Building a Credit Policy That Works

Before you extend credit, you'll want to craft a policy that ensures you're making it easier for customers to pay you without making it a cakewalk for the unscrupulous to scam you.

Your credit policy is simply your approach to ensure your customers cough up what they owe you. It's really just a system for determining how you are going to collect payment from your customers. It doesn't have to be written down and notarized, but it does have to be planned out.

Think of all the possible credit policies that you could adopt as existing along a continuum. At one end of the continuum would be a completely lax credit policy that would allow customers to pay for the goods or services at their leisure (perhaps an arrangement you've made when you've lent money to close family). At the other end of the continuum would be a completely tight credit policy that would always require payment in cash up front, before the goods or services are delivered (such as ordering at a local fast food restaurant). In the middle would be a credit policy that balanced cash and credit.

Where along the continuum should your policy be? While it really should be as close to the completely tight end of the continuum as your business conditions will allow, reality dictates that, for most of your customers, your approach will be closer to the middle ground. To set up your policy, you'll have to answer three basic questions:

• Which types of credit do you want to offer?
• To whom do you want to offer credit?
• How much credit do you want to offer?

Exploring the Types of Credit to Offer

Industry customs will go a long way toward helping you to determine which types of credit you offer. Consider everyday examples:

• lawyers usually send bills after services are rendered
• ice cream vendors want cash before they'll pass your sundae over the counter
• clothing stores usually accept credit cards

The credit options you offer will also depend upon the type of business you operate and the type of customers you have. Understanding the basic guidelines for deciding the types of credit to offer can help immensely in your decision-making:

• Some small storefront businesses that sell primarily to individual customers accept only cash, although their numbers dwindle by the day. Of those that offer credit, most limit what they accept to checks and credit cards because the risks are fairly low.
• Home businesses, mail order businesses and eCommerce businesses need to accept credit cards, and, in many cases, online payments. Some accept checks.
• Business to business operations usually offer credit terms (payment due in 30 days, due in 60 days, etc.) to their customers. In most cases, the terms are determined by industry customs. Such terms are commonly called trade credit and have important implications for your cash flow.
• Professional small businesses, such as doctors, lawyers, consultants and accountants, usually offer credit terms to both individual and corporate customers.

If you don't fit into any of those categories, and you're having trouble deciding which types of credit to offer, weigh these considerations:

• Set your credit policy in relation to your cash flow needs. Your policy should be set to ensure that you're able to generate from your billings the level of cash that you need to operate your business.
• Expect to achieve your ideal credit policy only through trial and error. You'll inevitably make some errors about which individual or business is a good credit risk and which is not.
• Remember that your credit policy will change over time as your business needs change, the economic conditions in your industry change and the economic conditions in the country change. You should re-evaluate your policy periodically to determine if it is meeting your needs.
• Realize that the credit terms you offer might differ from one customer to the next. Your best customers might deserve more generous terms than your other customers. Conversely, your worst customers might deserve less generous terms than your other customers.
• Realize that the credit terms you offer to a particular customer might change over time. If a customer begins to be late on payments, you may have to reduce or eliminate the credit terms you offer that customer until he or she re-establishes a good payment record with you.
• Make sure that you coordinate your credit policy changes with your sales people, if you use different people to handle sales and billing/credit. You cannot change your credit terms after the sale, so it's crucial that your sales people are aware of your policy and any changes you may institute.
• Remember it's perfectly acceptable to offer a cash discount to customers who don't pay by credit.

Assessing an Individual's Creditworthiness

You might as well acknowledge right here and now that if you extend credit, you're going to have customers who won't pay you on time or even pay you at all. It's unavoidable. No matter how keen your judgment of other people is, you can't always identify the deadbeats. 

And, of course, not all of the customers who don't pay you on time are deadbeats. Some may be unable to pay you for any number of reasons beyond their control, such as a family emergency or an unexpected downturn in their industry.

The only foolproof way to avoid bad debts is not to offer any credit. Because that isn't practical for most businesses, you'll have to do the next best thing, which is to take all reasonable precautions to protect yourself and to ensure that you're not extending credit to the wrong person or business.

Taking precautions to help you reduce the chances that you'll extend credit to someone who doesn't pay his bills is an extremely important step for a small business owner. One bad debt can strain your cash flow or, in extreme cases, put you out of business. Just don't forget that the decision to extend credit to customers does not mean that you have to extend credit to every customer.

The precautions you take will depend upon whether the customer is an individual or a business. Essentially, you want to gather enough credit information on your customers to give you a good idea whether they are a good credit risk. 

The information you'll want to gather will be different for different types of businesses. For example, if you operate a mail order business, you may need to take steps other businesses don't have to take to make sure that the credit card is legitimate because you can't see your customer or the card they're using.

Obtaining Credit Information on Individuals

The information you'll gather on individuals will depend upon whether the credit is a credit card, a check or some other type of credit.

Individual Information and Credit Cards

Accepting credit cards presents a fairly safe credit risk for you because the risk really falls on the credit card company. And that accounts for one of the reasons you're paying them 2.5 percent to 5.5 percent of your credit sales. 

The card issuer takes responsibility for checking the cardholder's credit rating and for collecting the bills. As long as you follow the credit card company's procedures (checking the signature and expiration date on the card, for example) you should be able to eliminate the risk to yourself.

Individual Information and Checks

Accepting checks involves more risk than accepting credit cards because checks can, and do, bounce. When checks bounce, you — not the bank — will be the one left holding the bag. 

When you accept a check from a customer, take the following precautions:

• Ensure the check is signed and dated, that the amount is properly filled out in both places, and that the payee line is either filled in or left blank for you to fill in.
• If you don't know the person giving you the check, ask for a driver's license a phone number. Take down the driver's license number; you might need it (and the phone number) if you have to track him or her down later.
• Look for hints that something may be out of order. Is the customer's address not pre-printed on the check? Does the address on the check match the address on the driver's license? If you belong to a merchant's association or some other group that gives you access to a bad check list, call to find out if the customer is on the list. (In fact, you might consider joining such an association for that very purpose.) If that isn't an option, ask questions of the customer until you're satisfied that everything is in order. If the customer's answers are insufficient, don't accept the check.
• If the check is for an unusually large amount, call the customer's bank to verify that sufficient funds are in the account.

Individual Information and Other Credit

If you offer credit terms to an individual other than by check or by credit card, such as a lawyer who sends the bill after services are rendered, you can purchase a credit report on the individual that will give you information about his or her credit history. These reports can be obtained from any of the credit reporting firms, such as Experian or Equifax. To find a credit firm, just Google "Credit Reporting Agencies" or some similar listing.

Before you can secure a credit report, you must have permission from the customer. There are, however, two exceptions to the rule that you have to get permission from the customer:

• if you already offer open account terms to the customer
• if the customer owes you money

you don't have to get permission before you obtain the credit report.

Assessing a Business's Creditworthiness

Credit information is generally easier to obtain for businesses than for individuals because businesses often have more publicly available information.

The amount of information you collect should be in proportion to the amount of credit you intend to extend. If the credit limit you're offering is relatively low (say, $500), and the company has a good credit reputation as far as you know, you may not want to spend your time gathering more credit information. If, on the other hand, you intend to offer a high credit limit to a start-up company or a company that you don't know well, you may want to collect as much information as possible.

Information from Financial Statements

Financial statements are a valuable source of information. They'll tell you about the company's cash flow and about the income it's generating. You should ask for the:

• current balance sheet
• current income statement
• previous years' financial statements

You don't have to be an experienced accountant to get useful information out of them. The balance sheet is probably the most useful of the documents. It will show you both the cash the company has on hand and the amount of money it owes to other businesses. That will give you a general idea of its present ability to pay its debts. You'll also want gauge a business's creditworthiness by compare two sets of numbers.

The first set of numbers is the ratio of the company's current assets to its current liabilities. This is called the current ratio. If the current liabilities are greater than the current assets (in other words, the ratio is less than 1:1), the company is probably not a good credit risk. Anything over 2:1 (in other words, the current assets are at least twice as much as the current liabilities) is a sign that the company is probably a good risk. Anything between 2:1 and 1:1 is an iffier proposition, and you should probably seek more information.

Also compare company's total equity to its total debt, called the debt-to-equity ratio. If the total debt is more than the total equity (in other words, the ratio is less than 1:1), you should be careful. This is especially true for smaller companies. It is not uncommon, however, for larger companies to carry more debt than they have equity.

Income statements and the previous years' financial statements are generally not as helpful as balance sheets. But if you can get your hands on statements for the past three or four years, you should be able to get some feel for how the company has been doing by comparing the numbers. If income is on the rise during those years, the company is growing and it may be a good credit risk. If not, perhaps you should be hesitant to extend it credit.

Information from Credit References

Businesses can also provide credit references. But let's realize up front that credit references are, for the most part, worthless. If you ask for a reference, which names and numbers will a potential creditor give you? It'll give you only those references who will say good things.

The only value to these references, then, is if you call a credit reference and they give you negative information about the business (or say they never heard of it). In that case, you know the company's credit isn't any good. If their best references have bad things to say about them, why would you even consider extending them credit?

A possible alternative is to find out on your own who else they do business with, and ask those companies for a reference. If you have salespeople, they are often a good source of information about who else the company does business with.

How Much Credit Should You Offer

Your decision on how much credit to offer will be largely based on a combination of your gut instincts and trial and error. A good rule of thumb is to start with a small amount of credit and make your customers earn their way to higher limits.

When we talk of determining how much credit to extend to your customers, we're usually talking about how much credit to extend to your business customers. Most of your individual customers will be paying by cash, check or credit card. But if you sell goods or services to other businesses, they may ask you to extend a line of credit to them.

What Extending Credit to Businesses Means

Offering a line of credit to your business customers means you'll have two more decisions to make: 

1. how much of a credit line to extend ($200? $500 $1,000?)
2. which repayment terms to impose, such as the length of repayment time, interest or discounts

Like many aspects of business, hard-and-fast guidelines for determining how much credit to extend to your customers simply don't exist. But here are a few suggestions that might help you with your decision:

• Start small, particularly if your credit-checking reveals the company may be undergoing financial problems. Depending upon what you're selling, you might start with a $100 credit line with payment to be made within 10 days. Make your customers earn higher credit limits and better terms.
• Don't assume everyone is entitled to the same level of credit. Lenders don't, so why should you? If you're leery of a particular customer, keep the credit level low until he or she has proved to be creditworthy.
• Reward your best customers with higher credit limits or more favorable terms. You'll come to appreciate them. Also, if you end up with some customers who don't pay on time, your good customers may be the only thing between you and insolvency.
• Understand that larger companies are necessarily better at paying their bills on time (or at all) compared to smaller companies. In other words, don't give a company a higher credit limit or better terms than you otherwise might just because it's a "name company." In reality, the bureaucracy at most large companies can make debt collecting an extremely time-consuming process. Of course, if you want the large company's business badly enough, you may have to give in to their payment cycle. For example, if your terms are 30 days, but the large company pays its bills on a 60-day cycle, you may be forced to accept the 60-day terms. A large company is generally not going to change its payment cycle just for you.
• Don't hesitate to reduce a customer's line of credit or shorten the terms if that customer makes payments late. If you reduce the terms, however, you must inform the company before its next purchase. You cannot inform them of a change in your policy after they've already purchased your goods or services. Thus, if you have salespeople, you should tell them about your policy changes so that they can inform the customer.
• Coordinate your credit policy with your business needs, particularly with your cash flow needs. You've got your own bills to pay. You need to figure out how much you need coming in each month, and your credit policy should be designed to deliver enough income for you to meet your business needs.