Credit Policy

CRF thanks Cliff Miller for his help with this material.

The word, "policy", can be a broad and frightening term. While most companies have their own policies, procedures, and guidelines, it is unlikely that any two firms will define them in a similar manner. Furthermore, while many individuals appreciate the need for a workable set of regulations, "policy" carries some negative connotations of bureaucracy and inflexibility. The word is derived from the same root as politics and police, and the sentence, "It's not our policy," can infuriate customers.

In this paper, we will use a definition that appears in the Credit Executive's Handbook: A policy is a general course of action developed for recurring situations, designed to achieve established objectives. We will examine the need and benefits of such a credit policy, the reasons for different approaches in various organizations, questions of how detailed or long a policy should be, and the need for supplementary procedures. We will then develop a sample policy, together with some specific procedures, which can be easily modified for your own company's needs.

An Opportunity for the Organization
There are at least four reasons to have a written credit policy, and they each add to the productivity of your entire organization.

First, the responsibility of managing receivables is a serious undertaking. It involves limiting bad debts and improving cash flow. With outstanding receivables often being a firm's major asset, it is obvious that a reasoned and structured approach to credit management is necessary.

Second, a policy assures a degree of consistency among departments. By writing down what is expected, the arms of your company (whether marketing, production, or finance) will realize that they have a common set of goals. Conversely, a written policy can delineate each department's functions so that duplication of effort and needless friction are avoided.

Third, it provides for a consistent approach among customers. Decision making becomes a logical function based on pre-determined parameters. This simplifies the decision process and yields a sense of fairness that will only improve customer relations.

Finally, it can provide some recognition of the credit department as a separate entity, one which is worthy of providing input into the overall strategy of the firm. This allows the department to be an important resource to upper management.

One can see that developing a policy is more than a necessity. It is an opportunity to improve the efficiency of your entire organization.

Why Policies Differ
Credit policies differ in both length and content.

Concerning length, some are as short as several paragraphs, while others can go on for many pages. As one might suspect, there are advantages and drawbacks to each approach. In a positive sense, a detailed policy leaves little room for doubt. Procedures are spelled out, and employees need only refer to their manual to know how to perform. There will be no gray areas between departments, and consistency will reign.

On the other hand, a long and excessively detailed policy can limit employee creativity or empowerment. New ideas on how to work in a changing world will be superseded by a set of omniscient regulations. Also, a huge volume of rules can be overwhelming. There is the story of a cartographer who wanted to map his country so perfectly that he drew it on a scale of one to one. When completed, he found that he had nowhere to place the map. Similarly, too many written regulations can actually get in the way of productivity.

The above arguments present a question of balance. As noted in our initial definition, a policy must express a general course of action. It can be supplemented, however, with some procedures that can guide daily functions. We will use this approach in our later examples.

The question of companies having policies with differing contents is worth mentioning. This can result from many factors which may include the competitiveness of your industry, the location, profit margins, your company's goals for market share, the company's own cash requirements, production needs, or the size and culture of your firm. It is a truth that many policies can be designed, and each one may be correct for a particular firm.

With this in mind, we will not try to provide a generic credit policy. Instead, we will offer an approach for the development of your own policy and a format which may prove effective.

Developing Your Policy
In order to write a policy, there are at least six questions that you and your company must answer:

  • What is our mission?
  • What are our goals?
  • Who has specific credit responsibilities?
  • How is credit evaluated?
  • How is collection handled?
  • What are our terms of sale?

    Additionally, other areas you may wish to include concern your company's views on reporting, ethics, quality, training, deductions, and credit interchange with other professionals.

    We will now begin building a credit policy. In the following pages, we will look at each of the above questions individually. Several potential answers will be offered for each question, and you should choose one that best fits your own company. Keep in mind that there is no right or wrong answer, but the one you choose should reflect what is best for your own firm. While this is a credit policy, you should remember that you will need support from your management as well as marketing personnel. The policy needs to be advantageous to all, so it would be appropriate to consult with others when you choose answers.

    Once the questions are answered, they can be put together in the format of a policy. A sample is shown in Appendix 1. A worksheet is also available at the end of this paper for you to record and consolidate answers for your own firm.

    Question 1. What is our mission?
    The most important part of a policy is defining your department's mission. Some firms choose to call this a vision or a purpose, and it must coincide with the firm's overall direction. For example, a mission might be worded as follows:

    The Credit Department is responsible for maintaining a high quality of accounts receivable while selling to all customers that represent prudent credit risks. We will provide flexible mechanisms to protect our substantial receivable investment.

    A company, however, that is striving to gain market share may wish to have a far more liberal credit policy. Its statement might read as follows:

    It is our policy to provide credit to all potential applicants, regardless of payment experience. The Credit Department will attempt to screen out customers that will result in obvious bad debts. We will attempt to build relationships with all other customers and affect collection without jeopardizing a sales relationship.

    A firm that has a strong market position and is primarily concerned about its own cash flow would take a far more conservative approach toward its mission:

    The Credit Department is responsible for collecting our investment in accounts receivable. It is our responsibility to take no unwarranted risk, and to see that payments are made within terms. We will advise our Sales Department of customers that are risk situations and make efforts to limit our credit exposure in these areas.

    These three examples represent quite different roles for a credit department. In our sample policy (Appendix 1), the firm chose the first paragraph.

    You should now choose one that best fits your company or write one of your own. Enter this on your worksheet as the first paragraph of your policy.

    Question 2. What are our Goals?
    You can take at least two approaches here.

    First, one can write a specific set of numerical goals as follows:

    Our goals are to limit bad debts to ____% of sales, Days Sales Outstanding to ____ days, and receivable ageings to no more than ____% beyond 60 days. We will visit ___ customers during the next year, limit our outstanding deductions to no more than ___, and review all credit limits of over $_____. We will also cut credit department costs by $_____.

    These goals must be arrived at in conjunction with your management. The Credit Research Foundation also provides many industry benchmarks that can help to arrive at reasonable goals for your firm.

    A second approach is to write a generic statement on the subject:

    The department strives to meet goals, established by senior management, which relate to bad debts, receivable ageings, and Days Sales Outstanding.

    This approach may be advantageous since goals frequently change. Thus, the credit policy does not require constant revision. It is important to note, however, that this should not be treated as a mechanism to ignore goal setting. Instead, written goals should be established in a separate memorandum so the entire organization understands its aims.

    Our sample policy used the first approach. Now, write your policy's goal statement on your worksheet.

    Question 3. Who has Specific Credit Responsibilities?
    This may be the most important part of your policy statement. If properly defined, it establishes the role and authority of each individual who relates to credit. Duplication of effort is avoided and inter-departmental squabbling is eliminated.

    An example of one policy, in which the Credit Department has ultimate authority, is as follows:

    The Credit Department reports to the office of Treasurer. It includes all functions relating to the extension of credit, collections, and cash application. The Credit Manager establishes all credit limits, has final authority to release or hold all orders when credit problems exist, decides when credit privileges should be revoked, and decides when formal credit activity should be initiated.

    A more typical approach, however, recognizes a team concept within the organization. There is nothing wrong with sharing responsibility and authority as long as it is properly defined within the policy.

    For example:

    The Credit Department reports to the office of Controller. The Credit Manager may establish limits of up to $_______, and the manager may delegate up to $_______ of authority to other credit personnel. Higher limits must be approved by the Controller of above.

    In the event an order is being held because of credit problems, the Sales Manager may override the decision for a single order. For further orders, the Sales Manager must review the situation with the credit manager and controller. If a consensus cannot be reached, the situation will be referred to the President for a decision.

    Notice that this latter policy places some limitations on the Credit Department. This should not be viewed as a loss of power. It is merely a way of providing a well-defined mechanism to achieve input from another portion of the organization. It permits the Credit Manager and Sales Manager to "agree to disagree" while still maintaining a pleasant business relationship.

    Similarly, in the following example a firm has chosen to define the treatment of serious delinquency as a team approach:

    When normal collection activity is exhausted, the Credit Manager may recommend the use of a Collection Agency or attorney. The Controller and Sales Manager will initial such requests.

    You should now write one or two paragraphs that defines the credit authority and responsibility within your organization, and this should be listed on your worksheet.

    Question 4. How is Credit Evaluated?
    Depending on the size and complexity of your organization, this section may involve a varying degree of detail. A general statement for a larger organization might be as follows:

    The Credit Department establishes limits for all active customers. Such limits may be based on D&B or TRW ratings, NACM reports, credit references, financial statements, security, or other information obtained directly from the applicants. All decisions are judgmental with no utilization of scoring techniques.

    The department reviews larger limits on a periodic basis. All limits are subject to revision, based on changing levels of credit worthiness. The department receives referrals of all orders that would place an account over its limit, and credit personnel may release additional orders if higher credit is justified.

    You will notice that this type of statement does not provide day-to-day instructions. This company might want to develop a Procedure to meet this function. An example is shown in Appendix 2.

    A different approach would be to list some details in the policy itself. This might lend itself to a smaller organization where orders are for a lower dollar volume. For example:

    The sales representative will obtain a credit application from each customer. This will contain a bank reference and three trade references.

    After calling references, the Credit Department will determine if a customer has demonstrated the ability to pay bills in a prompt manner. If so, a credit limit will be assigned. This credit limit should not exceed the highest extension reported by references. If a higher amount is necessary, the credit department will order a report from NACM, D&B, or TRW to review further experience. Such a report will always be obtained for limits over $__________.

    For limits in excess of $___________, a financial statement will also be obtained.

    Limits will periodically be reviewed. If trade experience with our company slows beyond ___ days, the limit will be revoked.

    Our discussion here is obviously limited. Books have been written on this subject. What is important is to establish a consistent procedure so all potential customers are treated equally. After considering your firm's approach to the evaluation of credit, enter comments on your worksheet.

    Question 5. How is Collection Handled?
    This question is at the heart of any credit policy. How your department answers it will determine the major activities you perform.

    Again, you may wish to rely on a general statement such as:

    The department is responsible for performing collection activity. Form letters and/or statements may be supplemented with telephone collection calls. Sales personnel will be advised of particular problems. In some cases, credit personnel will visit customers. If appropriate payment arrangements cannot be made, the credit department may withhold further shipments.

    The Credit Department determines if an account is not collectable by the above means. Uncollectable accounts usually include bankruptcies, assignments to creditors, and customers that do not respond to our normal collection activities. In such cases, the accounts will be referred to collection agencies or attorneys.

    An alternative company might rely solely on telephone contacts. Their policy would read:

    All customers will be called when they are ___ days past due. At least three calls will be initiated. If no payments are received, the sales representative will be asked to contact the customer. If there is still no response, the Controller of our firm will decide if an account should be sent to our attorney.

    Or a different approach may leave collection responsibility with the sales force:

    The Credit Department monitors all collection for the company. The department provides Sales representatives with a weekly list of customers who are ____ days past due. The Sales Representative makes customer contacts and advises of results. If delinquency still exists after an additional ___ days, orders are withheld.

    The Credit Department will then supplement these calls with final collection letters or statements. If payments are still not received after an additional _____ days, the Credit Department will determine if referral to an agency is warranted.

    In the case of bankruptcies, the Credit Department files proofs of claim. The department represents our company with creditor committees and coordinates with attorneys.

    After thinking about how your collection function should work, describe it on your worksheet.

    Question 6. What Are Our Terms of Sale?
    It is important to have no confusion about when bills are due. For some businesses, this is not a difficult problem. They have a homogeneous product line with consistent set of terms. Thus, their policy may be relatively simple:

    Terms of sale have been established by management as ______________, and all credit worthy customers are expected to pay within this period.

    For other companies, however, the problem may be more complex and critical. Some companies have many product lines with varying sets of terms. Other firms offer special seasonal dating. Finally, others may react to competitive practices and grant individual customers special arrangements.

    These firms may choose to address the issue within their policy or with individual procedures. An example of such a policy would be as follows:

    The standard terms of sale available for satisfactory credit risks are:

    Product:
    ___________________________________
    ___________________________________
    ___________________________________
    Terms:
    ___________________________________
    ___________________________________
    ___________________________________

    Any exceptions must be based on competitive practices and generate a satisfactory return on investment. They are to be requested by the Marketing Manager, reviewed for credit worthiness by the Credit Manager, and approved in writing by the President.

    This firm might then rely on a more specific Procedure, an example of which is shown in Appendix 3.

    Now enter your own company's policy on your worksheet.

    Other Factors Worth Mentioning
    You now have written the basic portion of your credit policy. For many firms, this will be sufficient. Yet American industry is complex and there will probably be items that you wish to add. This could include comments on ethics, legality, quality, industry-specific programs, reporting, personnel, credit interchange and professional organizations, systems, deductions, returned checks, collection mechanisms, international trade, and record retention. There are undoubtedly items that belong on this list that we have not anticipated.

    You will note that our sample company (Appendix 1) has included some of these issues in a final section called Receivable Maintenance and Service. While each firm requires a different approach, we certainly recommend a statement that reinforces ethical behavior and credit professionalism.

    Finally, we must remember that a policy is not a static document. It should be reviewed periodically to reflect changing circumstances. One might even consider making this part of the document itself by adding this final sentence:

    This Policy will be reviewed on an annual basis.

    Conclusion
    This paper began by mentioning the negative connotations of the term, policy. Hopefully, as you have considered what will go into your own document, the positive aspects have become apparent. You should now take what you have written down, read it as a whole, and make sure it reflects what is best for your organization. This will be your credit policy.

    We have resisted the temptation to take a dogmatic approach and write something for all firms. Instead, we have provided a framework for the individual credit managers to work with in a creative manner. This approach should contribute to your company's well being, your own personal satisfaction, and how our credit profession is regarded.


    Appendix 1

    Sample Company's Credit Policy

    Mission:
         The Credit Department is responsible for maintaining a high quality of accounts receivable while selling to all customers that represent prudent credit risks. We will provide flexible mechanisms to protect our substantial receivable investment.

    Goals:
         Our goals are to limit bad debts to ___% of sales, Days Sales Outstanding to ___ days, and receivable ageings to no more than ___% beyond 60 days. We will visit customers whenever necessary and strive to resolve all deductions within 90 days.

    Organizational Responsibilities:
         The Credit Department reports to the office of Treasurer. Functions include the application of payments, establishing credit limits, and monitoring collection of receivables.

    The Credit Manager establishes limits of up to $_______ and may delegate a portion of this to other department members. Higher limits are approved by the Treasurer or above. If credit privileges are withdrawn from a customer, it is our policy to consult with marketing personnel in the decision process. If a consensus cannot be reached, the situation is referred to the President.

    When accounts cannot be collected with normal means, the Credit Manager recommends the use of a Collection Agency or attorney. The Treasurer and Sales Manager approve such requests.

    Credit Evaluation:
         The Credit Department establishes limits for all active customers. Such limits are based on trade information and financial statements when necessary. (See Appendix 2 for a Procedure).

    The department reviews larger limits on a periodic basis. All limits are subject to revision, based on changing levels of credit worthiness. Individual orders are referred to the credit department when an account is over its limit or 15 days past due, and an effort is made to resolve such problems. If satisfactory arrangements cannot be made, the order is withheld.

    Collection:
         We strive to have a consistent and courteous approach to collection. All customers are called when they are ____ days past due. If no payments are received after three calls, the sales representative is asked to contact the customer. If there is still no response, the account is considered for legal action.

    In the case of bankruptcies, the Credit Department files proofs of claim. The department represents our company with creditor committees and coordinates activities with attorneys.

    Terms of Sale:
         Terms have been established as Net ___ days. All credit worthy customers are expected to pay within this period. Any exceptions must be based on competitive practices in accordance with established procedures. (See Appendix 3 for an example.)

    Receivable Maintenance and Service:
         The Credit Department initiates the handling of all deductions promptly to assure quality receivables. Customer inquiries always receive immediate attention.

    We are dedicated to behaving in a moral and legal manner. The sharing of business information and other credit matters will be in compliance with NACM's Canons of Business Credit Ethics.

    This policy will be reviewed on an annual basis.




    Policy Approvals:

    ___________________________
    Credit Manager

    ___________________________
    Marketing Manager
    ___________________________
    Treasurer

    ___________________________
    President


    Appendix 2

    Sample Company

    Procedure #1 Credit Evaluation Effective Date: x/x/xx Revised: x/x/xx

    Purpose:
    This procedure defines Sample Company's approach to evaluating new customers.

    Details:

    1. For any new customer, the appropriate sales representative will obtain a credit application. This will include a minimum of three trade references and telephone numbers, a bank, and the names of the principals. The sales representative will estimate the amount of credit which will be needed to service the customer within normal terms of sale. If the required limit is above $xxxxxx, a financial statement will also be obtained.

    2. The credit representative will check the D&B rating and may automatically establish limits according to the following matrix:
      5A1-5A2
      4A1-4A2
      3A1-3A2
      2A1-2A2
      $xxxxxxx
      xxxxxxx
      xxxxxxx
      xxxxxxx
      For any other ratings, the credit department will initiate an investigation.

    3. For limits under $xxxxxx, three trade references will be called. The credit manager will consider if the customer has demonstrated an ability and willingness to pay at the required level, and a judgmental decision will be reached. If enough information is not available, additional sources such as NACM trade reports will be ordered.

    4. For limits that are requested in excess of $xxxxxx, the credit department will always obtain a trade report from D&B, TRW, or NACM. In the absence of derogatory information such as judgments or liens, an appropriate limit will then be established.

    5. For any higher limit in excess of $xxxxxx, a financial statement will be reviewed. Considerations will include liquidity and debt capacity. In general, we will require positive working capital, a debt:equity ratio of no more than 3:1, and our limit will not exceed 25% of the applicants net worth unless approved by senior management.

    6. Before rejecting any customer whose potential volume exceeds $xxxxxxx annually, the application will be forwarded to the controller for review.

    7. If necessary, the credit department may rely on guarantees or Letters of Credit to complete sales.

    8. If open terms cannot be justified, the customer will always be given the opportunity to purchase on a cash basis.

    9. For all accounts with limits in excess of $xxxxxx, a new trade report will be obtained annually.


    Appendix 3

    Sample Company

    Procedure #2 Competitive Arrangements
    Revised: x/x/xx
    Effective Date: x/x/xx

    Purpose:
    Normal terms offered by Sample Company are Net xx days. At times, we may find that a customer is offered a longer set of terms by competition. This procedure outlines steps that we will take when a customer requests that we be competitive in this area.

    Details:

    1. The sales representative will confirm that different terms of sale are truly being offered by a competitor. This will be accomplished by actually seeing an invoice or letter offering these arrangements. We will not initiate non-standard terms, but we will consider meeting competitive practices.

    2. The sales representative will complete a memorandum, addressed to the Sales Manager, which includes the following:
      1. What arrangements are being offered by specific competitors?
      2. What are our annual sales?
      3. What is our anticipated gross profit?
      4. How much additional receivables will be outstanding if we offer this competitive arrangement?
      5. Based on a cost of capital of x%, what will be the cost of carrying these receivables?
      6. For how long would we be expected to continue this arrangement?

    3. The Sales Manager will review the request and determine if marketing factors justify granting this request. If so, the memorandum will be initialed with a recommendation for approval and forwarded to the Credit Manager.

    4. The Credit Manager will review the situation from a standpoint of additional risk. If in agreement, the request will be approved and forwarded to the President for final approval. Otherwise, it will be returned to the Marketing Manager with comments that detail the credit difficulties.

    5. The President will make a final judgment. If the President approves the arrangement, the Sales Representative will be instructed to notify the customer.

    6. The Credit Department will take steps to adjust ageings and delinquency letters to reflect new arrangements. The department will monitor the account to be sure that the special arrangement is followed.


    Credit Policy Worksheet

    Mission:









    Goals:









    Organizational Responsibilities:









    Credit Evaluation:









    Collection:









    Terms of Sale:









    Receivable Maintenance and Service:









    Approvals:









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