CREATING A

CREDIT POLICY
FOR YOUR ORGANIZATION

According to the Merriam-Webster dictionary, the word policy can be defined as a definite course

or method of action selected from among alternatives and in light of given conditions to guide and

determine present and future decisions. While most individuals appreciate the need for policies as

a workable set of regulations, it can carry some negativity when viewed from a customers

perspective. Customers may perceive policies as unnecessary roadblocks barring them from what

would appear to be basic rights or customer expectations. Despite this, there are a number of

reasons to have a written credit policy. This document defines those reasons, along with

establishing a mission, goals, and various other aspects of an organizations credit policy. This

document outlines the process of how an organization can create and implement a credit policy,

with the primary focus being payment in a timely manner while maintaining good customer

relationships.

When creating a credit policy, an organization should understand and develop the following:

1. Credit policy description and the reasons for having one

2. What is the credit departments mission?

3. What are the credit departments goals?

4. Who holds responsibility?

5. What is the credit evaluation

process?

6. Do you have full customer

details?

7. What are the terms of sale?

8. Aging of Accounts Receivable

9. Invoicing policy

10. Collections

11. Defining DSO

12. Conclusion

1. Credit policy description and the reasons for having one.

Credit management starts with the sale and ends only when the full and final payment has been

realized. It is as important a part of the deal as closing the sale. Technically, a sale is considered a

sale only when money has been collected. Many companies place the responsibility solely on their

customers for any unpaid debts. Quite the contrary is true. It is often the lack of a clear credit policy

within a supplier organization that results in late or unpaid invoices.

A Credit Policy should be a well-configured and consistent process that a company incorporates in

order to control the risk it assumes when extending net payment terms to its customers. It can be

very general or very customized; it really depends on the company extending the terms. Although,

every credit policy serves the same

ultimate goal (i.e. to safeguard a

companys receivables in a fair and

consistent manner), they can still

differ from organization to

organization in both length and

content it depends on the

company and how detailed they

want the policy to be. The reason

why the content of the policy differs can be due to many factors such as your companys cash flow,

profit margin, how competitive the market or industry is, your location, your customers location,

production needs or the size of your company. Consider these issues regarding the creation of a

credit policy:

One of the most important reasons why a company should have a credit policy is to safeguard its

accounts receivable. In addition to that, a pre-set credit policy gives stability, efficiency and

effectiveness to the company.

It also involves limiting bad debts and improving cash flow. With outstanding receivables being a

firm's asset, it is essential to have a structured approach to credit management.

The policy provides consistency among departments, laying down a common set of goals. It can

also help in defining each department's functions so that duplication of effort is avoided.

The policy also allows companies to have a consistent approach among customers, ensuring its

decision-making is more structured. Writing down and making the customer aware of the policy

reinforces its application, and also gives a sense of fairness among customers and strengthens

the customer-supplier relationship.

2. What is the credit departments mission?

The mission of your credit department defines the risk averseness of the company in relation to

offering credit in light of the overall mission of the organization. For example, if the company is

striving to gain market share, it may have a rather liberal credit policy. On the contrary, a company

with a significant market share can choose to be more conservative in its credit approach.

3. What are the credit departments goals?

There are a number of approaches that a company might take when establishing goals. A simple one

might be the establishment of a no new customers are to receive credit consideration for the first 3 to

5 orders policy, with the understanding that they may be converted to specific credit terms after such

time if warranted. However, this may be an unattractive policy to some customers and your company

will have to determine if incorporating such an approach is worth risking a potential sale. Another

approach includes defining a more objective, measurable strategy. Some of the factors to be

considered when doing so include:

Defining your companys CEI (Collectible Effectiveness Index) the ability of your collections staff

to collect funds from customers.

Determining your companys average DSO (Days Sales Outstanding).

Identifying your companys acceptable percentage of bad debt write-offs.

Determining the cost of credit approval.

Measuring the time it takes to approve a customers credit.

Establishing an acceptable percentage of receivables by aging identifying which invoices are

overdue and by how much.

Reviewing customer accounts annually.

Communicating effectively; internally and with the customer.

Of course, each of these items should have a defined, measurable component.

There may be other

approaches to consider as

well, including goals

established by senior

management possibly

relating to bad debts,

receivable ageing, and DSO.

This approach is helpful in

situations where goals change

often, thereby avoiding

constant revisions to credit policy. Again, like the overall credit policy of the company, the goals can

be generic or highly customized according to the needs and nature of the business

4. Who holds responsibility within the organization regarding credit management?

This section is perhaps the most critical component of the policy statement, as it establishes the

roles, responsibilities, authority and accountability of each individual who has involvement with

customer credit. This helps in avoiding duplication of efforts and strife among various departments.

The responsibilities may be considered in terms of your organizations workflow.

In this context, the workflow may include the way customers/orders are analyzed, processed, and

collected. This entire cycle can become very complicated as the company grows. It is important to

identify the various to-dos and checkpoints across the sales cycle. For examples, who is

responsible for collecting the required documentation from the customer (signed purchase order and

credit sheet)? Who does the actual credit research? Who analyzes the results of the research? Who

determines the credit limits? Who then does the invoicing and the customer follow-up?

If the company sets up a good workflow, seldom should there be a situation where it all comes to a

halt. It is, however, still necessary to have a policy in place, because changes will happen and the

company should know what to do in that situation. For example, if a customer wants to significantly

increase its credit limit, how is the approval process handled and who is the ultimate authority to

approve it?

Properly assigning these tasks and holding the respective individual(s) accountable is essential in

enforcing the credit policy across the company.

5. What is the credit evaluation process?

This is another important part of the credit policy and again, the level of detail depends on the size of

the company and its overall credit philosophy. A generic policy for a larger organization may be as

follows:

The Credit Department of the company establishes credit limits for all its customers per the

limits based on rating agencies, credit references, financial statements, security, or other

information obtained directly from the applicants...

The above approach does not list specific details within the policy; however, a smaller business can

have a different approach when it comes to evaluating their customers credit position. A general

statement might be as follows:

The sales representative will obtain a credit application from each customer. This will contain

a bank reference and three trade references. After calling references, the credit department

will determine if a customer has demonstrated the ability to pay bills in a prompt manner. If so,

a credit limit will be assigned

Irrespective of what approach is followed, it is important to establish a consistent procedure so all

potential customers are treated equally

6. Do you have full

customer details?

Screening customers in a

fair, consistent and

thorough manner is an

important factor in a

properly structured credit

policy. Having all

necessary customer

details only makes the screening process simpler and efficient while minimizing the risks. It allows the

credit department to filter obvious bad debts from the rest. Overall, it contributes toward building

relationships with the right customers, reducing risk situations and limiting the companys credit

exposure. With detailed information about the customer, a business can assess the risk of providing

credit and also ensure that it has the information necessary in case its needed for a legal action to

pursue payment

7. What are the terms of sale?

One of the best practices for

terms of sale is to follow the

generally accepted terms in the

given industry. By doing that, the

company reiterates the standards

that are already being practiced

and accepted in its industry.

This includes a clear understanding of when the bills are due. For businesses with a simple and

straightforward product line with a consistent set of terms, this is not a difficult issue to handle. For

situations like this, you may choose to have a generic policy for terms of sale. However, for other

companies, with many different product lines with a variety of terms and conditions, this may pose a

much larger problem. In this case, your company may want to establish individual policies within the

overall policy specifically to address individual products.

8. Aging of Accounts Receivable

Receivables exist because most industries offer their customers payment terms rather than cash on

delivery. If a supplier refuses to abide by such industry practices, they may face loss of business and

a hit to their reputation; customers may switch to competitors offering more standard industry terms.

Therefore, it has become a general way of doing business in most industries. Common approaches

include terms such as - Net 10 (payment ten days after invoice date), Net 30 (payment 30 days after

invoice date), 1% 10 Net 30 (1% discount if payment received within ten days, otherwise, payment

due 30 days after invoice date).

Developing an Aging of Accounts Receivable form is a good way to identify any receivables beyond

the agreed-upon terms of sale and helps identify problem customers. Although many billing solutions

can automatically create such a form, a basic format would be as follows:

Bold Supplier Company, Inc.

Acme, Inc. $20,000 $15,000 $2,000 $3,000 $0

MFG, LLC. $45,000 $35,000 $7,000 $2,000 $1,000

Total $65,000 $50,000 $9,000 $5,000 $1,000

9. Invoicing Policy

Seeking payment from customers is a critical component of the credit management process. Not only

does it ensure a steady flow of cash payments (in an ideal world), but also helps in promoting healthy

relationships with the customers. In order to manage invoicing procedures and customer

management effectively, a business should have accounting/billing systems in place as well as a

clear process for handling disputes and delays. The following steps in invoicing may reduce delays or

problems:

Invoice quickly Submit an invoice at the earliest possible convenience, whether its done

electronically, via email or sent through the mail. Invoicing electronically, whether through third-

party e-Invoicing, an enterprise billing system or small business billing software, will typically allow

for faster and more accurate invoicing.

Ensure the invoice is accurate Inaccurate invoices may create confusion, delays in payment

and overall tension between the company and its customer. As indicated immediately above,

billing electronically will typically help a supplier organization get it right the first time and help

protect the companys cash flow.

Provide invoice details The customer should be able to see within the invoice the product or

service the invoice covers, the quantity, the delivery time and place, the specific amount due,

when its due and the payment options available to them.

Quickly resolve any exceptions When an invoice is not paid because of an error, its called an

exception. Its worth putting in place a process by which any exceptions can be handled quickly

with the correct details. The faster an exception is handled, the faster payment can be made.

It is important to regularly

communicate with the customer in

terms of invoicing, required

payments and alerting them of

any unpaid balances.

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10. Collections

The entire credit policy boils down to collections. A well thought-out collections policy should include

processes for both the best-case scenario (the customer pays on time or early) as well as the worst-

case scenario (i.e. payment is 90 days or more overdue).

Under the best-case scenario, the policy should include everything that occurs following the approval

of a credit limit and terms such as the hows and whens of invoicing, follow-up calls, pre-due date

communication, and payment acceptance and processing.

However, the company needs to be prepared for possible worst-case scenarios. If a customer does

not pay the invoice in a timely manner, the company should have a past due process. Things to

consider when developing a past due component of the policy include:

Enforcing the credit policy: Ensure everyone within the company, including sales and account

management, understands the circumstances in which the credit policy will be implemented and

enforced if payment is late.

Communication internally and with the customer: When an invoice is past due, who will

contact the customer? Will it be a member of the sales team, the account management team or

the credit management team?

Expediting Payment: When collecting the past due payment, will new terms be made available

to the customer? Will a discount be offered in order to bring about payment?

Collections Agencies: will the collection effort be outsourced (or insourced) to a third-party

collections agency. If so, at what point does this occur?

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11. Defining DSO

DSO or Days Sales Outstanding is a common

metric used in Accounts Receivable and Credit

Management. It is an expression of the average

time (in number of days) that receivables remain

outstanding. When calculating DSO, know that it

can be determined for any given period of time:

per year, per quarter, etc. In addition, its important to agree on the terms used for the formula. For

example, will your company use receivables, sales or revenue when calculating DSO?

For our purposes, we will use term sales for calculating average annual DSO. For that, the formula

is as follows:

(Accounts Receivable / Annual Sales) x Days per year

Approx. 45.6 Days Sales Outstanding (indicates and average of 45.6 days to pay invoice). At Net 30
terms, avg. payment is 15.6 days late.

12. Conclusion

Creating, deploying and enforcing an effective credit policy may appear to be a mammoth task for

many organizations, however, in the long run, it positively impacts a companys bottom line. A large

number of companies, especially small businesses ignore this aspect and it reflects in their poor

growth. Companies devise new ideas and create new and innovative products (or services) to open

new revenue streams, but they often overlook having these in-house policies, which can improve the

bottom line dramatically.

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