Quick Overview
Customers who pay late or default can leave you short on cash even when sales and profits are strong. You can reduce customer credit impact on cash flow by checking credit before offering terms, matching limits and terms to risk, monitoring receivables, and using invoice factoring to turn eligible invoices into working capital.
Do you invoice your customers after goods or services are delivered? It’s common in the U.S., with nearly half of all B2B sales leveraging the mode, Atradius reports. Net-45 is the typical term, meaning customers have an average of 45 days to pay after receiving their invoice. Because it’s viewed as routine or even expected, many small business owners don’t see this for what it is: issuing credit. And the harsh reality is that not all customers deserve these terms, nor does everyone who has earned credit deserve the same terms. In this guide, we’ll explore customer credit impact on cash flow and what you can do to ensure you’re extending in a way that protects your business while supporting its growth and customer relationships.
Customer Creditworthiness Helps You Evaluate Payment Risk
Before we dig into customer credit impact on cash flow, let’s take a quick look at what customer credit really means and how it influences payment risk.
The 5 Cs of Credit Are Used to Help Gauge Customer Creditworthiness
Creditworthiness simply refers to whether an entity is deserving of credit or extended payment terms on an invoice. It answers the question: “Is this customer likely to pay their balance in full and on time?”
A business’s creditworthiness is measured differently depending on who is performing the evaluation and why they’re doing it. For instance, a credit bureau like Experian or Dun & Bradstreet (D&B) will typically use a proprietary algorithm to determine a credit score that can be used to make decisions, while a lender or business offering trade credit may use that score or their own checks. Regardless, there are five standard elements used to measure creditworthiness.
- Character: The first core factor is character, which refers to a customer’s trustworthiness and track record of paying past debts. In many cases, this is the only factor a business considers while extending credit.
- Capacity: The debtor’s financial ability to make payments based on cash flow and income, also referred to as capacity to service debt, is a major consideration when creditors look beyond the surface data.
- Capital: The overall financial strength and value of the customer’s business or personal assets also weigh into most credit decisions.
- Collateral: When the above are not enough to qualify a business for credit, sometimes assets the customer can offer as a backup security to cover unpaid debts are considered.
- Conditions: External economic factors or market trends that might impact their ability to pay may also be considered, although this comes into play more often with institutional lenders.
Payment Risk Increases When the 5 Cs Are Not Met
Few businesses will have perfect credit checks because credit bureaus set the bar exceedingly high. For instance, business credit scores typically range from 1 to 100. The closer the business lands to 100, the more likely it is to pay in full and on time. In D&B’s PAYDEX model, which assigns businesses a score between 1 and 100, the top score a company can receive is an 80 unless they pay their invoices early.
Each aspect of the five Cs influences creditworthiness in a similar way. The more solid a business is in an area, the more likely they are to pay your invoice in a timely manner. Similarly, weaker results signify the business may be more likely to have trouble paying, either because they haven’t established good financial habits or haven’t had enough time to demonstrate that they do follow strong practices.
This is not to say that creditworthiness predicts payments with certainty. It’s merely a risk assessment, not a guarantee the customer will or will not pay.
Once You Extend Payment Terms, Customer Payment Risk Becomes Your Cash Flow Risk
It’s often said that cash flow is the lifeblood of a business. While many focus on profitability, those profits can’t keep the lights on until the money actually hits your bank account. Cash flow reflects that timing. It’s the money flowing in and out of your business. To stay afloat, your inflows must outpace your outflows. Because your receivables are likely your greatest source of inflows, anything that impacts the speed and likelihood of payment impacts your cash flow. Customer creditworthiness, therefore, is also a key predictor of cash flow risk.
Late Payments Leave Revenue Trapped in Accounts Receivable
Only 52 percent of B2B invoices are paid on time, Atradius data shows. While late payment consequences affect the debtor in terms of penalties and fees, they also leave you covering payroll, supplier bills, and overhead while cash from completed sales remains tied up in receivables.
Defaults Turn Expected Revenue into Bad Debt
Five percent of invoices are written off as bad debt, per Atradius. That means the expected cash never reaches the business. While the obvious cost here is the lost payment, it’s important to note that you’ve already absorbed the costs behind the sale. Replacing these losses requires additional sales.
Unpredictable Payments and Payment Delays in Business Make Cash Flow Harder to Forecast
Even when customers eventually pay, inconsistent timing makes it harder to know whether enough cash will be available when bills come due. Payment uncertainty weakens your financial forecasts and may force you to keep more cash in reserve or arrange backup funding.
Customer Concentration Magnifies Credit Risk
When a single customer or small group of customers accounts for a large share of your receivables, a single late payment impacts your business even more.
Receivables Quality Can Affect Financing Access
At a minimum, most lenders will review your accounts receivable data as a whole. They’re looking for signs that your inflows are predictable, steady, and sufficiently cover your outflows. Some will take this a step further and look into the creditworthiness of individual customers. This is more common when you’re applying for asset-based lending or accounts receivable financing, such as invoice financing or invoice factoring.
However, the symptoms of inadequate customer creditworthiness will likely show up in other areas that lenders pick up on. For instance, if your customers aren’t paying on time, it will likely affect your ability to cover your own expenses and pay on time. That means your credit score can plummet and your access to funding may be limited as a result.
Your Receivables Can Show You When Customer Credit Risk is Rising
After you extend terms, your receivables become a running record of how customers handle credit. Review them regularly to identify patterns that suggest payment risk is rising.
Rising DSO Shows That Customers Are Taking Longer to Pay
Days sales outstanding (DSO) tells you how long it takes, on average, to collect payment after a sale. If it rises while your terms remain steady, customers are holding your cash longer and increasing the amount tied up in receivables.
Aging Reports Highlight Increasing Invoice Risk
An aging report shows how long each invoice has been outstanding. A growing share of balances in older aging buckets means payments are slipping and the risk of bad debt is rising.
Customer-Level Trends Can Hide Behind Overall Averages
Company-wide DSO can remain steady even as an important customer starts paying more slowly because faster payments elsewhere offset the change. Review average payment times and customer aging to identify which accounts pose the greatest risk.
Changes in Payment Behavior Are an Early Warning Sign
Issues often appear in payment behavior before it reaches a credit report. Repeated requests for more time, broken payment promises, partial payments, and growing disputes may indicate that a customer is struggling.
Customers Approaching Their Credit Limits Increase Your Risk
A customer who repeatedly approaches or exceeds its credit limit is using credit faster than it pays down the balance. Each additional sale increases the amount of cash your business has at risk.
Leverage Proactive Credit Controls and Other Credit Risk Management Strategies to Protect Cash Flow Before Payment Problems Begin
The best time to protect your cash flow is before problems begin. Consider implementing credit control measures proactively.
Check Credit Before Offering Payment Terms
Before you extend terms, pull a business credit report and look for patterns in how the customer handles its obligations. Trade references, public records, and financial statements can provide more context when the balance would be large enough to hurt your business if it went unpaid.
Set Credit Limit Policies Based on Customer Risk
Even customers with good credit should have a cap on how much they can owe at once. Base it on their financial strength, expected order volume, payment history, and how much of a delayed balance your business can afford to carry. Review the account before approving any sale that would push it over the limit.
Match Customer Credit Terms and Conditions to the Level of Risk
Creditworthiness should also shape the terms themselves. New or higher-risk customers may need to pay a deposit, accept shorter terms, or begin with smaller orders. Customers who consistently pay as agreed may earn more flexibility over time.
Monitor Customer Credit After Approval
Approval reflects what you know about the customer at that moment. Schedule periodic reviews and take another look whenever your DSO, aging reports, or the customer’s payment behavior show signs of trouble. If the risk rises, adjust their limit or terms before the balance grows.
Use Proven Invoice Collection Strategies
Send invoices promptly, check them for errors, confirm they reached the right person, and follow up on a consistent schedule. When a customer misses a deadline, move to the next collection step immediately.
Reduce Dependence on Individual Customers
A customer with excellent credit can still face a sudden cash crunch, leadership change, legal problem, or market downturn. If too much of your revenue and receivables comes from that account, their problem quickly becomes yours. Track how much is tied to each customer and work toward a broader customer mix when one begins carrying too much weight.
Turn Creditworthy Receivables into Working Capital with Invoice Factoring
Invoice factoring is typically viewed as an alternative to business loans and lines of credit, but it can help solve some of the biggest challenges companies have with customer credit and cash flow because of the unique way it works.
Get Immediate Payment on B2B Receivables
With factoring, you sell your unpaid business-to-business (B2B) invoices to a factoring company, also known as a factor. The factor provides you with most of the invoice’s value right away, then waits for payment from your customer. You receive the remaining balance minus your factoring fee when the customer pays. This not only eliminates the wait for customer payments but frees you from collections on factored invoices.
Improve Your Credit Controls
Before you’re approved for factoring, the factor will evaluate the creditworthiness of your customers and share details about how much credit can be safely extended without exposing your business to unnecessary risk. While you can still generally work with customers whose invoices don’t qualify for factoring, following the factor’s guidance on credit will help protect your cash flow and business.
Reduce Bad Debt
By following the factor’s guidance on credit, you’ll likely reduce or eliminate bad debt. However, some businesses or industries fit into a higher risk category. If you still have concerns about bad debt, ask your factor about non-recourse factoring. In a non-recourse factoring agreement, your factor assumes the risk of non-payment in specific situations, such as if your customer becomes insolvent.
Reduce Customer Credit Impact on Cash Flow with Viva Capital
Whether you’re specifically trying to minimize customer credit impact on cash flow or just want to improve your cash flow as a whole, we can help. You can be approved in as little as eight hours and qualify for same-day funding to ensure your cash flow keeps pace with your work. To learn more or get started, request a complimentary rate quote.
