The Three Components of Credit Policy

by Chirantan Basu; Updated September 26, 2017

Credit is at the heart of business transactions. Businesses extend credit to customers and make purchases on credit. However, sometimes customers fall behind on their payments and companies find themselves with uncollected debt, which reduces cash flow. An up-to-date credit policy helps a company proactively manage its outstanding invoices. The key components of a credit policy are goals and responsibilities, credit analysis and collections.

Goals and Responsibilities

The goals of a credit policy are to reduce the outstanding invoice amounts and the bad debt expenses. Companies could set different performance metrics, such as the average number of days an account is overdue and the total dollar value of outstanding invoices. For example, a company could set limits on the maximum number of days an account can remain overdue before the company writes it off and removes the customer's credit privileges. Setting organizational responsibilities is also important because it establishes an accountability chain and avoids duplication and confusion. For example, the managers of a company's retail stores may have the authority to approve credit limits up to $500, but the corporate finance department would have to review credit applications of higher amounts.

Analysis

The purpose of credit analysis is to distinguish between the customers who pay on time and those who do not. The credit policy should specify the format of credit application forms and establish clear guidelines for reviewing these applications. Depending on the size of the credit limit request, credit officers and managers may need to review Dun & Bradstreet credit reports, financial statements, operating history and other information from the application form before granting credit approvals. Analysis should be an ongoing process because changes in business and economic conditions could affect the financial health of individual companies or entire industries. Proactive credit management may require a company to turn down credit applications from certain companies and reduce or cancel the credit limits of others.

Collections

The purpose of the collections policy is to reduce the bad debt exposure of a company. The probability of a collection drops rapidly as an account ages. In other words, the longer an account is overdue, the more difficult it is to collect the outstanding balance. Collection procedures typically depend on the size and dollar value of the overdue account. A small business with a limited number of accounts may take a personalized approach to collections with phone calls or even personal visits. A large business with hundreds of accounts may adopt a gradual system of escalations. For example, it may send an email reminder when an account is seven days overdue and initiate telephone contact after an account is overdue for two weeks or more.

Other Considerations

The other components of credit policy include the terms of sale, the credit period and cash discounts. Common credit terms include "net 30" and "2/10, net 30." The term "net 30" means that full payment is due within 30 days. The term "2/10" means that a customer gets a 2 percent discount if he pays the full invoice within 10 days. Additional sections may include descriptions of ethics, quality, internal management reporting and record keeping.

About the Author

Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.