Default arising from customer credit risk is inherently guaranteed across all industries, however taking certain steps can minimize this risk. You are bound to face customers that either file for bankruptcy, or are slow payers that can dampen your cash; especially if you have substantial cost associated with servicing that same customer. Keeping your Days Sales Outstanding ratio (DOS) as low as possible will translate into your business always having the adequate funds to keep the operations going.
The DOS ratio simply measures your ability to convert accounts receivable into cash. The lower the ratio, the quicker you are at getting cash in the door. On the other hand, a high DOS ratio translates into your business having a higher risk of customer default on their debt. First of all refrain from automatically granting every customer credit on account. Establish a strict credit policy that is both effective, and adaptable. The first line of defense is the Credit Application, which should be a robust and rigorous process.
Every customer credit approval process should include credit references from existing vendors that the customer has, recent financial statements, recent tax return, as well as included language about late fees and finance charges. In addition, it should spell out the amount of credit the customer is approved for, and payment terms. A common mistake businesses make is that they let a customer purchase beyond their approved credit amount, this is a mistake as it undermines the entire credit application approval process, in addition your customer now will not take your credit limit amount serious.
As a business owner you need to understand when it’s time to cut your losses, selling more, or continuing to provide services to a delinquent customer does not increase your chances of collecting on already past due invoices, it only drives you deeper in the hole. Concerted effort needs to be placed on collecting outstanding invoices. One of the best methods that always worked for me is analyzing outstanding accounts receivable on a weekly basis, as well as keeping in constant communication with each of my customers on where their balances stood, as well as ascertaining payment expected date.
Keeping in constant communication with your customer is crucial, as this will signal to your customer that you are keeping an eye on your receivables. Not keeping in constant communication with your customers however signals that you are in no rush to collect on outstanding invoices. Giving early payment discounts, or charging late fees is a proper way to encourage a customer to pay their invoice early, and prior to the due date. Common discounts given are 2%/10, which essentially mean that you will give a customer a discount of 2% on an outstanding invoice, only if paid within 10 days from the date of the invoice.