Learning Resource: Creating a Credit Policy in 9 Easy Steps Print

November 2009

Creating a credit policy has many advantages. Perhaps its greatest benefit is that it provides a blueprint for how a business deals with its most valuable asset, the customer. Without a sound credit policy and processes, many small businesses will remain unaware of how to profitably manage their receivables, a function that contributes significantly to profits and can account for up to 40% of a company’s assets.

Of course, without sales a company cannot continue to operate, but a sale is not truly a sale until payment has been collected. Especially now, as challenging economic conditions are forcing businesses to do more with less, it is time to become proactive about credit management.

To realise the full benefits of a formalised credit policy, nine areas must be addressed:

  1. Mission statement
  2. Goals
  3. Define credit limit authority
  4. Credit evaluation
  5. Credit limits
  6. Terms
  7. Account monitoring
  8. Credit hold
  9. Collections
Mission Statement

The purpose of the mission statement is to clearly outline the function of the credit team. This should include acknowledgement of their role in risk and customer relationship management. The timely processing of credit applications, setting appropriate credit limits and communication with customers ranging from new account status to billing issues are essential functions within every business.

Your mission statement should be broad and brief, and it should not discuss the individual procedures. Other sections of the policy will discuss these procedures more in depth.

Goals

Every credit policy should have stated goals which spell out how to measure the effectiveness of your overall policy and supporting procedures. Our recommendation is to have three high-level goals which are measurable, understandable and challenging.

Define Credit Limit Authorities

The third section of your credit policy defines authority for the credit approval process. For example, the business owner may wish to approve all transactions over a certain amount.

There are two key traps to avoid when assigning credit limit authorities:
Don’t over-engineer the process: Applications should not be slowed down due to cumbersome approval processes.
Be sure to assign a staggered approval process: The business owner should not be approving all new applications unless the number of new customers is very small.

Credit Evaluation

There are a range of data sources that can be used to evaluate the creditworthiness of a potential new customer. As a consequence, it is important that you outline which data sources are to be utilised, particularly if there are different sources for different sized credit relationships.

To be consistent, you should develop a credit evaluation scorecard so all employees follow the same evaluation procedure. Once you have established consistency you may wish to segment your customers. You could identify customers as Low, Moderate or High Risk and use this segmentation to help you set credit limits and prioritise collections.

Credit Limits

The best approach to extending credit is to assign limits/availability based on a customer’s ability to repay their debt. This will be determined during your credit evaluation and the best information will come from financial data and trade references.

Your guidelines should be flexible, however the goal should be to set appropriate limits which provide freedom to low risk, prompt paying customers and more conservative limits for your slower paying customers.

Terms

Be clear about what you expect from the very beginning. Customers will often have their own credit policies, such as paying after 45 days. If it is your policy to only extend credit for 30 days you need to decide whether you want to play by the customer’s rules or pass on the business.

Account Monitoring

Account monitoring is an area that many businesses neglect. This generally occurs because they have limited time and knowledge about exactly what this process should include.

The first key point is that businesses need to evaluate customers at regular intervals. Ideally all active customers should be evaluated on an annual basis. If this is not possible, critical customers (i.e. the top 20 percent or customers with higher exposure levels) should be singled out for evaluation.

The account monitoring section of your credit policy should summarise the sources of information which are to be used as well as the re-evaluation process. If time is a particularly pertinent issue, as is the case for many businesses, a credit bureau, like Compuscan, can conduct the annual evaluation process for you or set up an alert system that will identify increasing customer risk as and when it occurs.

Credit Holds

Holding orders or ceasing the extension of credit can become a major source of conflict with sales but it is an important source of leverage for collections. To really work, your policy must have the buy-in of the sales team. Best practice is to identify customers who have exceeded the credit limit by 10 percent. In addition, you should establish a time frame for how far past due you allow your customer to go before you hold their orders. A conservative policy would be to hold orders or cease credit immediately after a customer goes past due, while a more liberal policy allows a much longer period before you begin holding orders. Your policy will also depend upon your company’s market conditions and risk appetite.

Collections

Last but not least is the development of the collection policy. Your collection procedure should be prioritized according to both the customer’s risk and exposure level.

A decision table should be developed outlining when customers should be contacted and you shouldn’t be afraid to contact your higher risk customers before the invoice is due. The best collection process is one which is proactive and consistent.

Creating a formalised credit policy will take some time as you will be required to address a number of important questions regarding your business operations. However developing a sound credit policy is best practice and it will put your business on firmer ground.

If you want to learn more about “Creating Your Own Credit Policy” contact Compuscan Academy at Tel: 021 888 6000 or e-mail us at This e-mail address is being protected from spambots. You need JavaScript enabled to view it