What is a Credit Policy (and What Should be In It)?
Are you thinking about offering credit to your small business customers? There are pros and cons to extending trade credit.
With trade credit, customers purchase products or services and receive a bill sometime later or with a due date in the future. Because customers don’t have to pay at the point of sale, they may spend more. Also, extending credit can keep you competitive and grow your customer base.
Although credit can encourage spending, it can cost your business. Your customers might not pay, leaving you with slow cash flow and bad debts.
Developing, refining, and enforcing a robust credit policy will help reduce exposure to customers who can’t pay on time.
What is a Credit Policy?
A Credit Policy is a set of guidelines and rules that clearly lays out the business’s philosophy on extending terms to customers and collecting overdue accounts. It’s a document which specifies operating “standard” models for all stakeholders while providing rules for exceptions.
A good policy outlines the procedures for evaluating a customer’s creditworthiness, for extending credit to customers that are most likely to pay their bills on time and for establishing purchasing limits based on a customer’s credit history and ability to pay.
When adhered to by all employees, a credit policy helps minimise a company’s risk of not receiving the cash from a sale made on credit.
An effective credit policy is directly tied to the goals of your business and the amount of risk your business is comfortable incurring.
Why have a Credit Policy?
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, has little regard for the solvency of its potential buyer. However, the Finance team cares more about the risk to cash flow and the bottom line that would be caused by granting credit to an insolvent client.
Having a written credit policy ensures that there is less subjectivity and streamlines credit decisions.
What should be in Your Credit Policy?
Since an effective credit policy isn’t a one-size-fits-all proposition, it must be tailored to the individual business. Depending on the size and type of the business some or all of the following should be included in your Credit Policy.
Purpose, Function & Scope
This is where you define the objectives of the credit policy and Credit Management and the scope of the responsibilities contained in the policy.
Credit Application and Assessment
Define the steps for setting up a new customer for credit sales, including how you will assess creditworthiness.
Be very clear on the criteria for acceptance of an application for trade credit.
Also, define the frequency and method you will use for monitoring the creditworthiness for existing customers. Are there any triggers that would prompt a review, such as a sharp increase in the size of orders?
How will you set credit limits? Will all new customers have the same credit limit? Or will you work on an individual basis determining their limit based on financial information and risk ratings?
As more people become involved in the business you need to be clear about who has the authority to make specific decisions, such as writing off debt, granting of credit limits, issuing refunds, or granting a credit account to a customer who didn’t meet the minimum requirements.
This makes sure that these decisions are controlled and monitored.
In larger organisation you may have a hierarchy of authorities such as:
- Below £100 – Credit Controller
- Up to £1,000 – Credit Team Leader
- Up to £5,000 – Credit Manager
- Up to £10,000 – Finance Director
- Over £10,000 –Managing Director
How will you set payment terms? Will there be consequences for late payment? Do you offer discounts for early payment? Will you put accounts on stop?
Terms and Conditions of Sale
Who should be involved in the negotiation of Terms? If the customer wants to deviate from your standard terms who has the authority to agree to changes?
Order Acceptance, Stops and Release of Suspended Orders
Define the parameters for accepting or suspending an order from an existing customer? Does your software allow you to put accounts on stop and automatically suspend orders for stopped accounts, or accounts that have reached their credit limit? If it’s a manual process, who is responsible for it?
Who is responsible for monitoring suspended orders and realising them when circumstances change, and who has the authority to release orders without the reason for the suspension being resolved?
Collections Performance and Targets
What are the Key Performance Indicators (KPIs) and targets you will use to monitor the effectiveness and performance of your credit control efforts?
Common KPIs are:
- Days Sales Outstanding (DSO) = average time it takes from invoicing to payment.
- Bad Debt = usually measured as a percentage of revenue in a given period
- Debt in Dispute = value of debt in dispute or query which is being delayed for payment by customers
Outline the methods that will be taken to collect outstanding debt.
We all know about using the phone and email in credit control, but what about SMS or face to face collections? Do you have a series of escalation letters, if so, what are the trigger points for their use?
What role do other departments, such as the sales team play in the collection process?
Do you have an internal escalation process?
Also include all methods of payment accepted by the company and the which one is preferred.
Each query type should have an owner, be it a person or department, that is responsible for its resolution and the policy should document the service levels for resolution.
Debt Recovery and Bad Debt Write Off
This is where you decide what you will do when you’ve exhausted all your credit control efforts. Do you send to a debt collector or use the online small claims court? Is there a minimum value that you would pursue in this way?
If you chose not to pursue it who can authorise the debt to be written off? You don’t want just anyone in the business deciding a debt is uncollectable. Every write-off is a direct hit to the bottom line!
Refusal/Withdrawal of Credit
This is quite an emotive subject and some in the business, and the customer, are likely to disagree with your decision.
You should outline how, and to whom, you would communicate your refusal or withdrawal of credit, based on your criteria outlined in the rest of the policy.
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.
If you’d like to know more about how a credit policy could benefit your business, then why not book a call.