Contents of the free course 
Introduction
Cutting Down on Credit
Why We Need Credit Control
Sales Discounts
Perils of Overtrading
Risky Customers
Have you also considered these aspects of the course?
- Cracking the Credit Problem
- Is my Customer Credit Worthy?
- Credit Control Routines
- Debt Recovery Through the Courts
- Statutory Demands, Insolvency and Bankruptcy
- VAT and tax Relief for Bad Debts
- Model Answers
- Sample Reports and Forms
- Differences in Small Claims Procedures
- England & Wales and Scotland
- Helpful Official Booklets
Increase your earnings! Take the full course and receive nationally recognised qualification or call us free at 08000-75-8000 for further information
Introduction
Most firms have to provide their customers with trade credit. The aim of this course is to ensure that your customers do not take advantage of your willingness to provide this credit.
We will look at:
. the problems caused by providing credit, including the consequences of bad debt and late payments
. how to assess whether your customers are credit worthy
. how good credit control routines prevent customers from keeping your money longer than necessary
. how to collect debt from non-paying customers through the courts
. where debt collection fails, we will see how to claim income tax and VAT relief on the bad debt.
This course won’t make you an instant expert at credit control and debt recovery. However, it will give you some useful guidelines to collecting debt efficiently. Good cash flow is essential for business success. We hope that this course will make the cash flow for you.
Increase your earnings! Take the full course and receive nationally recognised qualification or call us free at 08000-75-8000 for further information
 Cracking the Credit Problem
Competitive pressures mean that many businesses have to give their customers trade credit. Credit is an unsecured, interest-free loan to customers. Uncontrolled credit is like giving customers the key to your bank account. If you have a bank overdraft on which you are being charged 15% interest, every £1000 advanced to customers costs you around £12.50 per month in interest charges. Even if you don’t have an overdraft, you are still losing the opportunity to earn interest on money ‘lent’ to your customers.
Cutting Down on Credit
Before we look in detail at methods of controlling credit, lets think if there are any ways in which we can cut down on the amount of credit given. For example:
. Do you really have to give credit? Is there any way that you can get customers to pay cash with order? Can you promote a cash based business (like ‘cash and carry’ or factory sales outlets)?
. Can you issue an invoice but only release the goods when paid? This is called ‘proforma’ invoicing. This way your customers give you cash 'up front’.
. Can you get a deposit with order? This way you can cut down the amount of credit given to each customer.
. Can you ask for stage payments? This will lessen the amounts outstanding (but it only works for contractors - like builders).
. Should you give credit on every order? It is very expensive to administer credit, especially for those customers who normally spend small amounts of money with you. You could end up spending more money on debt collection than the profit generated on small orders. Is there a certain order size below which you should insist on cash with order?
Of course you may find that, in your line of business, none of these options are available. You simply have to give credit. This is unfortunate because giving credit involves a great deal of administration. You probably know from bitter experience, that you have to take the following steps to collect cash from your credit sale.
. Raise an invoice and delivery note
. Record the customer’s debt in your books
. Send credit notes (for returned goods) when required
. Keep a list of poor payers (called an Aged Debtors report)
. Send statements (which are reminders to pay the invoice)
. Send chase letters to slow paying customers
. Telephone debtors asking them to pay you
. Record receipts from customers in your books. Pay the receipts into your bank account
If you raise a lot of credit invoices, you should seriously consider a computerised accounting system. This will save a great deal of time which would otherwise be lost on credit administration. Computerised sales administration is covered in the ‘Accounting With Computers' full course.
Increase your earnings! Take the full course and receive nationally recognised qualification or call us free at 08000-75-8000 for further information
Why We Need Credit Control
The normal credit period offered to customers is 30 days. In fact, the average debt collection time is nearer 81 days because of slow payers. This extra credit period can put pressure on your cash flow.
Often small firms suffer most because they have fewer administrative staff available to chase debt. They are also reluctant to apply pressure to their larger customers for fear of losing their custom. Let us have a look at some of the ways in which unregulated credit can damage your business.
Bad Debts
A debt becomes ‘bad’ when all reasonable means of collecting that debt are thwarted. Not only do you lose the value of the bad debt, you also lose the administrative costs incurred in chasing the debt.
Few businesses appreciate the true cost of bad debt. To recover a bad debt, the business must make additional sales. The following table works this out for you.
Cost of Borrowing
It is important to keep a tight control of your cash, otherwise you could end up borrowing money to subsidise your customer’s business. In fact, if your customer keeps you waiting long enough for payment, you could end up losing the whole of your profit in interest charges on outstanding debt!
Example 1
Sale Price
of Goods
£ |
Cost of Goods
£ |
Lost
Profit
% |
Additional sales required
to cover bad debt
£ |
500
1000
3000
5000 |
475
900
2550
4000 |
|
|
Number of days to erode all profit on a sale:
Cost of Bank Borrowing
This table does not allow for any administrative overheads involved in chasing the debt. Allowing for this would mean that profits were eroded even more quickly!
Businesses which have been operating for a number of years tend to build up ‘reserves’ out of profits. ‘Reserves’ are sums of money reinvested back into the business. Some of this money is used to fund debtors. Money used to fund debtors is a transfer of reserves from your business to someone else’s. Every pound that you can keep in your own account earns interest for you. If you have an overdraft then every penny kept out of your debtors’ hands reduces your overdraft and saves interest payments. With overdraft rates running between 3% and 10% over bank rate, this is a handy saving for any business.
Sales Discounts
Some businesses try to minimise their outstanding debt by offering their customers a discount for prompt payment. Lets have a look how effective this is likely to be.
Example 2
In your business would you offer a customer a discount of 2% as an inducement to pay in seven days instead of thirty days?
Yes No
What effect would the discount have on your profitability?
Better Worse Much Worse
Profit Margin |
10% |
12% |
14% |
16% |
18% |
20% |
|
Days |
Days |
Days |
Days |
Days |
Days |
2% |
72 |
60 |
51 |
45 |
39 |
36 |
5% |
180 |
150 |
129 |
114 |
99 |
90 |
10% |
360 |
300 |
258 |
225 |
201 |
180 |
15% |
540 |
450 |
387 |
339 |
300 |
270 |
20% |
720 |
600 |
513 |
450 |
399 |
360 |
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You can use the following formula to work out the answer. The formula converts the discount into an annual interest rate like an overdraft or loan interest rate.
I = R x 365
D
where:
I is the annual interest rate
R is the discount offered
D is the number of days paid early.
Let’s assume that our payment terms are 30 days, but we are prepared to offer a 2% discount for cash paid within 7 days. The effective annual interest rate would be:
R x 365 = 2 x 365 = 32%
D 23
We can now compare the annual interest rate we are offering our customers with the rate we can borrow from the bank. If we could borrow money from the bank at 12%, this means we are paying 20% more than we need to secure the discount. This makes the discount unattractive to us. We are better off waiting for the normal credit period of 30 days. If we were to offer the customer the same rate of interest as we could effectively borrow from the bank, ie 12%, we would only give 0.7% discount for payment 23 days early. This is unlikely to impress most customers so they probably won’t pay earlier. There is a more exact method of calculating the true interest rate called the Annual Percentage Rate or APR. This would provide an even higher rate of interest than calculated using the ‘simple’ method above. However, APR can be difficult to calculate and the ‘simple’ method outlined above gives us just as clear an indication of the cost of offering a discount.
Have a go at the following question.
Exercise 1
A company is considering offering a discount for early settlement of invoices. The normal payment terms are 60 days. A discount of5% is offered for payment within five days. The company has borrowings on which they pay interest of 12%. Should they offer the discount?
Work out the annual interest rate on the discount (using the interest formula) I = R x 365
D
Should they offer the discount - Yes or No?
There can be other problems connected with offering discounts. Sometimes, customers take the discount but still pay after the normal number of credit days. You can then be left in the awkward position of trying to reclaim the discount from the customer after the event. This causes unwelcome friction and generates extra paperwork. On the other hand, if you let the customer get away with it, he will do this repeatedly which depresses your own profitability.
One way round this problem is the ‘retrospective discount' . Under this system, you agree a discount with your customer but the customer has to pay the invoice in full. Provided the customer pays the invoice early enough to qualify for the discount, you rebate the amount of the discount. This eliminates arguments since the discount is only paid to the customer if he complies with the discounted payment period. This puts control into your hands. It can also offer you a slight cash flow benefit in so far as the full amount is paid into your bank but the discount is paid out some while later.
Perils of Overtrading
Giving too much credit could stretch our cash flow to breaking point. Hopefully, giving credit to customers gives them an incentive to trade with us. However, if customers delay payment for long enough, we could have trouble in paying our own creditors - these are people we owe money to. In an extreme case, a profitable business, with full order books, could be brought down by short term payment problems. This is called ‘overtrading’ The cash squeeze is particularly noticeable in times of expansion. The only way round this problem in the short term is to borrow money from the bank. The long term solution is to control credit properly.
Inflation
At the time of writing this book, inflation in Britain is low. However, inflation has been as high as 27% per annum in the past. If customers pay late, they are effectively paying you in ‘devalued' money. This represents a small but persistent leak in the value of money returned to you.
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Risky Customers
Some businesses fail because of the ‘knock-on’ effects of the failure of a major customer. It can be dangerous to extend large amounts of credit to a single customer unless you are sure that customer is credit worthy. If your business relies on a few key customers, be careful to check their financial viability before advancing significant credit. . Where possible, deal with a number of customers so that the lack of payment from one customer will not bring your business down.
Even if you have a large number of customers, you still need to avoid customers who won’t pay. There are always a few unscrupulous business people who order goods or services for which they either can’t or won’t pay. Sometimes, they project a high profile image but actually have no asset backing. Make sure that your credit control procedures pick up these bad debt risks as early as possible. The suggestions contained within this book should help you to minimise your exposure.
Summary
We have seen that giving credit can expose us to risks in:
- bad debt
- interest charges on loans or overdraft
- the risk of overtrading.
The way to solve these problems is to:
- only extend money to customers who will be able to pay
- establish good credit control routines
- recover debt from bad payers through the courts
Increase your earnings! Take the full course and receive nationally recognised qualification or call us free at 08000-75-8000 for further information |
