Credit is certainly not a new concept and it is safe to say that merchants and tradesmen who carried out business thousands of year ago also had a credit policy of sorts that allowed them to maximize business. A credit policy is nothing but a clear, well designed plan of how you are going to collect money from your customers at a time other than during the actual transaction.
Some businesses may offer credit to both commercial customers and non-commercial customers, I.e. individuals. However, in most cases, the question of credit only pops up with commercial customers who are more likely to do business with you only if you can bill them and have an arrangement by which they pay at a later date instead of expecting cash on the table on delivery of goods.
Often, the question of ‘should my business establish a credit policy’ may be a moot one considering that if you are in a niche where your competitors are offering credit, you really have no choice to but to toe the same line yourself. If this is the case, then you still have the option to design a credit policy that suits your business dynamics, risk profile and your liquidity needs. Not convinced that you need a credit policy yet?
Why should my business establish a credit policy?
Well, it makes great business sense to plan out and have a clear policy on all the critical aspects of your business and without doubt, your financial transactions are a most important aspect, indeed. Before we get on to your question of ‘‘should my business establish a credit policy’, let’s see why extending credit may be a huge lifeline for your business.
Look at it this way. Business X is a small outfit that regularly makes purchases from you to the tune of about $10,000 every quarter year. Since you only take cash up front and Business X has limited liquidity, there is no scope for this relationship to grow any further in the foreseeable future. There are two reasons for this:
1) Because Business X is not getting credit, they can’t buy more from you and scale up their business, which is limiting their growth and thus their purchasing needs stagnate.
2) Because you have an inflexible payment policy, even if Business X manages to grow and improve their liquidity position, they may prefer to go to your competitors who offers a month long credit period, allowing Business X to utilize the cash in other business activities for a month longer than you do.
Now, let’s assume you quickly identify that your lack of credit is pushing Business X to your competitors and you establish a two month credit for this customer. Not only are they more likely to remain loyal to you, they are also more likely to increase their order size. So, from the $10,000 customer that they used to be, Business X is now a $30,000 customer for you.
That’s exactly what extending credit can do for you business: it makes your business more attractive to customers, improves the flexibility in dealing with your charges and thus makes more customers seek a longer or more expansive relationship with you.
Okay, that’s a good reason for your business to implement a credit extension system. But, it is equally important to ensure that you don’t get scalped by your credit customers.
That’s definitely a big risk of you don’t have a clear idea of what you are doing with your credit system. Imagine that you let your customers buy your goods and pay at their will and convenience. How do you know when the money will come in? How can you plan your expenses? How can you fund you production or business growth? In fact, without a reliable idea of when your sales receipts will be in your bank account, your business comes to a standstill in every way that matters.
Then, there is the question of how long you want your customers to enjoy credit. You have to factor in that, if the cash was in your account, you would be using it for your business in some way. The credit extension prevents you from doing this. So, there is a cost that you bear for extending credit. The length of the credit should be determined so that this cost does not overwhelm the value addition that the credit extension offers to your business.
All of these and many other aspects are addressed by your credit policy. This is the answer to your question ‘should my business establish a credit policy?’; if you want to ensure that your business is attractive to your best customers and you also want to avoid unmanageable dues from your customers, you will need a sound credit policy.
What should your credit policy do?
A well designed, well-planned credit policy has many advantages to offer:
• Right from the time of customer acquisition, both you and your customers are aware of the payment related terms and conditions. For example, you may have a policy that only orders above a certain value warrant credit or that only customers who have been with you for a specific number years get credit. Your policy standardizes your processes and allows you to give fair and just treatment to all customers, making it easy to track and manage accounts.
• Within your business, there is no ambiguity in any department about when a customer should pay and what credit he is allowed. There is clear internal communication that makes it easier for everyone, in every department to ensure that customers get the credit they are entitled to, no more and no less. There is no question of miscommunication either escalating your risk exposure or causing long standing customers to face issues.
• It makes it easy to plan ahead because you know when receivables are likely to come in and to what extent. Production planning, inventory addition, and many other activities that hinge on liquidity operate seamlessly when you have a clear cut credit policy that you follow diligently.
• You are in a position to maximize profits by identifying worthy customers ahead of time and offering credit flexibility so that they can engage more deeply with your business.
• It clearly defines the credit limits that you are willing to allow in your business and outlines the parameters that will influence your willingness to extend credit.
• It sets down the processes and procedures to follow if a customer fails to pay as per agreement, thus establishing a clear system for dealing with overdue debts. This organizes your dues, and ensures that timely action is taken as soon as a payment becomes due so that no delays or oversights occur at any point.
How to create the perfect credit policy for your business
The first thing you should remember is that there is no standard template for a credit policy that you can start using for your business. An effective credit policy is the one that is developed with the specific business characteristics in view. That’s because there are a number of business and external factors that influence the length of credit or the total amount of credit you can offer. Take a look at a few of these:
• What kind of business do you operate?
The turnover in your business, the competition, the competitor policies, the size of the average customer order, the total cash outlay required for a customer order of average size- these are just some of the factors that may vary with business type and impact the kind of credit you can offer. For example, a company that manufactures garments may be willing to offer a one month credit for purchases of over $2000. However, for a company that manufactures earth moving equipment, a $2000 credit limit may be meaningless because their products cost several times this amount. The credit limit should be designed keeping in view the customer’s needs.
• Your cash flow status
A start up that is still finding its feet may not be able to afford extended credit or huge credit limits because it may still have liquidity issues that are exacerbated if customers don’t pay quickly. A well-established firm with adequate funds can afford to do so, on the contrary. It is the cash flow status of the business that primarily indicates what kind of credit policy you should adopt.
• Industry norms
In some niche industries there are existing norms of credit that are followed and within this niche you are at a huge disadvantage if you want to adopt a lesser policy. In such cases, you may not have a lot of freedom about how to design your credit policy if you want to remain truly competitive.
• Prevailing economic condition
When the economy is flourishing and business activity is at a high level, giving credit may not present a huge risk because your customers are likely to be enjoying excellent turnovers too. However, if there is a downturn and businesses are struggling to remain afloat, you are likely to have cash flow problems and so does your customer. You want to minimize your credit levels as well as duration to keep your risk under control. The current economic scenario plays a key role in determining what your credit policy looks like.
• Risk aspects
A customer who has a long standing relationship with you is a much better risk than a new customer. A business that has always made payments to you on time is a much better risk than a business that has defaulted before. The exact same credit terms cannot be extended to every one of your business customers which means that the parameters that will influence your terms needs to be outlined in your credit policy.
Let’s backtrack for a moment and think about why you need to establish a credit policy, in the first place. The major benefit for you is that you encourage more businesses to maintain and deepen their relationship with you. In other words, you want to maximize your sales by making it easy for businesses to buy from you.
The more attractive your credit policy, the better it can help boost your sales. However, the other side of the coin also needs to be considered. When you extend huge amounts of credit for long periods, you also escalate your risk of default and increase the losses you will sustain if someone fails to pay you back. Your credit policy needs to have some critical components that help you manage this risk without compromising on your ability to maximize sales:
• Well defined credit limits: that tell you which customers get what kind of credit and what their credit limits are.
• Terms and conditions: That outline what happens if a customer pays before or after time, that is, are there penalties or discounts, and if so, what are they and when they will be applied.
• Deposit policy: You may want some customers, especially new ones, to make a deposit of a specific part of the payables before they can receive credit. Mention what percentage of the bill amount you will accept as deposit and which customers are exempt from this.
• Credit checks: Outline how you will check the customer’s credit worthiness, for example, via bank/ credit checks, from referrals etc. For businesses, credit checking via Dunn and Bradstreet may be utilized. Credit checks for consumers may be obtained via companies like Experian and Transunion. Also, mention what other information you will gather about a customer to ensure that they represent a good risk.
• Documentation: You cannot extend credit without doing the paperwork about all the terms and conditions of the financial agreement. Sales agreement, contract letters, credit application, bills, delivery invoices etc all make a part of the credit documentation and your credit policy needs to mention exactly which papers will need to be included for each credit customer.
In conclusion, the answer to your question ‘should my business establish a credit policy’ is a definite YES because this policy can help boost your business growth. However, it is critical to have an effective and water tight credit policy in place to enjoy all the benefits of extending credit.