What is a Credit Policy?
At the most basic and fundamental level, a Credit Policy is a set of guidelines that:
- Are used to determine which customers are extended credit;
- Set payment terms for those parties;
- Define limits to be set on outstanding credit accounts; and
- Outline the steps and procedures used to deal with delinquent accounts.
Not all credit policies are created equal, however. A quality credit policy should maximize revenue by allowing the extension of credit while minimizing the risk of bad debt. In order to best accomplish these goals, credit policies should meet other minimum requirements, such as being written, being consistently applied, and specifying the use of security instruments to secure the debt whenever possible.
While some of these subsections can be broken down further, the general sub-parts of a credit policy include:
- Mission Statement / Credit Goals
- Organization Tiers (Decision Limits)
- Credit Evaluation of New Customers
- Security and Risk Mitigation
- Recovery / Collections / Litigation
Who needs to use a Credit Policy?
A credit policy should be used by every company or sole proprietor who extends labor, material, or both prior to getting paid should have and follow.
Whether a business has a full-fledged credit department, a credit manager with a couple of employees, or has some other way of determining the parties to whom credit is extended, guidance and direction on making those decisions are needed. The nature of the decisions and guidance needed is dependent on the size, and organizational structure of the business, and the volume of credit decisions that must be made, but no matter who is making these decisions, the decisions should be made in compliance with a structured credit policy.
Since credit decisions are vital to a business’s ability to function smoothly, and directly impact the bottom line, sticking to a well-formed and properly drafted credit policy is of great importance. The best credit policies are well-structured, comprehensive, and always followed.
In what circumstances is a Credit Policy normally used?
Credit policies, whether formalized or merely a company’s general practices, are generally used whenever a decision has to be made in relation to credit, whether the decision is whether (or how much) credit may be extended, who should make the decision, what the terms should be, how to feel comfortable with ultimately being paid, or how to collect if things don’t go as planned.
Does a Credit Policy change according to the project location?
Credit policies as a whole do not change according to project location. However, certain sub-parts of a credit policy may be location specific. For example, a construction-participant company may create a mechanics lien policy as part of the “security/risk mitigation” portion of its credit policy. To the extent that the availability of this particular remedy is limited or modified by the location of any particular project, the practical implementation of the credit policy may be affected.
While this type of “change” doesn’t impact the credit policy as a whole, which might require the use of the security provided by mechanics liens wherever available, certain project locations may limit the availability of this particular security in certain specific situations.
Additionally, there may be geographic modifications built into the credit policy itself. A company may be more comfortable extending credit to “local” companies and limit the credit available to foreign or geographically removed companies.
Does a Credit Policy change according to project type?
Generally, just like the project location, the project type does not modify a credit policy overall. Also similarly to the project location, there are certain practical impacts that a project’s type can have for construction participants’ implementation of their credit policies.
Since the type of security available can depend on project type a credit policy mandate to “secure the extension of credit on all projects greater than $20,000” for example, could result in different practical implications. On public projects, a bond claim is the general remedy – but it is not available to parties contracting directly with the public entity. Or, in Arizona, only direct contractors can claim a lien against an owner-occupied residential property. Accordingly, some project types may be disallowed by the requirements of a particular credit policy.
What happens if I make a mistake with a Credit Policy?
Making a mistake with a credit policy can range from being inconsequential to having business-ending impacts. Credit policies, as defined above, are a company’s playbook for extending credit. If all customers end up paying, a mistake with a credit policy may just be a lack of some documentation, slower than desired cash flow, or work being done for a “risky” customer. However, if a large extension of work on credit is allowed because of credit policy mistakes (or a credit policy is improperly calculated to protect a company) and that extension is ultimately not paid, the lack of cash can force a business to close up shop.
Is a Credit Policy usually paired with anything else?
A credit policy is not one individual thing, but rather a grouping of related policies and procedures grouped together to provide guidance regarding a business’s extensions of credit. Therefore, there are many different parts of a sufficient credit policy and many other things with which a credit policy can be paired.
A credit policy generally goes hand-in-hand with “security” policies for liens or bond claims and litigation/collections policies. But there are relations to contract documents and clauses, payment terms, and more.