The three components of the credit policy

What is Credit Policy

Financial institutions must establish the criteria they will use to evaluate their clients and determine the level of risk to which they will be exposed with each credit. These policies are based on the strategies approved by the board.

Credit policies are the technical guidelines available to the financial manager of a company, with the purpose of granting payment facilities to a specific customer. This policy involves the determination of credit selection, credit rules and credit conditions.

Credit Policy Definition

A company’s credit policy sets the standard for determining whether credit should be granted to a customer and the amount of the latter. The company must not only deal with the credit standards it establishes, but also with the correct use of these standards when making credit decisions.

Likewise, the company must develop adequate sources of information and credit analysis methods. Each of these aspects of the credit policy is important for the successful administration of the company’s accounts receivable and thus avoid future problems. It should be considered that improper execution of a good credit policy or the successful execution of a poor credit policy will not produce optimal results.

If you have a company, you may have to start considering the option of giving credit to boost sales, especially if your competitors already do and have credit policies.

But granting commercial credit is not something that should be taken lightly because when you grant financing to your clients, you take risks.

The first and most tangible is the credit risk that materializes when the client simply does not honour their commitment. In addition, to grant credit you must set credit procedures and policies, hire specialists in credit analysis, fulfill provisions, carry out collection and monitoring. All of which implies management, time and costs.

However, credit risk and the costs of granting credit are not grounds for credit financing not being an integral part of the heart of commercial transactions.

The companies extend the credit to their clients who in turn make purchases on credit. This, in spite of the fact that sometimes the clients fall behind in the payments and the companies, encounter a debt of difficult collectability, which reduces the flow of cash.

An updated and fully complied credit policy helps companies to proactively manage their accounts receivable portfolio, minimizing risks.

The main components of a credit policy are:

• The Goals and Responsibilities
• The Credit Analysis
• The Collection

We will make an analysis of the most outstanding aspects of each of them.

Components of the credit policy

For the University of Missouri in San Luis, the United States, the components of a credit policy are:

• The setting of responsibilities, terms and conditions: duties of the debtor and the borrower, as well as the definition of the terms that will govern transactions such as discounts for prompt payment, interest rates, terms and payment schemes.
• Credit analysis standards: what will be the eligibility rules? It takes into account the requirements that must be met, procedures, collections, and so on. They are also the methodologies for valuation; while stricter, they tend to reduce sales more, but they also reduce the uncollectibility.
• Policies and collection procedures: will be preventive or formal and strict, what recovery measures will be stipulated?

Objectives of Credit Policy

Under the adage “clear accounts, long friendships”, the first step in the determination of credit policies is the establishment of the general terms that will govern credit operations, as well as the determination of objectives, metrics and responsibilities.

The components of the credit policy include the terms of the sale, the credit period and the cash discounts. Common credit terms include “30 net” and “2/10, 30 net”.

The term “net 30” means that the full balance must be paid within 30 days. The term “2/10” means that a customer gets a 2% discount if he pays the total bill within 10 days. Sections of additional terms may include descriptions of ethics, quality, presentation of internal management reports and record keeping.

• Short deadlines minimize the risk of recovery although they threaten the customer’s ability to pay.
• The discounts for prompt payment stimulate fast recovery; some operations may stipulate the collection of interest, others may be subject to special terms and conditions.
• All this must be agreed upon in credit policies.

The objectives of a credit policy are the optimization of the portfolio of accounts receivable that results in the reduction of the amounts of invoices pending payment and the expenses for the inability to collect.

Companies could establish different performance metrics, such as the average number of days an account is due, the total value in dollars of outstanding invoices or the percentage of accounts in past due status, with respect to the total accounts receivable.

Establishing responsibilities and autonomies regarding credit is also important since it defines a chain of accountability and avoids duplication of tasks and confusion.

For example, managers of a company’s retail stores may have the autonomy to approve credit limits of up to $ 500, but the corporate credit department would have to review funding requests for larger amounts.

Goals of Credit Policy

The purpose of the credit analysis is to distinguish between customers who will pay on time and those who do not. To do this, stipulate eligibility standards, collections and requirements to be met, which, the more rigid they are, will represent fewer concessions as well as probabilities of default.

The credit policy must specify the credit application forms and establish clear methodologies for reviewing these applications.

Depending on the amount of the credit application, credit analysts and managers may need to review the risk reports of specialized firms such as Dun & Bradstreet and other records, as well as analyze the credit ratings of the applicant, evaluate the financial statements, the history of operation and other information that the application form must contain, before granting credit approval.

The analysis of credit should be a continuous process since changes in industries and economic conditions could affect the financial health of companies or entire sectors. Revisions should be made two or at least once a year.

The proactive credit management may require the company to terminate the credit lines granted to certain companies and reduce credit limits of others.

Collection and collection policies

The site Alloysilverstein.com affirms that collection and collection policies allow having clarity about the steps to follow when the account becomes “delinquent”. The purpose of the collection policy as part of the credit policy is to reduce the exposure of a company’s uncollected debt.

The probability of a successful collection falls rapidly as an account age. In other words, the longer an account has expired, the more difficult it will be to collect the outstanding balance and the more cost it will represent. The collection procedure will depend on the size and dollar value of the overdue account.

A small business with a limited number of accounts can take a personalized approach to collections, such as phone calls, and even, personal visits.

A larger company with hundreds or thousands of accounts can adopt a gradual system of collection escalations. For example, a reminder can be sent by email when an account is seven days late, initiate telephone contact after an account has expired for two weeks, and deliver the collection management to a legal firm or specialized firm when the account exceeds 45 days late.