From XU Magazine, 
Issue 27

5 Elements of a Strong Credit Policy

Every business seeks to fulfil its growth objective by maintaining a healthy cash flow and building a strong relationship with its customers. While extending credit to customers can help businesses achieve these goals, it can prove detrimental to business longevity in the absence of a strong credit management policy.
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Businesses need an integrated understanding of customer risk profiles and their risk tolerance levels to ensure their credit management is effective. Without developing a thorough credit policy, businesses can face the risk of a cash flow crisis, not to mention reputational risk.

The key to mitigating credit risk is to draw up a carefully crafted credit policy that includes the five key elements:

1) Evaluate your risk tolerance 

Evaluating whether your customers are trustworthy is a crucial part of the process. However, a credit check is just one aspect of the equation. When considering offering credit, you will also have to consider your risk appetite or tolerance – that is, how much risk you can take on overall and how much the credit offering contributes to the overall risk. In all cases, it is important to ensure your business balance sheet withstands losses of offering credit without the risk of insolvency.

An effective way to monitor your risk levels is by calculating the DSO or daily sales outstanding regularly to assess the health status of your accounts receivables. DSO is calculated by dividing accounts receivable by total credit sales and multiplying this by the number of days.

A low DSO indicates that you collect outstanding payments quickly after issuing your invoices. On the other hand, a high DSO can be a red flag and indicates there is a delay in the collection of outstanding dues. For businesses offering credit timeframes of 30 days, a  DSO level of less than 45 needs to be the goal.

Another metric you can use to evaluate your risk tolerance relates to receivables turnover ratio. This measures how effectively your business collects outstanding receivables. To calculate this ratio, divide net credit sales by accounts receivable average. A high receivables turnover signals your business is effectively collecting receivables. It can also indicate a stringent lending policy that may be deterring quality customers. This ratio can also help you fine-tune your lending policy.

2) Clear terms and conditions

Before offering credit terms to customers, ensure that the terms and conditions of the credit are clearly worded. This can include details such as credit check process, need for banking and trade references, interest charges on late payment, and disclaimers among others.

Include the details of the time frame such as ‘40 days’, and the disincentives/penalties for delayed payment (interest charges) and/or any incentives you might offer for early payments. Ensure a standard format of a declaration form that the customer signs to indicate their understanding and acceptance of these terms.

List the actions that you will take for late payment or non-payment, including warning process, consequences (withholding or lowering credit), as well as the collections process such as litigation or debt collection agency.

Depending on the nature of the business and transaction, specific conditions may have to be added in addition to basic terms. These terms of trade have to be dated and signed by the customer to indicate their agreement and acknowledgement of the terms. The following details will also need to be included in the credit policy:]

  • How risky a customer is
  • The customer’s history concerning prompt or late payment
  • Recorded legal action if any of the customer
  • ASIC information on businesses and their directors

3) Assess the creditworthiness of customers

Obtaining a credit report from credit agencies can give you the details you need to make an informed decision on extending credit. The report can provide data on:

  • How risky a customer is
  • The customer’s history concerning prompt or late payment
  • Recorded legal action if any of the customer
  • ASIC information on businesses and their directors

Credit testimonials or references can give you an idea of the debtor’s relationship with other creditors. Ensure you ask the right questions to creditors from your industry who best align with your business profile to derive the most value from credit testimonials.

Collect relevant information from customers such as their identification, address, contact details and their signature that confirms their acceptance of credit terms. Use the relevant business number such as ABN or ACN to check if the business is legitimate and is currently trading. Obtain credit references for the business and ensure you have comprehensive information on its partners and directors.

Conducting an accurate and comprehensive overall assessment of your customers is crucial before determining whether you can offer them credit. Once you obtain the list of references, you also need to call them to confirm whether the customer has a history of late payments or is not a credit risk. After establishing this, you can move on to the state of providing with them the credit application document.

4) Use a streamlined credit application

The credit application form captures information, such as:

  • The customer’s or the business’s full legal name
  • Type of entity or business structure such as partnership, sole trader, trust, company or government authority
  • Details of all the owners, directors and partners of the business
  • Business Registration Number - ACN or ABN
  • Postal address and place of business
  • Email address
  • Telephone numbers during and after business hours

The credit application form is a vital document that helps you gather crucial information about your customers. The more information that the application form captures, the higher your chances of ensuring the payments happen on time.

 Apart from giving you a clear picture of your debtor’s identity and place of business/address, the credit application form also helps you to:

  • assess the debtor’s ability to fulfil their financial obligations
  • obtain credit reports in accordance with the Privacy Act of 1988
  • ensure the terms of trade are read and understood by the applicant

A recent trade survey shows that 80% of credit managers used the information that debtors provided in the credit application form to decide on credit policies. The other major sources of information for credit managers, as per this survey, were business credit reports, credit scores and ASIC information.

Upgrading your credit application process to state-of-the-art online systems is a great way of ensuring it is seamless, quick and accurate. This will help optimise your customer experience while minimising the risks of errors and delays associated with manual application processes.

5) Strengthen payment management and monitoring

After extending credit, adopt best practices of payment management and risk monitoring to ensure your risks of non-payment or delayed payment are minimal.

Create a system to monitor invoicing, payment collection and overdue payments risk. Conduct a periodic risk assessment of your debtors in alignment with your credit policy and ensure an established process of collecting overdue payments. If your re-assessment and monitoring show the debtor’s risk rating has declined or there have been adverse events such as court ruling, follow the process of terminating the agreement with your debtor.

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