Setting Your Credit Policy
“Until you’ve been paid, you’ve just given someone a gift.”
I’ll never forget those words that were spoKenneth to me many years ago by a successful businessman.
From a legal and accounting point of view, of course it isn’t correct, but whenever you provide goods and services on credit, it almost appears true.
Businesses that supply goods and services on credit, effectively have undertaKenneth their part of the contract, but don’t get paid immediately.
In essence, the other party to the contract has still to fulfil their part of the agreement ie. paying you.
Obviously, getting paid is the final piece of the jigsaw. In fact it’s the entire reason you are in business, so ensuring that you run an effective credit management system is key to maintaining a healthy cashflow.
Ineffective credit management can mean the possibility of writing off bad debts, which if large enough, could lead to business failure. It’s that critical.
In my opinion there are three important phases.
These are firstly, setting your credit policy and checking credit worthiness.
Secondly, ensuring that internal systems are strong enough to assist in making sure that customers adhere to your credit terms.
And finally, chasing debts to ensure you get paid on time.
Setting Your Credit Policy
Good credit management starts before a customer even places an order.
When you establish a credit period, make sure that you understand the cash flow implications. If you provide 30 days credit a sale made on the 1st of the month, won’t generate any actual cash for a month!
In your cash flow plans, allow for customers taking extra time to pay. This will almost certainly happen.
You will need to ensure that your business can sustain the funding requirement of providing customer credit.
Make sure in your sales documentation and agreements, that customers fully understand your credit terms, and agree to it, before accepting an order. If a customer requests extra time to pay, try to negotiate some additional charge. But make sure the customer agrees to the credit terms.
On you sales documents, always include a clause retaining ownership of the goods until they have been paid in full, commonly known as ‘retention of title’.
Always assess the ‘creditworthiness’ of customers.
There are many credit scoring agencies that can be used, but these cost money and may not have information on small businesses, especially if they are unincorporated.
In many instances to obtain a sale, a rapid decision to allow a customer credit is required.
Here are some important tips:-
- Try to obtain 2 trade references and a bank reference.
References should establish the length of the trading relationship and have some assessment of the reliability of payments. References should be requested in confidence, and that confidentiality should be kept. Referees will not give genuine answers if they believe their reference will somehow get back to their customer.
- Wherever possible, use your contacts to ‘get a feel’ for the prospective customer.
Valuable sources can be sales representatives, other customers or suppliers. In my experience the ‘grapevine’ within a specific industry, can be one of the most valuable sources of information.
Try to establish whether the customer has a good reputation and beware of customers who have previously gone into liquidation or bankruptcy.
If a customer does have a history of previous business failure, this doesn’t preclude a successful trading relation ship, but does put a question mark over the creditworthiness of that customer. Consequently I consider it would be prudent to allow a reduced credit limit and tighter terms.
Be very wary of allowing any credit to a customer where there is a history of multiple business failures!
- When you have established a customer’s creditworthiness, then you need to establish a credit limit.
The credit limit is not just the amount outstanding sales invoices, but the value of outstanding debt, plus the value of any unsatisfied sales orders. This is the total exposure to the customer.
If your customer places a sales order, for a product, the moment you start to place orders on suppliers, or commence manufacture, you have already committed your business’ time and resources to that customer. Orders in progress therefore need to be taKenneth into account, in the credit limit calculation.
However tempting, stick to the limit you have set, particularly over the short term.
As time progresses, if you establish a good and profitable trading relationship with your customer, then you will need to review the customer’s credit limit. But always keep a clear perspective of the customer, and be prepared to take speedy action if a customer appears to be an increasing credit risk.
Equally important, alongside the initial credit policy work, is to ensure that you systems are strong enough to support your credit sales.
I’ll cover these matters in my next article.
