Having a clear, thorough, and enforceable credit policy is critical for businesses that extend trade credit to their customers. It delineates who you’ll extend credit to, under what terms, and describes your process for collecting on delinquent accounts.
It’s intended to offer guidance to your credit department when faced with difficult decisions. It also standardizes credit practices so that both your staff and your customers know what to expect when credit is extended. A well-written policy that aligns with an organization’s mission will lead to fewer bad debts and increased profitability. This article provides tips on writing a credit policy that balances your needs with your customers’ needs.
A well-structured credit policy is crucial for managing your company’s accounts receivable, controlling credit risk, and maintaining a healthy cash flow. Here are some key steps to create an effective credit policy:
- Establish Clear Objectives: Your policy should start with clear objectives that align with your company’s overall goals. For instance, the policy might aim to minimize bad debt, maintain healthy cash flow, increase sales, or attract new customers.
- Define Your Credit Assessment Criteria: Your policy should outline the criteria used to assess a customer’s creditworthiness. This can include credit score, payment history, financial stability, years in business, and industry risk. Consider using a third-party credit reporting agency for this step.
- Set Credit Limits: Based on the credit assessment, set a credit limit for each customer. The limit might vary based on the customer’s creditworthiness and your company’s risk tolerance. A higher risk might justify a lower credit limit, or terms requiring more frequent payments.
- Outline Payment Terms: Specify your standard payment terms, such as net 30 or net 60 days, and whether you offer discounts for early payment. Also, detail any late payment penalties or interest charges.
- Establish a Credit Approval Process: Outline who has the authority to approve credit and the process they should follow. This might involve a credit manager for larger accounts and salespeople for smaller, less risky accounts.
- Detail Collection Procedures: Your policy should detail the steps to be taken if a customer does not pay on time. This can include reminder notices, phone calls, or escalation to a collections agency. Be clear about when each step should be taken.
- Monitor and Review: Regularly review customer payment performance and adjust their credit terms or limit as needed. Also, review and update your credit policy periodically to ensure it remains effective and aligned with your business goals.
- Document Everything: Be sure to document everything in writing and make sure all relevant employees understand the policy. This ensures consistency in your company’s approach to credit management.
Remember, a credit policy is not a one-size-fits-all document. It should be tailored to your company’s specific needs, risk tolerance, and industry characteristics. Be prepared to update it as your company grows and changes.
Quantify Your Comfort With Risk
Any time a company extends credit, they’re taking on some degree of risk. When setting your credit policies you need to determine how risk-averse you are. The less comfortable you are with it, the more conservative your credit policies should be.
Companies with a low tolerance for risk will establish firm guidelines for who qualifies for credit and who doesn’t, while more aggressive organizations may only restrict a limited subset of customers and establish far less rigid guidelines.
How Competitive Is Your Industry?
Businesses that operate within highly competitive industries may not be able to dictate stringent credit policies to their customers without losing them to competitors. It’s simply too easy for them to find another provider that’s more liberal with their payment terms.
Consider this when establishing your terms. You need to look out for your interests, but you also don’t want to set credit qualification requirements or payment terms that are too strict. Businesses with fewer direct competitors have more latitude to develop more favorable credit policies.
B2B Businesses Should Always Run Credit Checks on New Customers
Businesses that deal directly with consumers generally won’t require this step unless they’re engaging in high-dollar contracts. Businesses that deal with other businesses should always run a check to determine the credit-worthiness of new customers.
Normally this starts with a credit application and should include bank references, trade references, and other qualifying information. Your credit policy should then list specific metrics by which applicants are judged, and the terms you’re willing to apply to each risk category.
Consider Requiring Personal Guarantees From Questionable Credit Risks
Your policy should describe alternative ways that customers can pay when they fail to satisfy your credit requirements. This might include paying half up front, or some other arrangement that helps ensure at least partial payment.
You can also consider having the owner of the company sign a personal guarantee letter. This is a legal document that stipulates that the owner agrees to be personally liable for any debts that his or her company fails to pay. This supplies you with an extra collection avenue in the event that you need it.
Set Credit Limits Based on Your Cash Flow Needs and Your Customer’s Risk Category
Just because a customer qualifies doesn’t mean you should extend them unlimited credit. It’s wise to set limits and describe remedies when these terms are exceeded. As an example, when credit required is too high you may ask a certain percentage to be paid in advance.
These limits can and should be based on the customer’s performance during your credit check. Limits can be higher for customers with stellar credit histories, and lower for those with more problematic pasts.
Be Absolutely Clear When Defining Your Terms
A sound credit policy should never be vague or ambiguous. Payment terms should be spelled out precisely, describing exactly how long customers have to pay, and the steps that will be taken if this deadline is missed.
This may seem overly legalistic, but your credit policy exists to help you avoid bad debts that can cause major problems for your business. You can’t afford to be “nice”. But in reality, your customer will appreciate the clarity. Most don’t want to wind up delinquent and will be interested in your expectations for them.
Decide Whether You Want to Reward Early Payments or Penalize Delinquency
It’s sometimes useful to offer a carrot, in the form of a small discount, for early payments. This can entice customers to satisfy their bills sooner than they would otherwise. This can help with cash flow. However, if your customers tend to pay on time, be certain that you aren’t discounting bills without a good reason.
For delinquent customers, a late payment penalty may be the motivation they need to get up to date, lest their bill continues to rise. However, depending on your industry this may chase off prospective customers. If you choose to include a penalty, don’t make it so onerous that the threat is enough to cause business losses.
Be Sure to Control Your Disputes Procedure
It’s good to include a specific process for resolving disputes. By including this in a signed credit agreement, you gain the ability to dictate resolution terms, even if it is your customer that is raises the dispute. This can help you avoid costly litigation by requiring mediation, or other less combative measures.
Consider Steps For Collecting Past Due Accounts
It’s inevitable that some percentage of your customers won’t pay, or will pay considerably later than you’re willing to entertain. Your credit policy must contain guidelines for your credit department on processes for collecting on these debts.
This policy should include deadlines, in terms of the number of days after delinquency, for each enforceable collection action. This may include reminder letters, phone calls, and eventually referring the account to a collection agency. This isn’t a step to take lightly, so be sure your credit policy spells out all the ways you and your customers can avoid it.