Tuesday, November 2, 2010

How to Keep Credit from Killing You

In the last article we discussed how businesses finance operations by borrowing, and why offering terms can have unforeseen consequences.  In this article we’ll look at an extremely high hidden cost and how to combat it.

Impact of Delinquencies

I apologize.  I'm about to scare you.  It's very likely that after reading this post, you'll never look at debt the same way again.  You'll start operating a cash business going forward.  And you won't personally lend money as freely.  But that's not bad.  The way we typically account for debt shields us from the full impact.

When you grant credit to a customer, you either borrow from your savings or a third party to cover it.  And until they repay you, you lose the use of that money.  If you use your savings, you'll lose the interest you would normally earn.  If you borrow, you pay interest to a bank.  Most of us don't consider the impact of a default because we expect to be repaid.
What happens if they stiff you?

Can't you simply write off a bad debt?  

When you "write off" bad debt, you don't get the money back.  You're only removing profit retroactively. You won't view it on your financial reports and you won't pay tax on the income you never received.  But you still borrowed to lend your client money.  And your cash flow covers the interest on your debt until repaid.  If you're stiffed, that's forever.  

As we touched on in the last column of this series, the highest rate on all your open credit lines is the rate at which you pay interest. Why?  Because you assume that when your client pays you, you'll then pay down your highest rate loan.  If they don't, you continue to carry the debt.  Putting this together we can see that you pay interest on delinquencies forever at your highest rate.

“Okay,” I hear you grumble.  “I know that sometimes I finance my customer's purchases.  And I didn’t consider I was paying interest on delinquencies indefinitely.  And I didn't see until now that I was borrowing at my highest interest rate.  But my customers usually pay within a month or so, and only a few default.  Are a few bad clients costing me so much?”


The answer is a resounding yes!  Over time the amount can cripple your cash flow.  Let's look at an example.

Was Einstein Smart?

The famous physicist Albert Einstein claimed compound interest was the most powerful force in the universe*.  It’s truly horrifying for a borrower to see compounding turn a small loan into a veritable fortune over time.  Compounding adds interest onto the interest onto the interest… all the way back to the transaction date.
 

Say you borrow $1000 to extend terms to your client and they default.  I'll show the math below, but if you use a business line of credit with an average interest rate you'll lose $180 of net profit your first year.  After five years, $400.  After ten years, $940.  After twenty the profit you lose grows to nearly $5000, five times the amount of the original credit!  And the balance grows even larger and more quickly as the rate increases.

All this expense for extending a single customer who never paid you.  Imagine if you had a lot of bad debts.

One way or another, you're paying ballooning interest on each bad debt every year.  If you use debt, you're carrying more than you need to.  If you're debt-free, you've lost the compound interest on that money.  By granting credit you either decrease assets or increase liabilities.  The net result is the same: a substantial and ever-increasing drain on profit.  All because you extended credit, maybe years ago.  

You can how see even a few delinquencies can become prohibitively costly after several years.  If you are careless in extending credit, you can end up in a huge hole.

Want more proof?  Use the equation below to calculate the amount of money a family business could lose after generations of being stiffed only a small amount at the beginning of its history.  A terrific primer on compound interest is The Skinny On Credit Cards.

The Mathness Behind the Method

Expressed algebraically, the formula for compound interest is C(1 + r)t where C is the original Cost, r is the interest rate, and t is the number of times the interest compounds.  As the number of years shown by the exponent t, and the interest rate r increases, the result grows very large.

In our example, we used a rate of 18%.  The interest is 18% of the balance of the debtSo using the formula above the balance of $1000 debt after 5 years is: 1000 * (1.18)5 = $2287. In year six you pay interest on $2287.  At 18% cost of capital, that's $411.66.   After ten years, the balance quintuples to $5234 and 18% interest is $942.12.  After twenty years the balance increases to a whopping $27,339, and the interest is $4921.

The Bottom Line

Especially in the beginning of a business you must be miserly about extending credit.  Even better, don't do it at all.   There are times you need to offer credit; for instance, when it's expected or you're trying to compete.  But make credit the exception, not the rule.

Next time I'll discuss a way to prevent bad debt while keeping your customers happy.  In one of the next columns I’ll examine another hidden cost that can be extremely expensive and how to avoid it.  And later we’ll discuss how to flip around this equation so that you start making money on financing cost, not losing it.  It’s all next week so keep your eyes glued.  Until then,

profitable business All!

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