In an ideal world, businesses would never have to extend credit to their customers. Instead, as soon as a product or service was delivered, the customer would pay immediately in cash.
Of course, we don’t live in an ideal world. Extending credit is just a fact of business life; you must offer credit terms to be competitive. However, offering credit terms to customers does not mean that you should be willing to offer credit terms to all of your customers.
Offering credit is a useful tool for increasing sales because it makes it easier for your customer to buy from you. Extending credit to high risk customers, though, puts your cash flow and profit at risk. You have less cash when a receivable is not paid, and it can be quite costly if you have to initiate collection efforts-especially if you have to hire professional help. For these reasons, it is critical to have a written credit policy that provides guidance and ensures consistency in the credit decision process.
Your credit policy should include a risk classification system. Credit decisions are easier, and more consistent, if you base them on a customer’s risk rating, instead of your personal feelings, or only a few factors that you think are important. A sample classification system would look like this:
- Excellent – Always receives credit, and on the best terms.
- Good – Eligible for credit, but on less favorable terms (for example, has to pay in 15 days instead of 30 days, or receives a 5% discount instead of 10%)
- Acceptable – Might be granted credit, but must be approved on a case by case basis.
- High risk – not eligible for credit.
Having a written credit policy will ensure that you take a structured, disciplined approach to extending credit, and that everyone is aware of these rules for customer credit. Your credit policy should specify what information you must have to make a credit decision, as well as the information that must be in the credit file. At a minimum, you will want to have:
- Current payment record.
- Customer company data-revenues, credit rating, number of employees, products and services, banking information, credit rating, etc. Obtain as much information as you can.
- Current risk rating that you have assigned to the customer per your classification system.
- Cost of carrying the account. Take time to devise a formula that calculates the true cost of the account, including the cost of carrying the receivable, inventory, staff time to manage the account, and profitability by customer and products.
Your policy should specify the procedure for handling a delinquent account, with separate procedures for how you will treat accounts you want to keep and accounts you do not want to keep.
Do not forget to specify the person and position that has responsibility for managing the overall receivables process, including collections. Here are some other rules of thumb you should keep in mind:
- Consider your competition. You may want to offer 15 day terms, but if your competitors offer 30 days, you may have no choice but to do the same.
- Consider current economic conditions. In a slow economy, prudently relaxing your credit standards can lead to more sales. When you are experiencing a high demand for your products and services, tightening your credit policy can be a useful way to manage growth.
- Be careful of customers who have been in business less than one year.
- Selling to individuals is riskier than selling to corporations.
- Bad debt losses are typically higher for smaller companies than for larger ones.
[...] [Technorati] Tag results for credit wrote an interesting post today onHere’s a quick excerptThe Credit Decision By Bruce Kaufmann | April 19, 2008    In an ideal world, businesses would never have to extend credit to their customers.  Instead, as soon as a product or service was delivered, the customer would pay immediately in cash.    Of course, we don’t live in an ideal world.  Extending credit is just a fact of business life; you must offer credit terms to be competitive.  However, offering credit terms to customers does not mean that you should be willing to offer credit ter [...]
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