A revolving line of credit allows a business to draw amounts of financing needed for their business until they hit a provided credit limit. Continuous draws can be made, you don't have to wait and pay back the full amount if you need to take another draw. Although it is a good idea to pay off a draw before taking another one, once a draw has been made, an ongoing monthly interest is sometimes charged.
A revolving line of credit provides flexibility since owners can pay it back on their terms. There is a minimum amount that must be paid each month but there are no prepayment fees.
Why Extend A Revolving Line of Credit?
If a customer has the choice of choosing between two companies offering similar products but one extends a revolving line of credit while the other does not, which supplier do you think the customer will want?
Extending revolving line of credit allows your customers to utilize their working capital longer. This creates additional efficiencies in their business that would otherwise not have been there.
Depending on your credit terms, on average customers will increase their spending with you. This happens because customers can make use of the credit leverage you are offering them.
You'll also have the chance to build long-term relationships with customers. By opening the relationship door with a revolving line of credit, customers will do more business with you. If you manage that relationship well, you'll have to chance to create a more substantial customer lifetime value. Clients perceive a line of credit as a means of trust, by continuing to offer this benefit to your buyers it will eventually lead to a more significant customer loyalty.
You can further manage this relationship by offering discounts to customers who pay early. For example, if a customer pays net 50 instead of net 60, they might receive a 1% discount. Whether the discount works in your favor depends if you can make more than the customer's 1% over those same ten days.
As mentioned above, with a revolving line of credit comes increased efficiencies in cash flow and working capital for customers. This can be an excellent advantage for startups, who are always starving for cash.
Through cash flow efficiencies you've created for your customer, they will eventually grow, becoming a more significant customer. This, of course, means more business and revenue for your company. All the more reason to nurture customer relationships into longer-term relationships.
How To Determine Which Companies Get A Line And How Much
It would be great to extend customers as much credit as they need, if only they could all pay back the full amount. Unfortunately, that isn't how things work. We have to be careful with the amount of credit extended to each customer.
Not all customers are deserving of the same credit limit. Some can afford more than others. This is where determining customer creditworthiness comes in.
Credit Score - Just like a person has a credit score, so do businesses. Unlike personal credit scores, business credit scores may not reveal everything.
You can pull business credit scores from Experian, Equifax or Dun & Bradstreet (D&B). D&B will likely have more comprehensive business credit reporting. The main problem with business credit is that not all vendors report payments. In fact, none of them have to. Sometimes it is only at the request of the business owner that their business payments are reported.
To build a reliable credit picture, you'll want to check the customer's personal credit as well. If the business is a partnership, you'll need to pull credit for both owners. Keep in mind that there is a cost to pulling credit reports.
Years In Business - How long a business has been around is another critical factor, mainly because you can determine a more thorough payment history.
Keep in mind that just because a business is a startup doesn't mean you shouldn't extend them a revolving line of credit. They might turn out to be your best customer, but until they can prove that, their credit terms should be more stringent. Meaning, higher interest rates and net 30 instead of the regular net 60 for example.
Revenue - Verifying company revenue is another tool to help decrease risks involved with extending credit. Although some companies will be reluctant to let you peer into their books, you may want to restrict revenue verification to your riskiest customers.
One of the best the ways to verify revenue is to request the most recent audited financial statements from their accountant.
Associated Risks
There will always be accounts that are paid late or go uncollected. That is the nature of doing business. In other words, it's the risks we must take for extending credit. We're going to discuss both of these risks in more detail.
Doubtful Accounts - When a customer invoice is sent out, this creates an entry in accounts receivable, which is an asset on the balance sheet. For longtime customers and those who always pay on time, we don't have to worry about their outstanding invoices being paid.
For new and smaller customers, this isn't always the case. This group is where late and uncollectible payments can be found. For those types of fees, they are charged to an expense called doubtful accounts.
Doubtful accounts is a contra account to accounts receivable debit. This means it is subtracted from accounts receivable to provide the net value of accounts receivable.
Late Payments - While not as bad as uncollectible payments, late payments still present risk. They tie up capital longer than we've projected. If invoices are net 60 and 5% to 10% of them are coming in at an average of net 90, this can delay capital projects. It certainly impacts our working capital, which creates strains on paying suppliers and daily expenses.
How To Manage A Revolving Line Of Credit
We know there are risks associated with extending revolving credit loans. While we can't necessarily efficiently eliminate these risks, we can mitigate them. But mitigations comes with a cost.
Any company that puts effort into mitigating their revolving line of credit risks may find that uncollectible and late payments go down, but operational costs increase. What causes this?
These costs are mainly associated with the additional resources needed around accounts receivable management. There is software that can handle much of this task, freeing up resources. However, there is still a cost in purchasing and maintaining the software.
Credit insurance is another option for mitigating risk, but again, there are costs involved.
Increasing on-time payments can help reduce uncollectible and late payments. This is usually done by providing discounts for early payments, as mentioned above.
We can see there are a number ways to mitigate risk associated with providing a line of credit. But trying to eliminate them just isn't possible. One question to ask is: If the amount of revenue gained through the extension of credit is more than the loss, isn't that a win for your company?
Conclusion
Extending a revolving line of credit to customers involves a detailed credit policy and training for staff who will manage accounts receivable. This management is where risk mitigations come in.
Companies should expect some revenue loss on credit payments. But if the amount of revenue gained is in excess of the amount lost, it means the extension of credit was a worthy endeavor.
