The credit policy is a critical document for any business, but especially one in the credit-heavy construction industry. Your company should clearly lay out its philosophy on extending terms to customers and collecting on overdue accounts. If there’s no plan, there’s no hope for survival.
What is a Credit Policy?
Simply put, a credit policy is a set of guidelines that:
- Are used to determine which customers are extended credit and billed.
- Set the payment terms for parties to whom credit is extended.
- Define the limits to be set on outstanding credit accounts.
- Outline the steps or procedures used to deal with delinquent accounts.
When it’s broken down into its component parts, a credit policy seems to be an encapsulation of how risk averse a company is vis-a-vis extensions of credit and other monetary policies with respect to accounts receivable.
Many businesses – generally retail establishments selling goods or services to individuals – rarely extend credit, and require payment immediately upon purchase. For this type of business, a credit policy is a low priority, and this makes sense. There isn’t any exposure from extending credit when the business is not in the practice of extending credit to begin with.
For most other business, including those involved with the construction industry, a sound credit policy should be an integral part of the company’s business plan, monetary policy, and overall risk-management strategy.
Deciding what your Credit Policy should be
Once you have decided to formalize your credit policy, whether that entails creating one from scratch or piecing one together from elements your company already has in place, the question is: How do I make my credit policy a good one?
The end goal of all credit policies is to maximize the company revenue/business while minimizing the risk generated by extending credit. Credit policies are generally not off-the-shelf or grab-and-go products. While it’s true that the end goal of all credit policies is to maximize the company revenue/business while minimizing the risk generated by extending credit – the ways to get there can vary depending on many factors, such as:
- The size of the business
- The specific cash-flow of the business
- The industry of which the business is a part
- The overall economic climate
Depending on the percentage of credit sales – there is a strong link between the restrictiveness of the credit policy and the amount of sales. Clearly, the easier it is to get credit, the more customers are able to purchase, and sales go up. However, as we have seen more than enough of recently, making credit too easy to obtain can result in more failures to pay as more of the customers default on the obligations. Clearly, some balance must be reached between very restrictive and very lenient credit terms.
As outlined in the definition above, credit policies set forth the credit terms, the credit limits, the type of customer to whom credit will be extended (information needed before extending credit to a new customer, i.e. a credit report? number of years in business? how much they intend to purchase? etc.), and the policies for dealing with late payments and delinquent accounts.
Fortunately for parties in the construction industry, having a good lien and notice management strategy can enable businesses in the industry to have a more lenient credit policy without as much worry as a blind extension of credit.
The mechanics lien (or bond claim) laws, and the corresponding notice requirements, turn the extension of credit into secured debt by tying the debt to the property being improved (or the bond securing the work), and also make more parties liable for the payment of that debt. This can dramatically reduce the chances of not getting paid.
Crafting a Credit Policy
Since a sound credit policy isn’t a one-size-fits-all proposition, it must be tailored to the individual business. Nevertheless, when starting to craft your organization’s policy, there is some value in reviewing and starting with a comprehensive and expertly written credit policy template.
In order to draft a credit policy that fits with the goals of your business, you must first examine and understand how the extension of credit relates to the financial exposure of your individual company. It may not be enough to simply go by the book in terms of understanding the financial exposure of extending credit.
For example, a business where 100% of the credit extended is secured debt is in a much different position than a business who extends credit on an unsecured basis.
As mentioned above, companies in the construction sector have a leg up here.
The use of the mechanics lien (or bond) protections as contemplated by the laws of every state, allows a company in this field to be a bit less restrictive in their credit policy, if they so choose.
In any event, and no matter how restrictive or lenient you wish your credit policy to be, there are certain sections that should be evaluated and included in the policy. These are as follows (but are by no means limited to):
- The objectives of extending credit
- The terms and conditions of each sale on credit
- Your billing procedures
- What information is required before extending credit to a new customer
- Policies and procedures for dealing with past due accounts
As it stands, the creation of a credit policy is an individual endeavor and is more of an art than a set list of rules to follow blindly. An effective credit policy is a creature directly tied to the goals of your business and the amount of risk your business is comfortable incurring.
That being said, it is generally advisable to have a written credit policy.
While a small business may be able to function with a “credit policy” kept solely in the head of a few people, or even one person, and many businesses do have a set credit policy reduced to black and white, having a written policy ensures that there is less subjectivity and streamlines credit decisions. Having a written policy can result in consistency, continuity, and as a tool for evaluation.
Click the button below to download a sample credit policy. It explains in-depth how to craft a secure and effective credit policy for your business.