Tackling Customers that Always Pay Late
How to Deal Profitably with Chronic Slow Payers
There are three types of customers: those that always pay on time, those that sometimes pay on time, and those that never pay on time. A customer that pays on time does not require any collection efforts. Those who sometimes pay on time only require a collection effort when they pay late; getting them to pay is usually not difficult. Customers who chronically pay late are another matter, especially those who regularly pay well beyond your terms of sale.
For most companies, a substantial number of customers will pay beyond terms, but seldom more than 30 days late. Getting them to pay sooner requires negotiation. A lot of companies, as a matter of course, pay 15 to 30 days after any invoice’s due date. To get them to change their habits, you will need to use levers in your negotiations such as:
Avoidance of credit holds to ensure prompt delivery of the products and services the customer orders
Access to a higher credit limit
Eliminating their past due balances being reported to the credit agencies, credit industry groups, and other vendors requesting a credit reference
Better pricing, which needs to be done in conjunction with your sales team
Sales and upper management help facilitate your negotiations when they support strict adherence to your company’s credit policies. If late payments are not to be tolerated, all customer facing functions must be onboard.
Chronic Late Payers
There is also likely a substantial segment of your customers (often 20 percent or more) who will regularly pay significantly beyond the terms of sale. This creates cash flow shortages, an increased risk of bad debt, and a significant work requirement to mitigate the impact of late payments.
To better deal with these customers, it is helpful to segregate them into three groups:
Those who are financially strong (low credit risk) and are trying to increase their cash position through late payments.
Those who are financially weak (high credit risk), in addition to essentially turning down the faucet for your cash inflow, present a higher risk of never paying for everything they owe.
Those that only purchase in small volumes and who, therefore, require a disproportionate amount of collection effort compared to the value they provide for your company.
This last segment is the most easily remedied. Since they are abusing your credit terms, why not require them to pay with a credit card when they place an order? Your collection cost will wholly or significantly offset the cost of the credit card transaction, and the time saved can be devoted to focusing your attention on higher-value customers.
You should, moreover, make it clear to new customers who order small dollar amounts that late payments will not be tolerated. Then, make it a point to review the payment history of these accounts for their initial two or three orders. If they don’t pay promptly, drop their credit limit and require them to pay with a credit card when they place their next order. As an alternative to credit cards, you might also work with a lender who will provide invoice financing to your low-volume accounts.
The Impact of Bad Debts
The problem with larger customers who chronically pay late is the increased probability of a bad debt loss, which is costly. If your net profit is 5 percent, covering a bad debt loss will require selling 20 times the amount of the loss to get back to even. In other words, if your bad debt loss is $10,000 and your net profit is 5 percent, $200,000 in additional revenue is required to cover the loss. Significant bad debt losses, furthermore, can be a major factor in causing a vendor to become insolvent and subsequently shut down.
It is, therefore, incumbent that you minimize bad debt losses without overly restricting sales. That requires a balancing act. To maximize profits, you must accept some customer credit risk — hence the significant block of customers that will regularly pay beyond terms — without opening the door to excessive bad debt losses.
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Dealing with Financially Strong Customers Who Chronically Pay Late
The greatest challenge in dealing with financially strong late-paying customers involves many, if not most, of them being some of your largest customers. Frequently, these are large enterprises with a great deal of market and purchasing power. Some of these firms unilaterally impose their own extended payment terms on you. The new twist to this practice: an offer of trade finance through a third party that allows you to get paid much earlier. This largesse, of course, comes with a cost that is significantly higher for large invoices than for small ones.
An effective response to these chronic payment delayers is to raise your prices — if and when you can. Those firms with market and purchasing power won’t likely play ball. After all, they’re likely trying to knock your prices down as much as possible. Less powerful late-paying customers, however, can be steered into a higher pricing tier to compensate your firm for:
The additional AR financing cost: that of either their third party or your lending institution
The increased administrative cost incurred in closely managing and controlling these customers’ accounts receivable balances.
An AR software firm’s research revealed that problematic late-paying accounts required four to five times the amount of staff time than prompt-paying customers. To get a back-of-the-envelope estimate of your ‘collection’ overhead, simply add up the number of hours spent on collections over the course of a month and divide by the number of customers that are past due in any given month. The result is the time spent collecting per past-due account, which you can then multiply by your hourly cost structure.
The other alternative is implementing an intensive Collection Process for these priority accounts. It should include:
Collection Contacts start when your invoices are a few days past due, with weekly follow-up. You can begin with an email, but your next reach-out should be with a call.
Holding Orders after just 2-3 weeks past due. Orders should be put on credit hold until a payment is made of at least the value of the current order. It’s even better if you secure a payment greater than the value of the current order, as this will reduce the total AR outstanding.
Meetings with the customer to explain your firm’s position and try to get them to pay sooner if not when due. This should be done in conjunction with your sales team, preferably at the customer’s place of business. When credit and sales are aligned, especially on profit goals, you will have a better chance of convincing your customer to honor your sales terms. If the customer still doesn’t play by the rules, it is then easier for sales to adjust the next sale contract accordingly.
Managing Financially Weak Customers Who Chronically Pay Late
Slow-paying customers who pose a high risk of default on their payments merit more decisive actions. The first thing to do is rank them by dollars at risk. The more they owe you, the more priority they should be given. While you also need to deal with those with smaller balances, remember that they don’t pose the same risk to your company as a customer who defaults owing a large balance.
In addition, here are seven actions steps for your consideration:
Accelerate Collections. The process outlined above should be implemented with greater intensity and shorter intervals.
Use Automatic Credit Holds on all orders when there is a past-due balance. This is a key element in controlling exposure to these customers.
Payments that exceed the order amount are required before releasing a held order. This will decrease the total amount of accounts receivable at risk.
Review the Financial Strength and Liquidity of these customers. Some may no longer warrant any extension of credit. Once you have collected everything they owe, you should then require them to transfer funds or pay via credit card in advance.
Reduce Credit Limits as appropriate. When establishing a credit limit, explain it along with your expectations to your customers. Encouraging truthful communications and building a mutual relationship with your customers will pay dividends, especially when there are bumps in the road.
Mitigate the Risk with a UCC Filing. Even if your customer’s lender holds a first-position UCC filing, getting a security agreement in place and taking a second position puts you ahead of other unsecured creditors. If you are selling them easily identified inventory, a purchase money security instrument (PMSI) gives you priority over a first-position creditor. In other circumstances, bonds and liens can provide protection. There are service bureaus that can help you with security agreements, as can an attorney.
Consider Offloading the Credit Risk via Credit Insurance, a Standby Letter of Credit, or securing a guarantee from a financially strong third party. These can be very effective but may also involve additional costs. With the smaller dollar risky accounts, you might simply want to consider moving them to a credit card or a third-party finance service that can offer your customers a variety of terms. As with credit cards, there will be an added cost, but you will no longer be at risk of bad debt losses or slow payments.
Additional Work versus Automation or Outsourcing
As the number of at-risk customers increases, so does the work required to keep them under control and protect your cash flow. Your time spent on collections will multiply as well. At some point, collection software and other AR automation tools will make sense. These automation solutions also facilitate remote staffing options that can save on overhead.
Given your current circumstances, you might want to consider working with a bonded and certified third-party debt collection agency when the burden of collections becomes too much to handle. If you don’t have the resources to scale up your debt collection strategy, an agency can relieve you of some of the burden by making first-party calls under your company’s umbrella. Your customers won’t even know they are dealing with a collection agency but rather just one of your company’s collectors.
Using experienced collection experts should increase the amount of unpaid debt you collect, which automatically reduces potential write-offs – and offsets the relatively modest cost compared to in-house efforts. This can be very effective when there are a lot of smaller balance accounts. They can be off-loaded to the agency, allowing you to focus your attention and limited time on major customers and key accounts.
Thinking This Through…
Selling profitably to late-paying customers on credit terms is often necessary. Your focus should be on revenue growth and stability, but you also don’t want to be hampered by bad debt losses. That’s why a proactive debt-collection strategy is necessary. Risks are mitigated by holding your customers to account. Even so, you may still need to “fire” accounts that don’t pay by referring them to a collection agency or attorney.
With accounts that continually pay slowly and, in so doing, try your patience and distract from building the business, you need to change up the game. You don’t want their bad practices to become habit-forming. By following the recommendations described above, you will be able to shorten the payments cycle of many of these chronic, slow-paying customers, reduce your exposure to at-risk AR balances, and ultimately reduce the risk of crippling bad debt losses.
A good measure of how you are doing is your DSO (Days Sales Outstanding). If your standard terms are 30 days and your DSO is 45 days or less, you are very likely enjoying better cash flow and fewer write-offs than your peers with a higher DSO. If your DSO is creeping up through the 50s, slow payments and bad debt could negatively impact your profitability.