The definition of "policy" can be broad and some may feel that the word itself has negative connotations. A policy can be a written or unwritten guideline developed out of recurring situations and its intent is to achieve required goals and controls. Most businesses have their own set policies, procedures and rules of thumb tailored to their particular industry. There are some commonalities, but most policies will reflect the quirks of that particular trade.
While many corporations appreciate the need for a workable set of rules, the word "policy" carries some issues of flexibility and bureaucratic "red tape." Sometimes telling a client that "It's not our policy" can alienate and offend them.
Let's look at the need and benefits of having a defined credit policy. We will create a sample policy with some specific procedures which can be easily modified for your own company's needs.
Managing accounts receivables is a serious undertaking. One is required to keep bad debts down to a minimum all the while maximizing sales and improving cash flow. Most often, AR is the company's largest liquid asset so a reasonable and structured approach to credit management is imperative.
A formalized written policy assures a degree of consistency among departments. By writing down what is expected, the various company departments will realize that they have a common set of criteria. A written policy can streamline various functions so that duplication of effort and needless friction are avoided. It also allows for a consistent approach among customers. Decision making becomes a logical function based on preapproved parameters. This simplifies the decision process and yields a sense of fairness that will only improve customer relations.
A policy can provide some recognition of the credit department as a separate entity, one worthy of providing input into the overall strategy of the firm. This allows the department to be an important resource to upper management.
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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 can differ in both length and content. Some are as short as several paragraphs, while others can go on for many pages. There are advantages and disadvantages to each approach. 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.
A long and excessively detailed policy can limit employee creativity or empowerment. New ideas on how to work in a changing world will be squashed by a set of all encompassing regulations. A huge volume of rules can be overwhelming. Too many written regulations can actually get in the way of productivity.
Your policy should take into consideration 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.
Try not to design a generic credit policy. Instead, offer an approach for the development of your own policy with a format that will prove effective.
Developing Your Policy
In order to write a policy, there are at least six questions that you and your company must answer:
1. What is our mission?
2. What are our goals?
3. Who has specific credit responsibilities?
4. How is credit evaluated?
5. How is collection handled?
6. 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. Remember that you will need support from your management as well as sales/ marketing personnel. The policy needs to be advantageous to all, so it would be appropriate to consult with others when you choose answers.
Once all the questions are answered, they can be put together in the format of a policy.
Question 1: What is our mission or purpose?
A formal documented credit policy should be in place to protect the company from potential financial losses on new or existing accounts. A formal policy is required to minimize bad debt write-offs while at the same time allowing sales and marketing every opportunity to service new and existing accounts in good standing.
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:
Credit may be extended to any new or existing account that meets the credit requirements. If a customer has a favorable past history, new and updated information may only be requested as necessary in order to approve the transaction. Any customer which has abused their credit privileges in the past may be required to pay in advance either all or part of the new production with cash, credit card, certified cheques or post dated cheques.
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 filter 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 receivables. 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. Certain high-risk accounts, some foreign clients or previous insolvent corporations may not be able to get credit extended and therefore must pay by cash, wire, credit card or certified cheques or money order in advance of the work/product being manufactured and/or released.
(An example of the high-risk category would be foreign companies, previous delinquencies, one-time orders, or brand new companies with little or no financial information available, etc.)
These examples represent quite different roles for a credit department. You should now choose one that best fits your company or write one of your own. Start a worksheet and enter this 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.
* To reduce days sales outstanding to--days.
* To bring receivable agings to no more than--% beyond 60 days.
* We will visit--customers during the next year.
* We will limit our outstanding deductions to no more than.
* We will review all credit limits above $--.
* We will also cut credit department costs by $--.
These goals must be arrived at in conjunction with your management. There are many industry benchmarks that could 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 agings 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.
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 the Vice President Finance/CFO/Controller. 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 Manager reports to the office of VP Finance/ CFO/Controller. The Credit Manager may establish limits of up to $--, and the above manager may delegate up to $-- of authority to other credit personnel. Higher limits must be approved by the CFO/VP Finance. 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 be kept informed of such a decision.
You should now write one or two paragraphs that define 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 Manager establishes limits for all active customers. Such limits may be based on D&B or Experian ratings, credit references, financial statements, security, or other information obtained directly from the applicants. All decisions are based on judgment with no utilization of scoring techniques. The Credit Manager reviews larger limits on a periodic basis. All limits are subject to revision, based on changing levels of creditworthiness. 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.
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 may order a report from Experian, D&B or CBA 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.
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 creditors' 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 creditworthy 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:
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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 creditworthiness by the credit manager, and approved in writing by the president.
This firm might then rely on a more specific procedure. 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. While this will be sufficient for many firms, there will probably be items that you wish to add. These 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 have not been anticipated. While each firm requires a different approach, it is certainly recommended that a statement reinforces ethical behavior and credit professionalism.
Finally, it must be remembered 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 document 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.
This document has provided a framework for 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.
Paula Thorpe is a seasoned credit executive, writer and guest speaker who has worked for both North American and Global based industries. She holds her AC1 designation through the Credit Institute of Canada and is active in both the CIC and NACM. She can be reached at thorpepaula@yahoo.com.
To obtain a copy of a sample worksheet or sample policies, please contact the author at the email address listed above.
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