Types of Credit

Credit is always a risky business. Think about it--pay just a little bit, and you get the whole thing up front! Fortunately for business, most of us are honest, punctual people--and for those who are not, there are clearly consequences.

In business today, there are three types of credit which can be used in varying ways by varying types and sizes of businesses. For small businesses, an open account form of sales credit may be the best route for companies to take in the world of credit.

Open accounts are simple accounts based on individual purchases. Credit reviews are not necessary, though always recommended, and the terms of payment are largely customizable. In essence, the buyer will receive a discount for early payment (2% if paid within 10 days) and will be held to a final due date (30 days). These terms are typically worded like "2/10 net 30." Benefits of this credit form is the ease to which it can be monitored in a business, and its terms encourage customers to receive the discounts. Problems can occur if customers pay enough to receive discounts but do not pay the balance within the due date. Businesses must have a game plan to deal with latent customers and stand firm by it--whether punishment may be simply a stern warning or something more serious. Discounts can also be a serious drain on gross margins--and businesses must ensure that this potential loss of profit will become a problem in the future. However, if payment is received quicker thanks to the discounts, it very well may be worth it.

Whereas small businesses may be just fine with their open accounts, larger businesses may wish to increase sales by offering more extended forms of credit. Revolving accounts allow customers to pay percentages of the total sale or minimum payments (10% or $25.00, for example) for a period of time defined by the business (generally multiple months). This helps break up large sales, making it easier for customers to afford the item in question from paycheck to paycheck. Revolving accounts may work wonders for sales (especially if profit can be made from the interest on these accounts), but small businesses should shy away from the subsequent large investment of time and money in developing a formal credit policy and hiring a competent accounting/credit department. Contracts must be signed and enforced, interest must be charged for delinquents, and collections will have to be made one way or the other.

The last type of credit, the installment account, is generally used for large purchases and centers around the use of the signed contract. The contract (reviewed and approved by an attorney), spells our percentages for down payments, completion payments, security agreements (collateral), and even financing charges. These contracts can run from months to years, and contracts imply that court action can be taken should customers default on their contracts. Again, this credit form requires collection and credit departments and contracts should never be taken lightly--always use an attorney. Like revolving accounts, interest can make these accounts profitable given sufficient volume. Those who do not have the volume or sales large enough to warrant installment accounts should steer clear.