Elements of an effective credit policy

Creating the Policy

Establishing the basic framework for the extension of business credit is vital to the long term success of any organization regardless of its size.  A sound credit policy will facilitate greater levels of sales, foster stronger relationships with your customers and above all protect your investment in accounts receivable.

Some of the key elements to be considered and implemented:

1. Purpose of the policy
2. Objectives
3. Credit limit authority
4. Credit evaluation
5. Credit limits
6. Terms
7. Account Review
8. Collections

The purpose of the policy should be the establishment of the basic framework for governance of the plan.  Sub-sections will describe in specificity the details of the policy.

Metrics should be defined which will provide the basis for policy effectiveness.

Credit limit authority
Establish levels of authority varied by sales volume.  An organization's risk tolerance should largely determine the thresholds of authority at each level elevating ultimately up to senior financial management and principals.

These authority limits should be given thoughtful consideration as improper implementation can unduly delay the credit approval process leading to lost customers and sales.

Credit evaluation
This step is typically handled at the analyst level.  Data sources such as the NACM National Trade Credit Report are a valuable resource providing credit and risk managers with a unique illustration as to how potential customers are paying other trade creditors.  Data received from such sources should be incorporated into your decision model providing a basis for the ultimate decision on whether to extend trade credit and the establishment of a limit.  If the credit limit sought by the prospective customer is below a certain threshold, this information may be sufficient in making a credit decision.

Credit limits
There are many schools of thought on how best to establish credit limits.  A balanced approach should take into consideration the:

     a)  Customer's anticipated purchasing volume.

     b)  Customer's payment history with other trade creditors.

     c)  Customer's statement of cash flows.

     d)  Customer's balance sheet and overall financial condition.

     e)  Condition of the customer's market and industry.

Establishing the limit may be somewhat subjective, within certain tolerances, based upon any combination of the criteria measured.

Terms establishment may largely be dictated by the norms of any given industry sector.  Weekly terms may be customary in certain industries whereas seasonal terms may be the norm in others.  Regardless of the terms that are established, it is imperative that these terms be uniformly adhered to from the outset of the relationship with your customer.  Your customers may, and probably do, have internal policies on when and how frequently trade payables are processed, so requiring a customer's compliance from the start is critical.

Account review
Establishing the limits and terms is not the end of the game.  Policies regarding the periodic review of your customer's credit worthiness should be instituted.  In addition to the usual tracking of a customer's aging, creditors should implement a plan to review a customer's credit at regular intervals such as yearly.  This procedure may include having the customer complete an updated credit application which may alert you to important information such as a change in the legal composition of the business.

Despite the establishment and implementation of a sound credit policy, a percentage of your customers will ultimately be unable or unwilling to honor their commitment.  It is, therefore, important that a procedure be established on how to address these situations.  An approach that begins with a friendly reminder at the early stages of delinquency graduating to a final demand should be considered.  It is important to remember that the more an account ages the less likely it is to be collected.  10 Tips for Successful Collection Calls

Todd Elliott, President, NACM-SE