reward. Now you’ll estimate your appetite for the increased risk you’re taking on. This is a personal decision. Everyone is different. You’re the small business owner, so chances are you’re willing to take a calculated risk. Using your increased revenue, decide how much of it you’d be willing to lose on bad debt. This is your maximum default rate.
Rate the Credit-Worthiness of Your Customers
There are several methods to determine how credit-worthy your customers are. Dun & Bradstreet offers several products for credit risk management, including automated decision-making, business credit reports, and business credit scoring. If your customers are consumers, an individual credit bureau report might be more applicable. Both business and consumer credit scores offer the ability for you to calculate the likelihood of your customers defaulting on their obligations.
A final option is to request your customer’s financial statements. Financial statements are the most credible source of information to rate a customer’s credit capacity, if you know what you’re looking for. Focus on the liability section of the balance sheet and make a few calculations to determine the following.
- Days Outstanding for Accounts Payable: Total supplier purchases divided by average accounts payable. This formula gives an indication of how many days you’ll have to wait to get paid.
- Debt Ratio: Total liabilities divided by total assets. This formula gives an indication of how much of a company’s assets are financed, an estimation of indebtedness.
- Current Ratio: Current assets divided by current liabilities. This ratio should be higher than 1, an indication the company can more than cover its short-term obligations.
Risk management does not have to be complicated. Offering open credit lines to customers is a convenience that may pay for itself quickly. Smart business owners go through the steps of understanding how the risk/reward relationship specifically applies to their own business.