If you are an SME that supplies other businesses (B2B), the chances are that you are also a lender. In fact, you’re part of Australia’s second largest business funding sector, after banking.
This is because most businesses extend credit to each other: whenever you agree that an invoice can be paid 30, 60 or even 90 days after it was issued, you are for all intents and purposes lending your customer the face value of that invoice for the agreed period of time. If even after such generous terms they pay late, then you are lending for a bit longer – usually interest free!
The Reserve Bank of Australia esOptiPayated that trade credit owed by Australian businesses large and small totalled more than $80 billion in March 2013. The Reserve Bank’s report also suggested that trade credit is effectively used by businesses as a substitute for bank loans.
As bank lending to businesses dried up after the financial crisis, and now drying up during the current Royal Commission, credit terms between businesses were extended to help meet the funding shortfall.
Why offering credit is risky and expensive
Many businesses offer their B2B customer incentives to pay early, for example 5% discount if payment is received within 14 days, 3% if paid in 7 days. However, this rarely works and the reason, your customer is managing their own cash flow strain. As we wrote in previous blogs “it is a vicious cycle”.
Considered as an alternative unsecured funding line, that’s right unsecured and the facility can be a very smart revolving line of funds drawn against your issued and confirmed invoices and purchase orders. It is easy to think that trading on credit is a nice way for businesses to help each other out at a time when funding can be hard to come by. However, there are a number of reasons why this can be problematic – especially for smaller businesses.
This guide from Business Queensland neatly lists the key problems associated with extending credit terms:
- Reduced Cash Flow – you may wait for customer payments, which reduces your ability to purchase replacement products from suppliers. Many businesses consider debtor/invoice finance to reduce this risk.
- Reduced Profit Margin – funding credit sales reduces your profit margin. Usually, the cost of this only shows up in your profit and loss statement, so you need to keep this in mind when you are pricing your products and services.
- Large Debts – unpaid debts can pose a risk to your business. This is particularly true if you are exposed to large single transactions.
In short, by providing a customer with 45-60+ days to pay an invoice, you are doing them a massive favour at considerable risk and expense to your own business. The cash flow problems caused by the culture of late payment will sadly be familiar to most Australian business owners. The cost of funding the credit you extend is less obvious – and of course some of it might fall on your own suppliers as you take credit from them.
One bad call could destroy your business
The biggest problem, however, lies in the risks businesses take in supplying credit: should a major customer go bust, they will likely owe you several months’ worth of invoices- could your business survive such a loss?
Remember that, if a big invoice/s goes unpaid, that comes straight out of your revenues and cash flow, but with no lessening of costs. You still have to pay your staff, landlord and suppliers. That’s why providing credit terms without proper checks and measures is like juggling hand grenades in your office: You never know when one of them is going to take your business out!
Credit terms are an important part of modern business and in many industries, they are considered essential in order to win contracts. Indeed, smaller businesses often have no choice and have to accept the terms dictated by big business buyers. Unfortunately, most SME’s simply do not have the requisite skill set or staffing to accurately assess these risks.
Credit agencies, PPSR checks, recovery options, trade credit insurance and invoice financing are all ways in which the cost and risk of trade credit can be mitigated. We will discuss these in more detail next week.
In the meantime, businesses unfamiliar with assessing credit risk and the cost of offering credit should check to see how many hand grenades are lying around their offices. If in doubt, contact OptiPay’s expert advisers to find out how our invoice discounting packages can help you and your business succeed in the credit minefield.
Best of all OptiPay provides the expertise to protect your business, improve cash flow and your gross operating margin at a fraction of the cost of offering business discounts to slow paying customers.
“Get Tomorrow’s Cash Flow Today”