Improve Your Image While Preserving Cash

How often does a client ask to borrow money?  Maybe they requested to pay over time, or asked you for terms, or wanted to pay a small deposit with the balance in 30 days, or bugged you in any way to receive your goods and services before they paid in full.

A Credit Screen

Last week I wrote about how you pay interest forever on bad debts.  This week I want to offer a simple way to limit client borrowing while virtually preventing bad debts.  As a side benefit, you'll project a more professional and corporate image, letting your clients know you're serious about your business.  This technique identifies deadbeat clients without robbing them of their dignity.  In fact, rolling out this neat trick stops deadbeat clients in their tracks .

What is this trick?  A credit app.  Referring to your credit department projects credibility and stability while preserving your cash flow.  It lets your customers know you take credit seriously.

But this process powerfully deters deadbeats. 

Suppose a client has asked you - or one of your sales reps - to extend credit.  Instead of hemming and hawing, smile sweetly and reply "Of course.  I'd be happy to send you a credit app.  It usually takes two weeks to get a response back from our credit department once you return it.  When we get that back we'll know the terms they approve.  Until then, we're happy to continue doing business on a cash basis."

Identify Deadbeat Clients

What happens now?  If the customer has bad history with other suppliers, they'll drop their request immediately and never bring it up again.  They don't want you discovering they're a deadbeat.

If they're on good credit terms with other suppliers, they'll likely ask you for the form.  Then you'll have two weeks to run a credit check and I recommend you do it.  Then you can make a decision.

This turns around an uncomfortable moment into an image-building measure.  Most clients will view this little bit of bureaucracy favorably.  It alludes to a larger and more stable organization than they thought which gives you power.  Of course, they don't need to know you are the head of the credit department.

Do you accept credit cards at your business?  How do you handle it when a client hands you a card and asks to charge a trivial amount?  Do you have a minimum purchase, a surcharge, or do you eat the fees?  The first two methods piss off the customer and the last pisses you off.  Next week I'll share a way to use credit card purchases to improve customer service while adding profit to your bottom line.  And in a future post I'll share how to flip around the Cash Conversion Cycle to make you more money.  It's another ingenious tip from your Business Doctor.  Until then,

pfA!

Do you have bad debt?  Can you see how this technique could help?  Let me know your thoughts by leaving a comment.

How to Keep Credit from Killing You

In the last article we discussed how businesses finance operations by borrowing, and why offering terms can have unforeseen consequences.  In this article we’ll look at an extremely high hidden cost and how to combat it.

Impact of Delinquencies

I apologize.  I'm about to scare you.  It's very likely that after reading this post, you'll never look at debt the same way again.  You'll start operating a cash business going forward.  And you won't personally lend money as freely.  But that's not bad.  The way we typically account for debt shields us from the full impact.

When you grant credit to a customer, you either borrow from your savings or a third party to cover it.  And until they repay you, you lose the use of that money.  If you use your savings, you'll lose the interest you would normally earn.  If you borrow, you pay interest to a bank.  Most of us don't consider the impact of a default because we expect to be repaid.
What happens if they stiff you?

Can't you simply write off a bad debt?  

When you "write off" bad debt, you don't get the money back.  You're only removing profit retroactively. You won't view it on your financial reports and you won't pay tax on the income you never received.  But you still borrowed to lend your client money.  And your cash flow covers the interest on your debt until repaid.  If you're stiffed, that's forever.  

As we touched on in the last column of this series, the highest rate on all your open credit lines is the rate at which you pay interest. Why?  Because you assume that when your client pays you, you'll then pay down your highest rate loan.  If they don't, you continue to carry the debt.  Putting this together we can see that you pay interest on delinquencies forever at your highest rate.

“Okay,” I hear you grumble.  “I know that sometimes I finance my customer's purchases.  And I didn’t consider I was paying interest on delinquencies indefinitely.  And I didn't see until now that I was borrowing at my highest interest rate.  But my customers usually pay within a month or so, and only a few default.  Are a few bad clients costing me so much?”

The answer is a resounding yes!  Over time the amount can cripple your cash flow.  Let's look at an example.

Was Einstein Smart?

The famous physicist Albert Einstein claimed compound interest was the most powerful force in the universe^*.  It’s truly horrifying for a borrower to see compounding turn a small loan into a veritable fortune over time.  Compounding adds interest onto the interest onto the interest… all the way back to the transaction date.
 

Say you borrow $1000 to extend terms to your client and they default.  I'll show the math below, but if you use a business line of credit with an average interest rate you'll lose $180 of net profit your first year.  After five years, $400.  After ten years, $940.  After twenty the profit you lose grows to nearly $5000, five times the amount of the original credit!  And the balance grows even larger and more quickly as the rate increases.

All this expense for extending a single customer who never paid you.  Imagine if you had a lot of bad debts.

One way or another, you're paying ballooning interest on each bad debt every year.  If you use debt, you're carrying more than you need to.  If you're debt-free, you've lost the compound interest on that money.  By granting credit you either decrease assets or increase liabilities.  The net result is the same: a substantial and ever-increasing drain on profit.  All because you extended credit, maybe years ago.  

You can how see even a few delinquencies can become prohibitively costly after several years.  If you are careless in extending credit, you can end up in a huge hole.

Want more proof?  Use the equation below to calculate the amount of money a family business could lose after generations of being stiffed only a small amount at the beginning of its history.  A terrific primer on compound interest is The Skinny On Credit Cards.

The Mathness Behind the Method

Expressed algebraically, the formula for compound interest is C(1 + r)^t where C is the original Cost, r is the interest rate, and t is the number of times the interest compounds.  As the number of years shown by the exponent t, and the interest rate r increases, the result grows very large.

In our example, we used a rate of 18%.  The interest is 18% of the balance of the debt.  So using the formula above the balance of $1000 debt after 5 years is: 1000 * (1.18)⁵ = $2287. In year six you pay interest on $2287.  At 18% cost of capital, that's $411.66.   After ten years, the balance quintuples to $5234 and 18% interest is $942.12.  After twenty years the balance increases to a whopping $27,339, and the interest is $4921.

The Bottom Line

Especially in the beginning of a business you must be miserly about extending credit.  Even better, don't do it at all.   There are times you need to offer credit; for instance, when it's expected or you're trying to compete.  But make credit the exception, not the rule.

Next time I'll discuss a way to prevent bad debt while keeping your customers happy.  In one of the next columns I’ll examine another hidden cost that can be extremely expensive and how to avoid it.  And later we’ll discuss how to flip around this equation so that you start making money on financing cost, not losing it.  It’s all next week so keep your eyes glued.  Until then,

profitable business All!

3 Hidden Costs Destroying You

In the last article we wrapped up our series on developing and using performance measures (aka metrics) to create a world class sales force.  Properly applied, metrics enable you to identify future top performers and nurture and improve your top talent. Even a novice manager can achieve superb results by measuring results and tweaking processes.

Today we turn our attention to cash management.  The reason most often cited for business failure is under-capitalization.  The root cause is often financial ignorance leading to mismanagement of cash.

In the next series I'll explore three areas where you’re bleeding cash without even realizing it.  Unless you set up the right policies financial ignorance can damage and even destroy you.

In each of the next articles I’ll explore one of these hidden cash drains and how you can combat it. Knowing this might just save your company.

Companies must borrow money to finance their operations.  They pay interest on that money.  How you borrow those funds and how to avoid borrowing those funds when you don’t need to are critical components in effective cash management.

Would you believe you might easily be throwing away half your profit or even all of it in some cases? In an earlier post I discussed how I showed that one local merchant almost made a disastrous mistake.  In this series I’d like educate you and help you guard against making these mistakes.

First let’s define some terms:

Net Terms
This is the number of days you allow your customers to pay.  It’s typically expressed as Net X where X is the number of days you allow the customer to pay you back.  The most common is net 30 although net 10 and net 15 are common.

Cash Conversion Cycle
You pay a carrying charge on what you sell.  This is your CCC times your highest credit line.  To calculate the number of days, subtract the date a client receipt is available to you from the date money is removed from your bank account.  This can be deceptively longer than one believes.

Cash vs. Accrual
Whether you operate a cash or accrual business determines your CCC.  A cash business pays its supplier at the same time or after the customer pays for goods.  If your customers pay you for every sale and you then arrange to pay for these goods, you operate a cash business and your CCC is zero or negative.  An accrual business pays for goods before receiving payments and its CCC is a positive number.

Hidden Cost #1: Extending Credit

If you buy merchandise to sell later, you extend credit, possibly without even realizing it.  That means you operate an accrual business.  An accrual business finances its operations by borrowing.  A cash business doesn’t.

Most small business owners don’t realize it but even service businesses operate on accrual.  Sole proprietors often finance their operations with a personal credit card.  And accrual businesses pay interest.  Holding inventory, allowing your customers to pay on time, invoicing for services rendered, paying your creditors before receiving merchandise, buying goods to include in assembly...  All of these practices increase your Cash Conversion Cycle and make it longer for you to get paid.

These hidden expenses eat up profits and drive you crazy.  To understand the underlying reasons requires a shift in perspective.  Once you do, you can tweak your policies to fix it.

With a little work, you can set up your policies so your profit increases, not decreases.

The Risks of Extending Credit

Often it seems harmless to extend credit.  But you accept these risks each time:

• The payer can pay late
• The payer might default
• Your potential profit is eroded by financing costs

Also, borrowing affects your own finances.  You can overextend or alter your own credit profile which might impact your ability to borrow or dramatically increase your costs in doing so.

In the next article we’ll explore how much extending credit is actually costing you and we’ll discuss a way to combat this expense.  Then I’ll share why two other hidden costs are killing you.  In future columns, we’ll explore additional ways to combat these hidden costs.  It’s all coming up starting next week, so keep your eyes peeled.  Until then,

profitable business All!