Tips for Establishing a Credit Policy That Works
Developing and enforcing a business credit policy for your internal and external partners, such as customers and colleagues, is an essential risk management practice to protect your company from doing business with customers that can’t meet trade payment obligations on time – if at all.
A business credit policy outlines the credit department’s clearly stated governing principles involving trade credit. An effective credit policy should align your corporate goals with business procedures and help your company reduce bad debt and write-offs. It should also serve to strengthen your company’s payment cycles and lead to increased profitability. It needs to be updated periodically – ideally, once a year, reflecting new processes for credit and collections as tolerance for risk shifts across the portfolio.
The truth is, however, that not all companies even have their policies written down. Credit policies can be “institutional knowledge” at some organizations – seasoned credit professionals seem to intrinsically know the company’s appetite for risk, such that the best process to apply toward any account seems to come forward naturally. Yet newer team members in the credit department and salespeople may in the dark when it comes to how they should handle requests for extended terms, for example. When it comes to the credit policy, there should be no gray areas that lead to misunderstandings or miscommunications with colleagues or customers.
How to Develop a Business Credit Policy
Developing, refining, and enforcing a sound credit policy will help reduce exposure to customers who can’t pay on time or in terms. The Credit Research Foundation famously established the following six critical questions for developing a credit policy. How these questions are answered lays the foundation for the kind of credit policy that will be most beneficial to your company.
- What is your mission?
- What are your goals?
- Who has specific credit responsibilities?
- How is credit evaluated?
- How are collections handled?
- What are your terms of sale?
1. What is your mission?
Here the CRF is asking, “What’s the credit department’s purpose?” Consider your answer to be a statement of what you do and why you do it. It can be general or specific, but make sure it aligns with the corporate-level mission statement. An example: “The credit department defines the requirements for establishing trade credit for new customers and maintaining credit lines and limits for active accounts and returning customers with appropriate payment terms. The credit department also strives to offer optional payment methods to facilitate sales to customers with sub-optimal credit histories.”
2. What are your goals?
Simply stated, this is a quantifiable and measurable goal for your organization. How do you help ensure your company is paid and optimizes cash flow? This is a projection and a plan of what you will seek to accomplish with a healthy portfolio of accounts. Perhaps you aim to keep the percentage of past due accounts below a certain figure, or maybe you automatically approve credit requests for a certain amount when the account passes scorecard checks. More definitive goals, such as “reduce DSO by X%,” may necessitate more frequent revisions to the credit policy – but then, more definitive goals may be the most effective form of communication across the enterprise to mitigate risk. Again, the credit department’s goals need to align with the company’s overall goals and will likely need to be adapted or modified as changes to economic conditions and the competitive landscape occur.
3. Who has specific credit responsibilities?
Roles and responsibilities should be clearly defined to maintain order and enable team members to feel empowered, not diminished. Do salespeople try to escalate questionable credit requests? Does your colleague in accounts payable frequently ask for your team members’ help at the end of the quarter? Are your credit managers also responsible for collections? Being clear here can result in reduced redundancy and increased efficiency. For example, you could dictate that credit managers are solely responsible for assessments and approvals, in order to minimize collections and align with corporate financial goals (e.g., a “pre-check” from sales won’t expedite the order). If having salespeople involve themselves in the credit application process has caused problems in the past, you may want to require that only members of the credit department are authorized to communicate with applicants concerning their status and subsequent terms.
4. How is credit evaluated?
It’s safe to say that organizations will issue trade credit to applicants who have a history of paying on time and who share financial data that shows they can continue to pay on time. But if an applicant shows below-average risk scores from a third-party credit data provider or is unable to provide trade references or financial statements – is that a deal-breaker for your company? A company that has filed for bankruptcy may not be offered standard trade credit, but what about debtor-in-possession financing? Many organizations are also using credit scorecards (scoring models) to evaluate high-volume applicants at scale. Should applicants fail the scorecard’s criteria, what is the re-decisioning process? Here you determine what is or is not acceptable. While this may seem pretty basic to a credit professional, stating the company’s credit evaluation and re-decisioning process outright is necessary to ensure fair, unbiased, and consistent treatment of all applicants. Refer to our sample credit policy for more on credit evaluations and reviews.
5. How are collections handled?
Disputes and collections can be considered the dark side of trade credit. Most credit professionals would love never having to hound a customer for payment. However, when the agreement to pay is not honored, even unintentionally, collections procedures must come into play. What consequences does your company want to enforce for breach of contract?
At its most benign, the collections, or dunning, process can be as follows: After a payment is missed (and you can confirm the invoice was sent), an auto-generated email gets sent to the customer with a request to call or pay immediately. The collections staff follows up with a phone call within 24–72 hours (depending on whether you want to allow for a grace period), sticking to a script to maintain a professional tone. At the same time, a letter on the company’s letterhead is sent through the mail. Each company may have a different tolerance for how often they want to start or repeat this process; some companies may do this three times, taking up to 90 days, before they turn the account over to a collections agency. Other factors to consider when establishing the frequency and length of the collections process include the overall profitability of the product or service, risk profile of the account, and absolute dollar amount of the invoice.
6. What are your terms of sale?
It may not be as simple as “Net 30 across the board!” Different types of orders for different products require different terms of sale. Here, as in the credit evaluation phase of the business relationship, it’s important to have a clearly stated policy in order to remain fair and impartial and provide consistent terms to all accounts. In addition, it’s the law – familiarity and compliance with trade and anti-trust laws is critical for every credit professional. (See the section below titled “Extending Credit on Your Terms” for more about terms of sale.)
Benefits of a Credit Policy
By explicitly documenting processes and procedures, a sound credit policy will ensure consistency across your account portfolio and help lead to stable and predictable cash flow. It should be grounded in the deep knowledge you have about your company, its risk tolerance across the portfolio, and your experience with customers, their industries, and their payment behavior.
With that, here are three steps you can take to build a credit policy that works.
Know How Much Credit Can You Afford to Extend
The first step in establishing the parameters of your credit policy is to understand just how much credit your company can afford to extend, in the context of your customers’ ability to pay. Here, an analysis of the portfolio is crucial. Once you have a deep understanding of the accounts receivable – e.g., company size, industry, location, average credit extended – you can begin by setting a standard for certain criteria and milestones.
Learn Who Pays on Time—and Who Doesn’t
This leads to the next thing you’ll want to examine: Which accounts pay on time, pay late, or don’t pay at all. DSO (days sales outstanding) is a ratio measuring the average number of days that a company takes to pay its invoice. It’s calculated for a given period by dividing accounts receivable by total credit sales and multiplying the result by number of days. (DSO differs from DBT, days beyond terms, which is focused on the average number of days that a company takes to pay its invoice once it’s past due, or beyond terms.) It’s also helpful to compare your company’s DSO to industry averages; Dun & Bradstreet’s DSO report, produced in partnership with the Credit Research Foundation, provides these benchmarks.
You might find out that your riskiest segment of accounts takes more than 90 days to pay, but the majority of your accounts pay within terms. You might find out that your largest customers are the worst offenders, and due to the size of the invoices, they impact monthly cash flow. Many businesses tend to be more lenient on their larger customers because they don’t want to lose that big contract, but you may discover that those larger customers are costing money in the end. You may also find out that your newer accounts have a lower DSO than your established accounts because you’ve made better credit decisions than you did previously. Building an explicit credit policy is a good way to standardize those “better credit decisions.” For example, you might want to define that credit requests over $250,000 must pass certain checks, such as favorable credit scores, and that credit requests under $25,000 can be offered a payment discount. You also might realize that you need separate credit policies for customers outside the US.
It’s crucial to remember that the policy must treat all “like customers” the same to remain compliant with the Robinson-Patman Act/Anti-Price Discrimination Act in the US. (Similar laws apply in Canada and the UK, both called the Competition Act.) It’s generally lawful to set different terms for different buyers, “particularly if they reflect the different costs of dealing with different buyers or are the result of a seller’s attempts to meet a competitor’s offering,” according to the FTC. So, there must be a valid economic reason for a difference in terms of sale or payment terms.
Extend Credit on Your Terms (And Make It Possible to Always Say Yes)
You have to decide how long you will allow for payment, what early payment discounts you may offer, and whether to extend credit at all. Here are a few questions to consider when it comes to payment.
- Will you set terms at 30 days? Or 15? Remember that in order to comply with trade laws, exceptions to standard terms are based on meeting competition (which must be verified) or creating different classes of customers where all “like customers” are treated equally).
- Will you offer 2/10, net 30 (whereby you give a 2% discount when the invoice is paid within 10 business days instead of 30)?
- Do you accept COD or CIA for customers who don’t qualify for trade credit?
- Have the surcharge laws governing who pays the merchant fees for credit cards changed recently in your state?
- What about cryptocurrencies?
When it comes to payment, your credit policy should very clearly outline the penalties you are prepared to impose should you find yourself chasing late payments. Generally, a credit hold is placed on a delinquent account in case the customer tries to re-order. There are many options to then consider, such as late fees, lowering the credit limit (in the case where a hold is not placed), establishing an ACH prepay schedule, or requiring a deposit so you don’t have to stop shipping altogether. You can also consider requesting a promissory note for past due items, ask for collateral to secure the note, or ask for a corporate or personal guarantee. In addition, having trade credit insurance may help protect against high-risk accounts. Referring back to roles and responsibilities, you may want to clarify who is approved to communicate with customers about resolving credit holds and delinquent accounts when the customer does initiate contact, as these can be sensitive issues. Refer to our sample credit policy for an example of payment terms and variances.
In the current economic climate, it may simply seem impossible to say no to a prospective or returning customer. The good news is that credit policies which require obtaining a detailed block of information about the customer may in the end make it easier to say yes. Even marginal customers – from newer companies with insufficient credit histories to those that have indeterminable risk for a variety of reasons – even they may have potential. The key, then, is to manage against that reality to make the sale successful and provide a basis for mutually profitable future transactions.
When managing marginal customers, it’s important to maintain a mindset that every customer has potential. Recognize which opportunities come with risk, and then use strategies to limit your exposure, including:
- Require progress payments to mitigate part of the risk
- Limit exposure by shipping only one order at a time
- Employ security instruments such as deposits, guarantees, letters of credit, or Uniform Commercial Code (UCC) filings
Checklist: For a Complete Picture of a Credit Applicant
The credit policy should state the required information your company collects as part of the application. You’ll want to make sure you’re capturing all the data needed to provide a complete picture of the applicant to help you make the most informed business credit decision and provide the best possible terms. Remember, even if the applicant can’t provide everything, you can still extend credit, as long as the terms comply with the credit policy and corporate risk tolerances.
A Brighter Future
Establishing a credit policy and developing a systematic and scalable way to evaluate customers’ stability – and their ability to consistently pay for the goods and services you provide – is incredibly beneficial. With sound credit policies in place you may see:
- Larger sales volume: Customers may buy more at the outset if they know they can pay over time.
- More sales from existing customers: When you know which customers are good financial partners, you have a clearer view of which ones to invest more time with to win more of their business.
- New customers: Credit terms may entice customers who hadn’t done business with you to try your goods or services.
The credit policy you create will no doubt serve as the anchor for your entire business operations. With the right safeguards in place, it can guide your business toward streamlined processes and procedural insights that reduce your exposure to risk, ensuring your company becomes more profitable than ever before.