How to Write a Credit Policy
A business must make sales.
It must also protect its profits and continuity by avoiding overdue and bad debts.
Some businesses can make enough sales without offering credit terms, but immediate payment is not an option for most.
Offering credit terms to customers encourages sales, or at least the absence of the availability of credit will encourage potential customers to select an alternative supplier offering more favourable credit terms.
You may not realise it, but credit terms are part of your business’s marketing policy. If your trade or industry has adopted a common practice, you may want to follow it.
But offering credit terms comes with risks.
Allowing too much credit or not managing the credit carefully enough could result in irrecoverable debts. Bad debts are a direct loss of profit and can have a serious impact on your cash flow.
How do you manage the granting, monitoring and control of credit terms?
Your Credit Policy
Effectively managing accounts receivable is about ensuring consistency in your credit and collection processes. The secret to this consistency is designing and actively implementing a credit policy.
Your credit policy is the set of rules and guidelines that lays out your business’s philosophy on extending terms to your customers and collecting overdue accounts. It’s a document which specifies operating “standard” models for all employees while providing rules and a process for exceptions.
It will outline your procedures for:
- Evaluating a customer’s creditworthiness, extending credit to customers who are most likely to pay their bills on time
- Establishing purchasing limits based on a customer’s credit history and ability to pay
- How and when you will manage the late-paying customers that will inevitably happen
A small business may be able to function with a “credit policy” kept solely in the head of a few people or even one person. But having a written policy ensures that there is less subjectivity and streamlines credit decisions.
Having a written credit policy that is widely shared and understood limits the internal conflicts that inevitably appear when the personal interests of the people involved differ from each other.
For example, the sales team focused on making the sale doesn’t consider the solvency of its potential buyer. However, the Finance team cares more about the risk to cash flow and the bottom line caused by granting credit to an insolvent client.
Factors That Will Influence Your Credit Policy
The end goal of all credit policies is to maximise your revenue while minimising the risk generated by extending credit. There’s no one-size-fits-all credit policy. It must be tailored to your unique business.
It will be primarily influenced by two conflicting objectives: liquidity and profitability.
Liquidity can be directly linked to your accounts receivables and cash flow, so to improve liquidity, you reduce your credit terms and restrict to whom you offer credit.
Profitability can be linked to sales volumes, though you can be making lots of sales and still not be profitable, but that’s a conversation for another time.
To increase sales, you can offer longer credit terms or be less picky about whom you offer credit terms. The easier it is for your customers to get credit from you, the more customers can purchase, and sales go up.
However, making credit too easy to obtain can result in more failures to pay as more of your customers default on their obligations, impacting your liquidity.
The trick is finding the right balance for your business between being very restrictive and risk-averse and growing sales whilst accepting a greater level of risk.
For each business, the risk appetite will be different and depend a lot on your reserves and margins. How much can you afford to lose in relation to the extra sales you could make with a more risk-tolerant approach?
Other factors that will determine the extent and content of your credit policy will be:
- The size of your business
- The specific cash flow needs of your business, including any seasonality
- Your sector or industry
- The overall economic climate
What to Include in Your Credit Policy
Depending on the size and type of the business, some or all of the following should be included in your Credit Policy.
- The purpose of the policy – what are you trying to accomplish?
- The scope of the credit policy – some policies will cover suppliers too
- Specify who can extend credit, write off debt, put accounts on hold or even break the rules!
- How you will evaluate the creditworthiness of new customers and re-evaluate that of current customers
- Credit Limits
- Payment Terms
- Terms and Conditions of sale
- Collections procedures
- Collections performance and targets
- Disputes procedures
- Credit holds and releases
- Payment plans
- Write-offs and bad debt management
- Third-party collections
- Legal Action
- Refusal/withdrawal of credit
Whilst the policy summarises the key points, the detail should be captured in written processes (the what) and procedures (the how). You may have several processes or procedures for each section, depending on the complexity of your business.
When you’re writing a new draft or updating the current credit policy, keep these tips in mind:
- Don’t keep it confidential. Everyone in your business should know how you’re going to manage credit sales.
- Don’t make the policy so strict so you have opportunities to adjust the credit decision-making process later.
- Don’t make the policy too broad and/or open to interpretation. This might cause conflicting interpretations by department members or other stakeholders.
A credit policy is not a static document which gathers dust on a shelf on a shared drive somewhere. It should be an operational document that evolves with your business and should be reviewed at least annually.
Not sure where to start, or don’t think you have the time for it? Why not book a call with Nicki to see if we can help?