ENTREPRENEUR - Managing Credit
by Stephanie Dychiu

Wrote this after surviving Chartered Financial Analyst exam.

by Stephanie Dychiu

Extending credit to customers is risky business—it can dramatically increase sales, but also bury you in uncollectible debt. Here’s what you need to know to make credit work for you.

These days it’s practically impossible to run a business without offering credit to customers. If handled right, extending credit can really boost your sales. Generally, people like delaying payment for as long as possible so they can use their cash for other things. Or sometimes, they experience a temporary cash shortage, and flexible payment terms enables them to continue acquiring the goods they need until their cash position improves. Restaurateur Heidi Ng, proprietor of Don Henrico’s in Malate and West Avenue, confirms this: “Credit terms have a huge influence in my decision to go with a certain supplier,” she says. “It’s more convenient for cash flow and check releasing.”

The cost of giving credit
Extending credit may increase your sales, but this does not necessarily mean your profits will also increase. This is because you will be incurring additional costs, such as:

Additional working capital. Working capital is the cash you leave tied up in the business to ensure smooth day-to-day operations. It is computed from your balance sheet using the following formula: Receivables + Inventory – Payables. Extending credit can mean higher receivables. The higher the working capital stuck in your business, the more opportunity cost you incur, because this money could otherwise have been earning interest in the bank.

Higher salaries and admin expense. You will need to set up a Credit and Collection department to do credit investigation, keep track of receivables, and remind customers to pay up. This means hiring more people, buying additional office supplies and equipment, and higher phone and electric bills.

Bad debts expense. Hardly any business that offers sales on credit is able to collect 100% of its receivables. You must be prepared to absorb some amount of bad debt. This can range between 1% to 50% of sales, or even higher, depending on the industry you operate in.

You have to make sure the increase in sales that will result from relaxing your payment terms is enough to offset these additional costs, and make a tidy profit. Otherwise, it’s not worth it, just stick to your no-brainer COD (cash on delivery) payment policy and save yourself the grief.

Evaluating credit-worthiness
In the US, evaluating a customer’s credit application simply means calling up the credit investigation bureau, but here in the Philippines we unfortunately cannot be as straightforward. Anthony Que Garcia of Integrated Resources Construction, a firm engaged in the construction of residential and commercial buildings, relies on word of mouth and past experience to gauge clients' ability—and willingness—to pay. "Kung hindi ko kilala, I get extra careful," he says.

Here are a few ways you can get inside info on a customer:

Get a copy of his latest financial statements from the SEC. Examine your customer’s liquidity position by computing his current ratio (current assets divided by current liabilities) and average collection period (accounts receivable divided by average daily sales). These two ratios show his ability to repay debts. The current ratio should at least be 1.5 or higher, and his average collection period should ideally be a lot shorter than the number of days you’re giving him to pay for his purchases.

Ask for a bank certification. If the customer is an individual and not a corporate entity, the SEC won’t have any record of him. Ask him instead to present a certification from at least 2 banks confirming that he has maintained a certain average daily balance for the last 6 months (enough to get you paid).

Visit his place of business. Be very observant during the visit, noting the quality of the surroundings, number of employees, level of activity, and, most especially, the types of fixed assets lying around. Vehicles, machinery, equipment, and land are some of the properties you can lay claim on if he fails to pay his debts in the future. The atmosphere at his place of work will also give you an idea if his business is doing well or not.

Tap the grapevine. In business, it pays to gossip. Casually mention your client to his other suppliers, bankers, lawyers, and friends to see if any interesting information pops up. You might find out he has outstanding loans with too many banks and suppliers, and most of the fixed assets he owns already have claims on them.

Painless credit and collection
“Credit is all about relationships,” notes Heidi Ng of Don Henrico’s. “Normally, you only give credit to customers with whom you already have a good relationship. But sometimes that relationship can actually make it harder to collect. Mahihiya ka kasi.” In a society as non-confrontational as the Philippines, it is hard to talk about past-due debts. Transactions are often done through chika and pakiusap. However, there are mechanisms you can put in place to protect yourself without alienating your clients:

Always ask for a downpayment. Ideally, the downpayment should already cover your cost of production for the customer’s order, and the balance is simply your mark-up.

Require post-dated checks to be submitted before approving an order. This is by far the best way to protect yourself from bad debt. If the customer defaults, he will be liable not only for breach of contract but also for estafa, which is a criminal offense. This will make him think twice about not paying up.

Engage the services of a credit card company. This effectively passes on the risk of not collecting to the credit card company. In exchange, the credit card company will expect you to “sell” your receivables to them at a 3-5% discount, which means you’ll only get P95.00-97.00 for every P100.00 worth of credit sales generated by your business. Seems pretty steep, but if it means you won’t have to maintain your own Credit and Collection department, it just might be worth it.

Offer additional discounts for prompt payment. The discount you offer for early payment must be substantial enough to make customers feel they are suffering a big opportunity loss by not paying on time. Ideally, the effective yield of the discount should be higher than bank money market rates, otherwise the customer will feel he is better off putting his money in a time deposit instead of paying you right away. Offering discounts will cut your profit margins, but if it saves you the headache of running after customers who refuse to pay up, it might be worth it.

Insert penalty clauses for late payment in contracts and invoices. This so-called “fine print” on your documents should be carefully worded so as not to scare off customers. Consult a lawyer to make sure your penalty clauses are within the bounds of the law. “You can also do advance billing,” suggests Anthony Que Garcia of Integrated Resources Construction, “since they know you can deliver on time, and everything is ready when the due date comes.”

When all else fails . . .
Go to court! But leave this as a last resort, as it can be both emotionally and financially draining. “Businessmen should be encouraged to go into preventive law, not damage control,” says Atty. Eugenio Villareal, Managing and Litigation Partner at Escudero, Marasigan, Vallente, and E.H. Villareal (EMSAVVIL Law), and professor at the Ateneo School of Law. “Keeping a lawyer on general retainer is a good investment in the long run, because he can make sure your business documents carry all the necessary clauses to protect your interests from the very start.” A general retainer fee can be as low as P3,500 or as high as P20,000 per month, depending on the needs of the client and the law firm you decide to engage.

Before deciding to sue, Atty. Villareal advises doing the following:

Send a demand letter. The first demand letter can be signed by you, the business owner, sent around 30-60 days after the receivable falls due. A second demand letter, this time signed by your lawyer, can be sent after 90 days. Be sure to confirm the customer received your “gentle reminder” by getting someone from his office to sign a receiving copy.

Know your legal position. “Even if you know deep in your heart that you are on the side of the right,” says Atty. Villareal, “what is morally right is not always the same as what is legally right. Make sure there is evidence of an unfulfilled obligation and that you did not in any way contribute to the customer defaulting on payment (such as by unreasonably refusing payment tendered).”

Determine if filing a case will be cost-effective. Taking a person to court is expensive. Lawyers’ fees and filing fees can reach hundreds of thousands, even millions. “You must also determine if the person you’re suing has the capacity to pay damages,” says Atty. Villareal. “Otherwise, it may be futile.” Refer to the previous section on Evaluating Credit-Worthiness to determine your customer’s financial standing.

Going to court is unpleasant, time-consuming, and expensive, but is oftentimes necessary even if it is not cost-effective. “If you don’t take action, you’ll start accumulating massive unexplainable bad debts in your accounting books,” says Atty. Villareal. “Shareholders and bankers funding your business will not be happy with that.”

(This article originally appeared in ENTREPRENEUR, September 2002.)