Improving cash flow is likely at the top of your to-do list, but the most common way to do that is to focus on cutting costs and reducing inventory. One often overlooked way to improve your cash flow lies in managing your customer transactions. Here is a four-step plan you can implement to help get your cash flowing.
1. Check the Credit of New and Existing Customers
Too many overdue accounts receivable can cause a cash crunch, but if you prevent them from going overdue in the first place, your cash flow won’t suffer as much. It’s important to check the financial health of all new customers before extending credit to them. Start the process by asking them to fill out a credit application. Next, you’ll want to take a look at their credit reports. You can partner with your customers in the process and sign up for Experian Connect, or use an all-in-one solution for both consumer and business customers like MicroBilt. In addition to checking new customers’ credit history, you should also perform periodic reviews of your existing customers because even the best paying customers experience financial downturns. If you’re aware of problems early, you can revise the terms so you don’t extend too much credit to a customer who has suddenly become a bad risk. Most experts recommend reevaluating customer credit reports every six months to a year.
2. Set Credit Limits Based on Facts
Once you know whether customers are a good credit risk, you should set a credit limit for them. You will need to find a balance between what customer needs, and ensuring that you are protected from too much financial liability. Here are three ways to set limits.
- Use the net worth calculation. If you want to use hard numbers to set the limit, base the credit limit on the customer’s net worth. Most experts advise creditors to use between 5 and 15 percent of a debtor’s net worth, with 10 percent being the average. To arrive at this figure, use this calculation: Credit Limit = (Total Customer Assets – Total Customer Liabilities) / 10.
- Use the information given to you on the credit application or the trade references you find on customers’ credit report to create a credit line. You can either extend the same amount of credit other creditors have, or you can determine the average of the credit accounts and use that for your figure.
- Do a needs-based calculation. Some customers will ask for a certain amount of credit, based on how much business they expect to do with you. In those instances, you should analyze all the information you collected on them to determine if they are a good risk for that amount.
Some business owners use an combination of all the three methods to set customers’ starting credit limit. The important thing is that you base your credit limits on facts to reduce your exposure.
3. Immediately Address Slightly Overdue Accounts Receivable
To optimize your cash flow, you should strive for the lowest daily sales outstanding (DSO) that you can. The lower your DSO, the quicker you are collecting your accounts receivable, which translates to a healthier cash flow. To determine your score, use this formula: DSO = Accounts Receivable / Total Credit Sales x Number of Days in the Measurement Period
It is commonly understood that as accounts receivable begin to age, they become more difficult to collect. That’s why you should act immediately if customers are late paying an invoice. As soon as an invoice is past due, send out a reminder by letter or email politely telling them their account is overdue. If you don’t receive payment right away, place a call to them and ask if there is a problem. Some customers just need a reminder that their bill is due, and will pay it immediately after you contact them.
4. Aggressively Address Significantly Overdue Accounts Receivable
If your first attempts at collection don’t succeed, you will need to get more aggressive to prevent the account from becoming so aged that you’ll never be able to collect it. You should make routine contact with the customer so they understand you aren’t going to let it slide. For instance, you can contact them by phone every week, reminding them they owe your business money. If you still don’t receive payment, you will likely have to resort to other means, such as handing the account over to a collection agency, or taking the customer to small claims court.
You work hard in your business, and a healthy cash flow should be one of the benefits you enjoy. By creating a proactive system to deal with your customer transactions, you’ll take a significant step toward achieving it.