How to Establish a Credit Policy

For companies in many industries, offering supplier credit is part of the price of doing business. This is especially true for new businesses and professional services providers, who can’t always demand “cash on the barrel” for products sold and services rendered.

Before extending credit to any customer, however, it’s wise to establish a credit policy that details in writing exactly what your payment rules and expectations are. Many small business owners rely on gut instinct when deciding whether to extend credit to customers, but this can be dangerous. Putting a formal credit policy in writing shows customers that you’re serious about your business’s finances, and it gives you a legal leg to stand on should you ever have to sue a customer for nonpayment.

Of course the best time to find out how creditworthy your customers are is before their accounts are 90 days past due. Remember: Late payments are the same thing as an interest-free loan, and not collecting receivables can drain your company’s cash flow faster than an unplugged bathtub.

Finding The Right Balance

How you structure your credit policy will be one of your most important business decisions, since it will have a direct impact on your cash flow. A policy that’s too strict may turn some good customers away, reducing sales and income. But if you err on the side of being too liberal, you could end up with deadbeat customers and a high volume of uncollected receivables. Your goal is to find a middle ground that allows you to extend credit to good customers while identifying those who might be potential credit risks.

Your credit policy should be established in conjunction with your business’s cash flow requirements. Determine the level of cash flow you need to meet working capital and other day-to-day business expenses, and create your policy with this in mind. You will want to begin carefully monitoring your days sales outstanding -- a measurement of how long it takes you to collect receivables -- to see what kind of impact your credit policy is having on your cash flow.

Typically, a credit policy states your credit evaluation criteria, the maximum amount of credit you will extend to a customer, your specific payment terms, and any penalties or interest that will accrue on late payments. Start by drafting a credit application, which should ask for references from other creditors. Contact them and ask how timely your customer has been in making payments.

If the customer was late, did he or she communicate with the creditor openly and early on and try to arrange a payment plan? Obtain bank account information and ask about any credit arrangements customers may have with other suppliers. You can also run credit checks via Dun & Bradstreet for a small fee.

Setting Credit Limits And Terms

Based on the results of your credit check, set a credit limit for each customer you deem creditworthy. Next decide exactly how many days after delivery payment will be due. If your terms are net-30 day, which is common in many industries, your policy should specify that payment is due in your hands, not in the mail, no later than day 30.

The credit terms you offer don’t have to be the same for every customer. They can (and probably should) differ from one customer to the next. Nor are they cast in stone: Terms can be reduced or withdrawn from customers who become habitually late payers. Be sure to draft your credit policy so that this is clear and does not imply that, once granted, the particular terms of credit are indefinite.

Don Sadler is a freelance writer specializing in business and finance. Reach him at don@donsadlerwriter.com.