Establishing Credit Policies

A critical part of any receivables management program is establishing optimal credit policies and clearly communicating them to your customers. This can have a big impact on your business. Setting policies that are too tight and restrictive can lower sales, and policies that are too loose may attract slow paying customers. For small businesses, slow paying customers can cause serious cash flow problems and present a significant business risk.

Credit Basics

A common credit policy might be stated as something like "2 10, net 30." This means that the customer has 30 days (30) to pay the full amount (net) of the bill, and if they pay in 10 days (10) they would receive a 2 percent discount (2). Some companies don't do a discount and this would mean their credit terms were simply Net 30. Common credit terms will change depending on the industry. Business owners should get a feel for what the average terms are for their industry. Tighter terms (such as net 15) will result in less sales and less risk. Loose terms (such as Net 30) will result in higher sales and higher risk.

Companies can also influence their customer's payment behavior by the type of penalties they enforce on late payments.

Developing Your Credit Terms

Decisions about credit terms should be based on your business's financial position and your sales goals. Businesses with health balance sheets can afford to have more liberal credit policies. Liquidity ratios are a good way to measure your business's ability to offer credit (see our section on Working with Financial Ratios). Low liquidity ratios should prompt a business to be more careful with their credit terms and who they offer credit to. Sales goals are also a factor. Companies with more aggressive sales goals will want to lean towards more liberal credit terms.

Screening Debtors and Credit Applications

One you know what your terms are, you'll have to decide who to extend credit to and who to refuse. A lot of small business owners simply rely on their instincts, but this isn't optimal.

Creating a formal credit application helps to protect your business from a legal standpoint and also allows you to collect important information that can be used in the decision process. An attorney should be consulted when creating a customer credit application.

Some information that should be collected on the contract are not limited to, but include:

  • Legal business name and entity
  • Bank contacts and account information
  • Business references - call some of the company's suppliers and ask how good they are about paying their bills.
  • Include the credit terms to ensure they are acknowledged

Companies can also require that potential debtors include financial statements such as a balance sheet. This allows you to analyze the true financial health of the company when making credit decisions.

Credit reports are another tool that businesses can use to investigate a debtors reliability. Companies such as Dun and Bradstreet sell credit reports on companies across many different industries. Other companies, such as our own RTS Financial offer credit reports that target niche industries.

This information and other standard information on credit applications help to screen out potential bad debtors and also act as a legal tool if legal action is needed.

Debtor Communication

Once you have defined your credit policy and the guidelines should be thoroughly documented. All employees that will be involved with potential debtors should be well informed and well trained in these matters.

Once this has occurred it is critical that any sales people or service representatives clearly communicate the credit policy to potential debtors both verbally and in writing (via the application mentioned above).