The decision to extend credit to your customers is based on your company’s credit policy. Credit policy, you ask? Yes — credit policy. It doesn’t have to be formal, but it should be thought-out and in place when you need it.
A credit policy is the blueprint your company uses when deciding to extend credit to a customer. It outlines the methods (cash, check, credit card, etc.) under which your company accepts payment, the terms by which that money is due, to whom you will extend credit and how you will go about collecting payment from late-paying or nonpaying customers. With a credit policy that is neither too strict nor too lenient, you will ensure that your cash flow doesn’t suffer.
The primary goal of a credit policy is to avoid extending credit to customers who are unable to pay their accounts. Your credit policy has a direct effect on the cash flow of your business. A credit policy isn’t foolproof, of course: If you extend credit, chances are you are going to have customers who won’t pay you on time or even pay you at all. The only foolproof way to avoid bad debts is not to offer any credit. Since that isn’t practical for most businesses, you’ll have to do the next best thing — take reasonable precautions. A credit policy that is too strict will turn away potential customers, slow sales, and eventually lead to a decrease in the amount of cash inflows to your business. On the other hand, a credit policy that is too liberal will attract slow-paying, even nonpaying customers, increase your business’s average collection period for accounts receivable, and eventually lead to cash flow problems.
A good credit policy should help you attract and retain good customers without having a negative impact on your cash flow. To set up your credit policy, you’ll need to make three basic decisions:
- The types of credit you want to offer
- To whom credit should be offered
- The amount of credit you want to extend
The Types of Credit You Want to Offer
Industry standards are a great guideline toward helping you to determine which types of credit you offer. Here are some basic guidelines:
o Set your credit policy in relation to the cash flow needs of your business. Your policy should be set to ensure that you’re able to generate from your billings the level of cash that you need to operate your business on a weekly or monthly basis.
o Expect to achieve your ideal credit policy only through trial and error. You’ll inevitably make some errors about who is a good credit risk and who is not.
o Remember that your credit policy will change over time as your business needs change, as the economic conditions in your industry change and as the economic conditions in the country fluctuate. It’s good to reevaluate your policy periodically to determine whether or not it’s meeting your needs.
o Realize that the credit term you offer to a particular customer may change over time. If a customer begins to make late payments, you may have to reduce or eliminate the credit terms you offer that customer until they re-establish a good payment record with you.
To Whom Credit Should be Offered
When making this decision it’s important to take reasonable precautions when offering credit by gathering enough information on your customers to get a good idea as to whether they are a good credit risk. Credit information is generally easier to obtain for businesses than individuals because businesses often have more information publicly available.
The amount of information you collect should be in proportion to the amount of credit you intend to extend. Financial statements are a valuable source of information. They’ll tell you about the company’s cash flow and about the income the company is generating. Ask for current and prior year’s balance sheets and income statements. If the company cannot produce this information in a reasonable amount of time, that should raise a red flag that their recordkeeping might not be in order.
The Amount of Credit You Want to Extend
There aren’t any hard-and-fast rules for determining how much credit to extend to your customers, but here are a few general guidelines:
o Start with a small amount of credit and have your customers earn their way to higher limits
o Don’t assume that everyone is entitled to the same level of credit
o Reward your best customers with higher credit limits
o Don’t presume that larger companies are necessarily better than smaller companies at paying their bills
o Don’t hesitate to reduce a customer’s line of credit or shorten the terms if that customer begins to be late with its payments
Linda Hunt, delivers simple, practical strategies for creating systems and structure that create stability helping business owners to grow their business and earn more money. For more FREE tips like these, visit her at http://www.sumsolutions.com
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