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Are big banks lending enough to small businesses? Anyone involved in the small business sector has heard this question as of late. Numbers prove that lending from large institutions has gone down due to the recent financial crisis (as the FDIC data reports, in June 2007, all big banks held just over $400 billion of small business loans, where in June 2011, they held just under $309 billion). But the real question is, are these banks morally obligated to be giving more?
The truth is it’s hard to say. Both sides of the issue have valid arguments. Small businesses are the backbone of America, and even more so, their ability to be job creators (one of the things we as a country need most at the moment) is unparalleled. In order to have this power, these companies need cash; cash to begin and cash to grow. In the past, the big guys have helped these little guys out. However, due to the effect that lending had on our economy in the recent years, banks have had to become more hesitant in their lending. But who can blame them? Given what happened last time, shouldn’t we be thanking them for being more cautious?
As seen, it can be tough to pick a side. What can be done? Capitalize on what can be controlled. For the moment, small businesses will have to be patient while the big banks become re-acclimated to lending. However, sitting and whining isn’t going to make it happen faster. Therefore, work with what you’ve got.
We’ve discussed before ways to access capital by really “thinking outside the box”. As mentioned, budgeting is an excellent maneuver to really shave off excess cost. Even a little goes a long way. Also, be ingenious in accessing different avenues. There are many interesting lending options out there.
However, in the midst of all this debate, there is a positive angle. With small businesses having trouble accessing cash from other sources, it will force them to look within. The easiest way to get cash is to get it from the people that already owe it to you.
OVER 50% OF SMALL BUSINESSES, according to a survey done by Aite Group, Visa and Cash Edge, find collecting to be the most difficult part of managing their cash. In fact, at least 5 to 10% of their accounts are delinquent. If small businesses were able to better collect that “lost” cash, even just 50% of it, think of the kind of cash they’d have available.
If a small business is doing $10 million in sales a year, their delinquent accounts range from $500,000 to $1,000,000. Imagine, if they focused on better managing these accounts, the amount of interest-free cash they’d have flowing in.
Small businesses need to learn how to better manage their accounts receivable. Creating these habits now will have a lasting effect in the future. These businesses will have perfected the practice of collecting their capital, which will create healthy financial habits and put them in an excellent position when banks are able to lend freely again.
In times like this where there are obstacles that create friction, being proactive, working with what is available instead of working against what isn’t, is always more productive.
So, WHAT IF THE BIG BANKS WON’T LEND? Realize it’s a good thing. It forces small business to look within, bettering their business from the inside out.
Extending credit to customers is an intelligent business process that can be immeasurably valuable in gaining customer loyalty. However, if not done both carefully and thoughtfully, it can become one of the most damaging practices in business. Previously, we worked through the process of wisely determining credit extensions. As discussed, when defining this limit, small businesses often times pull credit reports from agencies such as Dun & Bradstreet, Experian, and Equifax. The problem is that these reports are very expensive. A basic report typically includes court filings (such as bankruptcies, liens, judgments, and UCC filings). Fancier reports include credit scores and financial stress scores that attempt to give an “accurate” picture of a business’ probability of re-paying its vendors. For example, Dun & Bradstreet has established a “Paydex” score (similar to the FICO score for consumers, but in this case, for businesses). The Paydex score measures how well a business pays its vendors, and it is on a scale of 0-100, with 80 signifying a customer that pays promptly. The below chart explains the Paydex scale:
Credit bureaus charge a lot of money for these credit reports:
What is really frightening is to put these numbers into perspective. Imagine the amount that can be spent on credit reports in one year. Using Dun & Bradstreet as an example, if a company has 1,000 customers and wanted to screen and monitor all of them, at $25 for the cheapest, most bare-boned report, that is $25,000 a year! $25,000, the equivalent of a brand-new car, or even the price to bring on a new employee.
It’s sometimes hard to believe that small businesses are actually willing to pay these prices, because the reality is: payment performance data of small businesses is almost impossible to get. Less than 2% of businesses report their customer’s payment data to credit bureaus. These 2% typically represent the large Fortune 500 companies that get perks, benefits, and discounts if they report payments of thousands of customers to credit bureaus. Relationships with their customers are more distant.
Small businesses, however, usually carry accounts receivable (A/R) on known and local customers that they see in church every Sunday. Business owners have little desire to report poor paying customers to the credit bureaus; it’s bad for business and for cocktails at the club. Moreover, small businesses are even less likely to report their own financials to the bureaus. Why would they? It does not provide them with any benefits.
Often times credit bureaus “claim” that their credit score and financial stress algorithms paint a very accurate picture of a small business’ payment habits. But, to determine the financial health of, say, a particular pizza restaurant in Manhattan, do you think that dividing the total pizza sales in Manhattan by the total number of pizza restaurants in Manhattan, and using that number, gives an accurate picture?
So why are these reports so expensive? Well, the big credit bureaus have been around for hundreds of years. They have been acting like an oligopoly and what they sell is their “premium brand”. For example, to register with the federal government for contracts or grants, every business is required to get a DUNS number, which is an identifier issued by Dun & Bradstreet. If you don’t get a DUNS number, you can basically forget doing business with the government.
These expensive prices make small businesses hesitant to pull credit reports because they know if they pull a credit report on a customer, and there is nothing wrong, than they will have wasted anywhere from $25 to $100 PER REPORT. Small businesses have therefore been gathering information and data on their customer’s risk profile from other sources:
At the end of the day, this is your business and you will always be the most informed source on your customers, but doing high quality, results-driven research will only make your decisions more precise.
It’s crucial for you to check the credit profiles of your customers when extending them credit. The information is not perfect, but you need to work with the information that is available. Nonetheless, make sure you fully understand the information at hand, the accuracy of it, and how much you’re paying for it.
Nearly 50% of U.S. small businesses send at least five invoices a day and still, somehow, unpaid receivables remain a chronic disease for small businesses.
A survey by Aite Group revealed that over 50% of small businesses (or 1 in every 2 businesses) struggle with unpaid receivables. That survey was taken in 2006. Just imagine what those numbers look like today given the recent financial crisis and the current unemployment rate of 9.1% in the US.
Businesses are cash strapped and must accomplish more with fewer resources. Businesses extending credit are in need of better ways to manage their accounts receivable so they can get paid faster and therefore, increase their cash flow to start generating more jobs.
As explained in our previous blog, there are considerable reasons why customers don’t pay. If you’re extending credit to customers you should explore every avenue that will help them pay you back. Put yourself in their shoes and do what it takes to win over their heart. More simply put: make your customers love paying you back. Where does this courtship begin? Try focusing on one particular aspect of accounts receivable management: how different payment methods can affect the likeliness of getting paid by your customer. As shown in the figure below, checks remain the dominant payment method for U.S. small businesses:
What is particularly interesting is that U.S. businesses face an expanding range of payments choices as they migrate from paper to electronic payments. The check itself is experiencing a revolutionary decline in favor of electronic payments, primarily ACH and card payments, as shown in the following graph. Paper checks are being “electronified,” either through check imaging or conversion to ACH debits.
What are the main reasons for such a trend? The chart below shows the key reasons why the usage of checks is declining:
Businesses are focused on cost. It’s that simple. A long-standing advantage of automation, the elimination of manual and paper-based processes consistently delivers more dollars to the bottom line due to increased visibility and the speed of transaction. The removal of paper from the accounts payable department is also one of the more alluring benefits. The costs to cut and send live checks as a form of payment are generally higher than that of electronic payments. Small businesses achieve higher per transaction savings by using electronic payment methods over paper-based checks. As shown below, small businesses can save 30-40% when using electronic payments vs. paper-checks.
Also, by using electronic payment methods, small businesses are able to accelerate their payment processing, which in turn allows them to take any early payment discounts.
What about fraud? Integration of payments with accounting systems is the correct action to reduce costs and mitigate the risk of payment fraud. Risk reduction and the spotlight on reducing costs go hand-in-hand. As the graph shows below, over 40% of small businesses experience fraud when using paper-based checks. On the other hand, ACH and wire transfers are the most secure form of payment methods.
Long story short: there are various ways in which you can manage your accounts receivable. You don’t need to always chase down your customers – there are nicer ways of increasing the likeliness of getting paid. However, given that over 70% of small businesses prefer to pay online, you should consider changing the way you’re getting paid by your customers:
Ask your customers whether they would prefer to use electronic payment methods (such as ACH) because based on the available data it appears to be exactly what they want.
Every small business extending net terms will have to deal with a collection agency at some point during its operations lifecycle. Engaging a collection agency is almost always considered as the last option, a necessary evil that should only be initiated after all other organic collection attempts fail. The reason for the chronic lag between the time an account becomes delinquent and the time the same account gets transferred to a collection agency can be explained in two ways:
DAMAGED CUSTOMER RELATIONSHIP
When a third party agency starts to deal with your customer, you risk losing that customer for good. However, if that third party did everything it could to preserve that relationship, the story could be different. But that is often times not the case, which brings us to the next point:
NEGATIVE INDUSTRY REPUTATION
Most of the time, the collection agencies are extremely opaque; their fee structure is not easily accessible. Moreover, these agencies use very unpleasant methods to collect outstanding payments, which at times, could be intolerable. Most of the time, they end up permanently damaging your relationship with your customer.
The natural question to ask is: how do collection agencies stay in business? After all, according to the Commercial Collection Agency Association (CCAA), commercial accounts placed for collections rose to close to $15 billion. And that was in 2008; that number should now be closer to $2o billion. Another metric: the trade credit space in the US is a $2.1 trillion industry, and close to 20% of it is delinquent.
Let’s take a look at the industry trends. Back in the mid-90’s the largest collection agency accounted for less than 5% of the industry-wide contingency-fee revenue of $5.5 billion in 1996 (according to a report by Dun & Bradstreet). As a group, the top 10 agencies accounted for just under 20% of the contingency-fee total. Today, when fees from outsourcing, telemarketing, and other non-traditional lines of business are considered, the top-10’s total market share is certainly larger, but based on the traditional contingency-fee measure, 80% of the business remains in the hands of the other 5,000 – 10,000 commercial and consumer agencies. In short, it is a massive industry, but yet so fragmented, opaque and as some would like to put it, sketchy.
It’s not that there are no laws prohibiting bad behavior of collection agencies. It’s that those laws are simply not enforced. As a result, a high number of agencies just ignore these laws. In fact, there are well over 6,000 collection agencies in the United States and only about 5% of those are properly licensed.
The Fair Debt Collection Practices Act has been around for a long time, but given the stratospheric collection fees these agencies charge (which range from 30-50%), the market has been attractive enough to take the risks associated with unprofessional behavior.
Why are the collection fees so high? Let’s just look at what small business owners currently do to manage their accounts receivable. Every small business owner has a percentage of their customer base that is always delinquent (the national average for 90+ days delinquencies is approximately 5%). They first pull expensive credit reports from the credit bureaus, they then try to get their customers to pay by calling them up (good luck, your customer is probably out to lunch), they then send them one reminder letter after another (definitely not an efficient use of their time), they then engage their lawyers to find a solution (costing hundreds of dollars in legal fees), and the list goes on. What’s worse, they waste precious time during this process and the probability of getting paid gets dramatically reduced as the account becomes more delinquent (this was already outlined in our first blog post).
In today’s world, small businesses lack the technology and effective tools to manage their accounts receivable seamlessly and without hassles. Receivables management is not their core business expertise. So to avoid dealing with late customers, businesses send these accounts to a collections agency. The industry is still dominated by old-fashioned mom and pop agencies operating with little-to-no-innovation over the last decade. The cost of collecting delinquent accounts is therefore still high, allowing collection agencies to justify the ridiculously high fees they charge, while getting away with violating the laws imposed by the Fair Debt Collection Practices Act.
Smaller collection agencies feel the competitive pressure more than the larger shops, which results in less transparency, both at the customer as well as at the debtor level. An increase in technology investment is critical to create more transparency in the receivables management industry.
Just as outlined in our previous blogs, start investing in technology to streamline your accounts receivable management processes. You will find that you actually may not need a collections agency to reduce your Days Sales Outstanding and keep your delinquency rates in check. Believe it or not, most processes can be automated, and through investment in technology you can save significant amounts of time and money, increase your cash flow and stay in control of your customer relationships.
If you are giving net terms (i.e. selling on credit) to your customers, you know they are treating you like a bank. They buy goods or services from you, and they end up paying you months later. You are paying others to run your business (suppliers, utilities, lease) and you are letting your customers use your goods and services without paying anything upfront. You are basically giving your customers free working capital.
Extending credit is probably helping your sales, but what about your net earnings? Are you making any profit (and we are not talking about income statement profit here; we are talking about hard cash)? If your customers are treating you like a bank, you’d better be prepared to act like one. If you want to stay profitable while extending credit, you definitely need to use some of the effective tools that banks and other lenders use to extend credit.
We know it is difficult to deal with receivables and act like a lender. It is not your core business. If you really hate and do not want to deal with receivables management at all, you can outsource your entire receivables process to companies like Blue Tarp or trade credit insurance companies such as Euler Hermes. But they are very expensive solutions for many small businesses.
In this article, we compiled some of the best techniques used by other creditors and made them available to you. Below you will find tips on 5 crucial areas of receivables management that will help you extend net terms in a more professional, less risky way.
1. TREAT NEW CUSTOMERS WITH CAUTION
Unless the customer is established, always start with Collect-on-Delivery (COD). If you are dealing with a new customer who never had a business relationship with you, it is important to start with caution. Showing your generous side might end up hurting you a lot. And don’t worry about seeming too anal: if they ever did business with others, they will know that you are just trying to run your business without giving away free cash. It makes sense to establish a track-record with a new customer before offering any credit terms. If they try to push you to extend credit, tell them you will give plenty of credit after they establish a business relationship.
Starting with COD or a very low credit limit will keep your risk exposure in check while allowing you to get to know your customer more.
2. COLLECT YOUR CUSTOMERS’ DATA WITH A STANDARD CREDIT APPLICATION
No matter what happens, have your customers fill out a trade credit application form. Getting as much information as possible will tremendously help you if that account starts going sour. Make your new customers fill out the application the first time they ask for net terms. Tell your existing customers you are updating your credit files and ask them to send you their trade credit information. If you don’t want to send them the same application form, send them an “existing customer info update sheet”.
Putting together a credit application is very easy. You can do a simple Google search to get a sample trade credit application. See sample trade credit applications in manufacturing, construction, wholesale and retail here.
Recently, many companies (like Dell) began automating their entire trade credit process. If you receive a high number of applications every week, you also may want to set up a similar system.
3. DECIDING ON THE CREDIT LIMIT
Before you decide on how much credit to give your customer, make sure you do an initial due diligence check on that customer. Check the trade references. Find out the range of trade terms your customer gets from other suppliers. The credit limit should be based on:
A) Your customer’s overall credit standing (You can check reports from Dun & Bradstreet, Experian or Equifax)
B) Your overall risk exposure (always track your open positions and aged trial balances. If you have an accounting system (such as Quickbooks, Sage or Peachtree) you probably can download it with a single click.
C) Your customer’s historical payment performance (how well they have been paying you)
Resist the urge to extend existing customers more just because they have been in business longer. Statistically, existing customers are just as likely to stop paying as new customers.
If you do not have enough information on a particular person or business, you might be better off doing an investigative research by using services such as Kroll. Especially for big ticket sales that may have an impact on your risk exposure, it might be worth the extra cost.
4. PERIODIC MONITORING
There are several red flags you can pick up before you realize your customer is in delinquency. Especially for customers that constitute a majority of your overall sales, monitoring their financial risk will help you make better credit decisions. Finding out about liens, judgments, suits or UCC filings of your customers, you can save a lot of time and money during your receivables management process. It may be difficult to monitor all your customer portfolio, but you should at least check your major accounts every once in a while. (Check out Cortera Pulse).
5. QUICK FOLLOW-UP AND A SOLID CREDIT POLICY
It’s a lot easier to set the expectations with new customers than with the old ones. So, the earlier you put up a credit policy in place, the easier it will be to manage receivables. Your policy does not need to be complicated or harsh, but it needs to be clearly defined. For example, let your customers know what your net terms are, what kind of late penalty you charge, when you will contact them about late accounts. Then stick to your word. Whenever someone is late, resist the urge to give them a rain check for this time. Follow your standard procedure.
Clear communication is a critical component of receivables management. Make sure you quickly follow-up on your late accounts. Your customers should know that you monitor your books very closely. If your customers think they are flying under the radar, they will gladly keep stretching their payments.
Always remember, by extending credit you are acting like a lender. If you can get paid in a shorter period of time, you can extend more credit, thus sell more. Unless you put those practices in place, it will always be difficult to increase your ability to extend more credit without increasing your risk.
Next time you call a customer to follow-up on an invoice, it is important you know how to sift through the excuses they usually give over the phone or in an email. Unless you know the precise reason why they are not paying on time, you may not be able to convince your customers to pay their invoices before their due date. As Jay Goltz puts it, collecting payments is “one of the most surprising, upsetting and dangerous challenges” small businesses face on a daily basis. So, you need a first class game plan.
Most of the time, your late-paying customers fall into one of the five categories we describe below. Your delinquent accounts will usually have customers from ALL of these categories. You should therefore know how to identify each customer’s category, know the reasons and figure out how to act accordingly. Here’s a basic guide that might help:
1. INDUSTRY-WIDE PAYMENT PRACTICES
Reasons: Some businesses pay late because of their sales, receivables and inventory cycles, or operational practices that are customary in their industry. Some industries are infamous for the notorious delinquency rates (such as construction and building supplies, manufacturing, wholesale distribution. For real-time past-due debt statistics, see Cortera’s Market Trends here).
What you can do: Having a corporate credit policy usually helps. Signal your customers that your practice does not allow for average industry cycles. The fact that many businesses are not able to collect from customers does not necessarily mean you should give up on your receivables. Your customers need to know that you have robust credit policies in place. You need to follow-up regularly on late invoices. You need to help them with their payments (giving them the option to pay in installments, for example). The point is, if you do what everyone else is doing in your industry, your delinquency rates will be just like everyone else’s. If you improve your credit practices, however, your customers will respond to your calls & payment requests.
2. CUSTOMERS WITH OTHER, CRITICAL SUPPLIERS
Reasons: You may not be ranked at the top of your customer’s payment priority list. Your product may not be critical to your customers’ business cycle, or your product may be easily replaced by products from other suppliers. Another important reason may be that your customer has other suppliers that have more stringent credit criteria. So, your customer pays them before paying you.
What you can do: The fact that they have other suppliers cannot be an excuse for them not to pay you. You need to have a firmer stand from the beginning. Have a clearly defined process for your accounts (here are some tips on effective in-house receivables management processes). There are many ways you can ask for the payment you deserve while still being cordial. Your customers need to know that it is as important for your business to get paid as it is for your customers’ business. But we live in a distracted world, and getting your customers’ attention like all the other suppliers is critical in the race to get paid. Always remember: the squeaky wheel gets the grease.
3. CUSTOMERS WHO ARE IN FINANCIAL DIFFICULTY
Reasons: The reasons for this can be anything. Your customer’s business may be going through tough times and they really are unable to pay you back. This category carries by far the highest risk for your receivables. Today, overall business bankruptcy rates are lower than 2009 levels, however the failure rate is still quite high in several industries.
What you can do: To avoid facing such a challenging situation, you need to constantly monitor your customer portfolio to see if there are any changes on your customers’ credit profiles. You can have an idea who is not doing well by simply looking at your customers’ court records such as judgments, liens, suits, UCC filings and bankruptcies. As soon as you know one of your customers is in financial difficulty, you should take action. Adjust the credit limits based on the information you have. If you sold something and waiting to get paid, hurry up and get in front of the line. Because if you don’t act quickly, you may never see that customer again.
4. CUSTOMERS WHO CAN’T TRACK THEIR PAYABLES
Reasons: Your customer’s internal accounting practices may be a mess. A disorganized accounting department or a lack of headcount that knows how to track and process payables may cause delayed payments, not only to you but to everyone dealing with that business. This is a typical scenario for new companies and startups that don’t have the systems in place.
What you can do: This customer requires more attention than others. You may need to follow-up regularly and remind your customer that they have an upcoming payment. Systematic reminders before and after the due date should become part of a standard operating procedure for this type of client. Depending on your relationship, if e-mails, faxes and letters are not powerful enough to get paid, you may have to try more severe methods and capture the attention of anyone in the company who is in a position to pay you.
5. CUSTOMERS WHO KNOW THEY CAN GET AWAY WITH IT
If a substantial part of your accounts falls into this category, you’d better do something to change that.
Reasons: It is the way you deal with your customers. If you have traditionally been tolerant towards the late-payers, your customers already know that there are very little repercussions to paying you late. In that case, it is obviously in their best interest to stretch the payments as much as possible. After all, it is basically free cash. The later they pay, the more working capital they will keep for their business.
What you can do: Standardize your credit policies. Set up clearly defined credit procedures for all your customers. Be firm on your deadlines and your follow-up practices. Collect more information, always monitor your customers, let the world know that you will follow-up on late accounts, precisely because it is your money. “Being predictable” is very important in credit. All your customers should know when they will be getting a call or a letter from you if they don’t pay you. Predictability will lead to credibility. Credibility will help you get paid earlier than you otherwise would.
As Michelle Dunn, founder and CEO of the American Credit and Collections Associations and author of “The Guide to Getting Paid” (Wiley, 2011) puts it, it is not always right to think that it is somebody else’s fault if you are not getting paid (here are some of her other tips).
Always remember that a few basic changes in your receivables management practices can create wonders for your business.