When running almost any business, a credit policy is indispensable. This document will outline your company’s stance on extending credit to customers and the terms and conditions of that credit. There are several components of a good policy, and it’s essential to get them all right. Here, we’ll discuss what goes into credit operations and how you can create a policy for your own business.
What Is a Credit Extension Policy?
It refers to the formal and documented procedure for extending credit. Generally, it should include these components of credit policy documents.
Credit Limits
What is the total amount of credit you can afford to extend to customers? You should consider the overall total vs. what you can afford to extend to each customer. Then, review customers’ creditworthiness before determining how much of that limit they become eligible to access.
Eligibility Requirements
What do customers need to meet before they’re eligible for credit with your business? These are a few factors you should review before making a final decision:
- Payment history with your company and other vendors
- Any outstanding balances they have with other creditors
- Personal and business credit report or score
- Any bankruptcies or liens against them
Credit Terms
What are the terms of credit extension after approval? Make clear decisions regarding these and other important factors:
- Whether they need to deposit a portion of the amount borrowed
- The interest rate you’ll charge on the outstanding balance
- How long they have to pay off the balance
- What payment methods you accept
- What happens if they don’t make payments on time
Documentation or Contracts
Finally, your policy should determine what documentation or contracts you’ll require from customers before extending credit. Sometimes, portions of the procedure might lead to the creation of documents, such as contracts formalizing the terms. Consider the following documentation examples:
- Credit applications
- Purchase orders
- Delivery receipts
- Sales contracts
- Bills of lading
- Modifications
How to Develop a Business Credit Policy
If you’re starting from scratch, you might be wondering how to develop a credit extension policy for your business. You’ll find that the steps correlate with the components of credit policy:
- Set credit limits. These will depend on your business’s cash flow and the creditworthiness of your customers.
- Establish eligibility requirements for your customers. Doing this will help you screen out those who are not likely to repay their debts.
- Set credit terms. These will include the interest rate you’ll charge and the time frame in which customers must repay their debts.
- Develop documentation or contracts for your customers. Formalizing the credit policy of a company protects the business in the event of a dispute.
Why Are Business Credit Policies Important?
In the past, businesses often operated without any formal contracts in place. People shook hands to formalize deals instead of signing on a dotted line. Over time, this practice became problematic, primarily when disputes arose. Formalizing credit policies can reduce the risk of these and other problems. Here are some of the many reasons you should establish a clear policy:
- It helps you avoid bad debt by screening customers before extending credit to them.
- It allows you to track how much credit you’re extending and to whom.
- It gives you a way to collect payments if customers don’t pay on time.
- It reduces the possibility of prejudices against eligible customers from marginalized groups.
- It reduces the risk of fraud and other unethical or illegal practices.
Some companies have so perfected their business credit policies that they have automated the process. Customers can know via a simple online application whether they qualify for credit and how much they can receive. Even without automation, having a formal policy in place can drastically improve the efficiency of your business and reduce undue pressure on your accounts receivable team.
