A Demand Letter is a strongly-worded reminder to the person you are collecting payment from that you are taking things seriously. A demand letter formally establishes that you are seeking payment - and if necessary - that you will take legal action to secure that payment.
If you intend to file a lawsuit or a Small Claims action against the person that owes you money, most Courts will want to see that you attempted to resolve the matter with a demand letter. Often times the powerful punch that this letter packs will push the debtor into finally paying you what you are owed.