Unless all of your customers pay in full at the point of sale or completion of service with cash, credit cards, or electronic transfers, you must bill for your sale and wait for payment. This means you are extending credit to your customers. If you are paid in this manner, be sure to set up a formal credit policy that serves your company's interests. This type of policy generally includes when and to what extent you'll extend credit, what terms to include, and what to do about collections if the payment terms are not met.
The importance of credit limit policies
Establishing an effective credit policy prevents you from overextending credit to customers and may help you avoid devoting future time and money managing accounts receivable (A/R), which are amounts owed to the company, and collections. It also allows you to grow your customer base and establish long-term relationships.
Credit policies as part of overall company strategy
Your credit-limit policies should take into consideration the overall company strategy, including cash flow management and sales. Keep in mind that smaller companies often need immediate cash to continue operations and cannot afford large extensions of credit to individual customers. Alternatively, to achieve sales targets, companies may need to issue a certain percentage of credit sales.
Just the act of sitting down and listing out formal credit policies is beneficial to you because it forces management to outline appropriate actions that should be taken prior to approving credit sales.
Components of a credit policy
A credit policy does not have to be one-size-fits-all. It can be tailored to accommodate different customers in different situations.
At a minimum, set a basic credit limit. This may be tied to the size of customer's partial payments through deposits and upfront amounts. A credit limit may be modest for a new customer and more liberal for one you've been doing business with for years.
The credit limit for a particular customer may also be based on a credit report. If the customer is a business, simply check with a credit reporting bureau such as Dun & Bradstreet or Experian; permission from the customer is not needed. If the customer is a consumer, permission to obtain a credit report from a consumer credit reporting bureau is required.
The credit policy should define payment terms, including any required deposits prior to the start of work. Typical payment deadlines are net 30 days, which means 30 days from the time of the sale. But any other period, such as net 10 days or net 60 days may be appropriate in particular situations.
Discounts for early payments may be offered. For example, with a net 30-day policy, a 2 percent discount may be offered for payment in full within 10 or 15 days. Conversely, interest may be charged for late payments. However, as a practical matter, delinquent customers may not pay the interest and small businesses wanting to retain these customers for future transactions may not press the matter.
Procedures should be set for employees to follow when setting up a new account or when selling to existing customers who request higher credit limits. When a large credit request comes in from either a new or existing customer, employees should know how to escalate the approval process and who in the company can make a final decision.
The credit policy should also include guidelines for collections of outstanding A/R. Determine what would constitute a delinquent A/R and what happens then. For example, a payment reminder or a telephone call after a week or two of a past-due A/R may be the first step to prompting a delinquent customer to pay up. Collections policy for consumer customers should observe federal rules in the Fair Debt Collections Practices Act. Small businesses should use invoice tracking in their accounting systems to be alerted to aging A/R.
Your credit policy is an important part of cash flow management. Learn more about steps to help you monitor and improve cash flow.