Establishing an Appropriate Credit Policy
December 2004
Last month we discussed how a well thought out credit policy can be an integral part of your company's success. Establishing an appropriate credit policy gives your sales staff another tool and your customers a way to pay for your products and services. Some customers may abuse this policy, but taking precautions and being selective about who you extend credit to will help protect your business. This month we will cover the different types and methods for extending credit.
Established standards in your industry will guide you in determining which types of credit you may want to offer. For example, accountants and lawyers usually send a bill after the service is rendered, produce vendors want cash, and music stores usually accept credit cards, and so on. The credit alternatives you offer will also depend upon the type of business you operate, cash flow dynamics and the type of customers you have.
Credit policy decisions need to be driven by your cash flow needs and your ability to generate needed cash from your billings to operate your business. Remember, you are not a bank or in the business of lending money. Your ideal credit policy will be fine-tuned through trial and error and the inevitability of making some errors about who is a good credit risk and who is not. Expect your credit policy to evolve as your business needs change, the economic conditions in your industry change, and a customer's history changes. Re-evaluate your policy periodically to ensure it still meets your business's needs.
Credit terms can and will differ from one customer to the next and may also change over time. Your best customers might deserve more generous terms; alternately, your worst payers deserve tighter terms or no terms at all. If a customer starts faltering on payments, you might consider reducing or eliminating the credit terms you offer them until they re-establish a good payment record. It is critical that you coordinate your credit policy changes with your sales staff. You cannot change the credit terms after the sale, so it's crucial that your sales people are aware of your policy and any changes you may institute.
We typically think of credit extension where the customer receives a bill in the mail after receiving the goods or services. But credit comes in many forms and any time you don't collect full payment in cash up front, you are extending credit by default.
There are several major classes of credit:
Terms: You may want to offer credit terms to your customers. This usually occurs when you sell your goods and services to other businesses, but occasionally you may extend terms to individual customers. This is the riskiest form of credit since you're forced to rely completely on the creditworthiness of the payer. When you extend credit it is advisable to have them sign a sales contract, a credit application and ask for a purchase order which further documents the terms and conditions of the sale and payment. To be binding, the credit terms must be in writing and the document must be signed by the customer.
Credit Cards: If you decide to accept credit cards, you'll first have to decide which ones you want to accept: Visa, MasterCard, Discover, American Express, or any of the others. The charge you'll pay to the credit card company will vary, depending upon the volume of your sales and the size of your transactions. The average fee typically runs between 2.5% and 5.5% of your credit card sales, although American Express runs a bit higher. You'll also have various transaction processing fees from your bank or third party processor. Accepting credit cards is the least risky of the credit options because most of the risk is on the credit card company. You will have to have a merchant account with your bank and also be aware of "charge-backs". This is when a credit card holder denies making a purchase and it usually indicates fraud of some sort.
Checks: Checks have been included here because they do involve collections risk on your part. If you accept checks, you'll have to decide which types of checks you'll accept (such as single-party or multi-party checks), and you'll have to decide which types of identification you'll require. With the advent of credit cards, debit cards, internet and other forms of payment, most small businesses have stopped accepting personal checks.
Here are some general guidelines to consider when establishing your credit policy.
Small retail businesses that sell primarily to individual customers accept only cash. Of those that offer credit, most limit what they accept to checks and credit cards because the risks are fairly low.
Home and mail order businesses, and any other businesses that deal with customers primarily over the telephone or through the mail need to accept credit cards, and some accept checks.
Small businesses that sell goods and services to other businesses usually offer credit terms to their customers (such as payment due in 30 days or less, sometimes with quick-pay discounts).
Professional small businesses, such as doctors, lawyers, consultants, and accountants, offer credit terms to both individual and corporate customers.
Your credit policy is simply your approach to how you want to make your customers pay what they owe you. It's really just a system for determining how you are going to collect payment from your customers.
Next month we will cover what to look for when determining credit worthiness and offer several helpful sources for managing your newly established credit policy.
