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Take a knife to your bad debts

01 Dec 06

From architects to plumbers, small resellers to major vendors and distributors, there is one crucial factor common to the success of any business. The transaction.

Despite the innovative payment options, partnerships and credit plans designed to smooth the path of trade, the wheels of business cannot turn unless there is a consistent exchange of money and goods, hence the old cliche ‘money makes the world go round’.
Obvious as this may sound, it’s not so easy to achieve, with many businesses falling into debt or bad credit with customers.
The problem is particularly rife among SMEs, where a combination of little or no financial management skills and a lack of resources leads businesses down the slippery path of debt.
“If you look at the SME sector, a lot of people go into business because they are really good with technology, or mechanics, or whatever trade they are in, but there is a whole set of other skills that their business needs as well”, says Michael Barnett, Auckland Chamber of Commerce CEO.
As well as a lack of skills, another major cause of small businesses running into debt is that they are under-resourced from the outset, says Barnett.
“It’s the old Kiwi attitude of running a business on the smell of an oily rag. Many small businesses are financially over-committed and don’t have the funds to pay for unexpected costs, like a month’s advance on their premises.”
The consequences of being in debt before a business has got off the ground are serious. Without enough cash it cannot afford stock or initial marketing costs, which in turn leave its reputation damaged.
Whatever the sector large amounts of money left unpaid between different players within it has a ripple effect throughout.
Large creditors or suppliers respond by tightening their payment and credit-checking processes, middle men are forced to hike up their prices, leaving end users worse off.
Thin margins in the IT industry make this sector particularly vulnerable to financial troubles, highlighting the importance of having a strong business plan and financial processes in the first place, says Geoff Cossey, managing director of CRM and anti-virus software specialist Chillisoft.
Chillisoft works with 500 to 600 resellers. A number of them manage credit efficiently and a number less efficiently or not at all, says Cossey.
The business has seen more bad debt in the last 12 months than it has in any other period, mostly because of an increase in the number of customers it deals with.
Although outstanding debt to the business as a percentage of total sales has not increased in the last few years, this year Chillisoft has refined its credit management processes to mitigate any future risk.
“The IT sector is no different to any other business-to-business or business-to-consumer trading in terms of the things you need for good credit management”, says Cossey, a former banker.
“It starts with clearly communicating your terms of trade with your customer.”
Terms of trade must be set out in a written contract which has to be agreed to by both parties before any trading begins.
Resellers should have similar terms of trade in place with their customers too, adds Cossey, and they need to have adequate cash flow to run the business and not rely on suppliers as a form of credit.
“Creditors should not be banks”, he says. “In business you need to have finance independent of your creditors. Similarly if you’re a reseller who has provided a product to a customer and you haven’t adequately explained what the product does so the customer doesn’t end up buying it, the reseller has to take responsibility for that too.”
Chillisoft’s trade agreements and credit management processes cover when an account is due and what will happen if the customer does not pay on time.
The Auckland Chamber of Commerce also recommends that businesses have clear processes in place to manage the risk of debt as part of a wider business plan.
“The two biggest reasons why small businesses run into financial trouble are lack of adequate resources to start the business and not having a clear plan, so they end up doing things in an ad hoc way”, says Barnett.
“They need to have clear goals for the first six months or year of the business and this includes looking at the skills, such as financial management skills, that your staff have and acquiring those if you don’t have them.
“If you have a plan you will be able to set out a cash flow against that and this will be the bible of how you run your business. If you’re going to your bank manager he or she will want to see your plan, so will suppliers and others your business deals with. It’s something that provides others with confidence that your business is in control, and once you have got your plan, you can put in place the right policies and processes your business will operate by and you must stick to them. In any areas where the policy isn’t clearly stated or enforced you leave yourself open to being mistreated”.
While Chillisoft’s bad debt risk is relatively low, with no single debt worth more than one or two per cent of the total outstanding, businesses with fewer clients, with debts concentrated on one or two debtors have a different risk profile, and this should be considered when systems and processes are being put in place, says Cossey.
He adds, “It also depends on what you’re selling. If the things you sell are not worth what you paid for them if you have to repossess them then sell them again, you need to bear that in mind. In IT margins are so slim on hardware that a customer could probably buy a brand new item for not a lot more than the one you have had to repossess and resell.”
Barnett and Cossey agree that a key everyday risk-management process for any business is carrying out credit checks on potential customers before an account is opened.
Although they are ones least likely to afford it, this is most important for younger SME businesses that, unlike their larger well established counterparts, are so desperate to trade they are less likely to be picky about who they trade with.
In recognition of this business solutions provider MYOB has teamed up with CreditWorks, a specialist credit-referencing bureau for trades, to launch a new tool allowing companies to check the credit-worthiness of their clients.
MYOB general manager, Peter Bramley, says, “Bad debt is a big vulnerability for small businesses. It’s easy for them to start working with a particular merchant with no confidence that person does not already owe someone else money, or went into receivership a few months ago and is now operating under a new name.”
While CreditWorks was previously used mostly by large businesses the partnership with MYOB now makes the service available to smaller and medium-sized businesses.
With credit agencies being a major risk-management tool for businesses it’s important that companies themselves report bad debtors to such agencies, says Cossey.
“At Chillisoft we report people to credit agencies if the situation has got bad enough, but the point at which we do this is clearly set out in the terms of trade, and people are warned directly before it happens”, he says.
However it is not all doom and gloom for businesses struggling to make a payment or going through a rough patch.
Keeping the lines of communication open is the best way to manage the situation and buy a company time to solve it, says Cossey.
“We get customers from time to time who may have a short term problem and can’t make a particular payment. When that customer has communicated this to us and informed us of what’s going and when we will get the payment we feel more relaxed about it and trust them more.
“It’s when they miss a payment and don’t let you know what’s going on, then rely on you to chase them up that alarm bells start ringing. We give clients the benefit of the doubt once or twice, but after that the trust in that relationship may be damaged.”
Chillisoft’s credit management processes are so robust that every email that is not replied to and every phone call that is not returned by a client with an overdue payment is logged, enabling the company to build strong customer profiles, on which it bases its trading terms.
Many small businesses may not realise that larger suppliers, banks and other agencies keep such complex file notes and that not being upfront about financial difficulties can be seriously detrimental to the business in the long term.
Whether its clearly explaining what products do in the sales process, clarifying terms of trade, dealing with financial backers, trading with suppliers or speaking to staff, good communication is crucial to maximising the profits of any business.

By setting their own standards of communication high, companies in the IT sector of all sizes help to forge the accepted general industry standards that make doing business easier and less risky for everyone.

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