This is the third in our series, “Establishing Best Practices for Extending Credit in Today’s Economy”.
In our previous Best Practices’ blog post, we discussed the value of developing a written plan for extending credit and formalizing the credit process. As part of developing an overall strategy behind offering credit to your customers, you should decide which procedures or types of transactions to include in the program and what types of customers will be eligible for credit.
In this blog post, we will focus on the first part: deciding which procedures or types of transactions to include in the program.
Leveraged transactions or procedures of all sizes are good candidates for selling on credit terms. Why? Because the fee you charge is high compared to the hard cost you incur to provide the service or procedure. Couple this with requiring a down payment and/or charging interest over the term of the payment plan, and lending risk can be minimized or eliminated, while growing the business and generating a high level of wealth creation for the owner(s).
Let’s look at an example from the dental market and also compare this to the results you obtain using outside of third-party financing.
To start, outside financing may seem attractive on the surface because the dentist gets paid immediately. If the need for immediate cash flow is critical to the dentist, an outside financing program is an option that should be considered. However, the dentist does take a discount on their fees and the lender will only approve certain patients. Also, only certain procedures are eligible for financing often at less than 100 percent financing. As a result, the dentist’s revenue potential from the highly leveraged procedure is severely limited because the outside finance company dictates who gets financed and how much is covered. Considering that highly leveraged procedures are a good way to grow a practice and create wealth for the dentist, outside financing is not the best option for achieving these goals.
It’s interesting that service providers, such as dentists, are willing to take, for example, a 10 percent discount on their fees which happen to be 28 percent of their profits (based on the national average overhead of 73 percent). This isn’t generating wealth for the dentist rather it is reducing profits.
Using an outside finance source for a $10,000 procedure nets them $9,000. Performing three of these procedures costs the dentist $3,000 in discount fees, while netting them $27,000 in cash.
Compare that to the dentist extending his own credit and charging interest over the term of the payment plan. Patient payments over 60 months with 18 percent interest would equal $15,236. Two patients would equal $30,742, which is actually more than the dentist receives from the outside financing company for three patients. If all three patients pay off their payment plans, the dentist would receive $45,708, which is $18,708 more than he would receive from the outside finance company. If the dentist averages three procedures a month, he/she would generate approximately $225,000 in additional income compared to the 28 percent reduction in profit by using an outside finance company.
Outstanding Receivable Balances
In certain situations, extending payment terms to an outstanding receivable account often is a more effective and less expensive option than sending the account to outside collections. This is called “soft collections.”
In today’s economy, many people want to pay their bill, but often lack the resources to make a single large payment. Affordable monthly payments are an attractive option for these people. If sent to outside collections, the agency generally suggests a payment plan as a first option in the collections process. For this, the business pays a 25 to 35 percent collections’ fee on what is collected. If the business extends its own payment terms, it saves the collections’ fee, while still receiving payments.
For example, assuming 10 accounts each with $3,000 balances due were sent to an outside collections agency. At best the company would net between $19,500 and $22,500 of the total $30,000 outstanding. Adding to the cost, often collections agencies only collect on 40 percent of the accounts worked, which further reduces the business’s net to $7,800 to $9,000 of the $30,000 outstanding. This translates into $0.26 to $0.30 cents on the dollar being paid to the business.
Compare that to extending your own credit based on terms that your customer can afford. You have two options for approaching this opportunity: 1) run credit checks on the account owner prior to extending terms; 2) extend the same terms to everyone without credit checks. If you run credit checks on accounts prior to extending terms, the terms offered can vary based on credit risk. This would include term and interest rate charged. If the situation doesn’t warrant this approach, extending terms that cover the perceived risk for the entire pool of accounts may be a simpler and better way to go.
Using our example, assume that standard terms are used that offer a 6-month term and 18 percent interest rate. If everyone pays, the business receives the full $30,000 due plus $1,595 in interest income. Comparing this to the outside collections option, the payments received from just 3 out of the 10 accounts is more than what would be received from the collections’ agency. That provides a 70 percent upside to the business that extends its own credit terms. Further, if the accounts do default, the business can still send those accounts to an outside collections agency.
Effective Automation is the Key
While extending your own credit for leveraged services and receivable balances offer enticing advantages over outside financing or collections services, trying to manage the process manually can substantially increase risk and place a large burden on existing staff. Using a software solution that automates the entire process lifecycle delivers significant benefits.
Effective automation not only eliminates error-prone manual processes it can enforce lending best practices and significantly reduce the workload for existing staff. A robust, easy-to-use system provides a rich set of capabilities to maximize results even for a small business with limited staff.
In our next blog post for “Establishing Best Practices for Extending Credit in Today’s Economy,” we will more fully explore best practices for deciding what types of customers are eligible for credit.