Credit Policy

General Considerations

Because credit policy concerns the company as a whole, it is usually established officially by top management. Sometimes responsibility for its formulation lies altogether with top management, but more commonly the chief credit executive and associates play an active role in its development. The heads of other interested departments may also be consulted.

Credit policy is probably most effectively implemented when all who are directly affected have some voice in its development. A credit policy assures that there will be consistency across departmental functions. It requires the endorsement of top management, preferably the board of directors.
While credit policy is the cornerstone of credit administration, there is no exclusive acceptable format.

If a credit policy is to have practical value, it must be related to a specific company, reflecting the goals that the company has set for receivables management. Every credit executive is entitled to a written policy statement from the officers of the company—one that is fully understood and accepted by sales as well as credit people. An effective credit policy permits and encourages the fullest development of the opportunities in administering credit. It can be a blueprint for action as well as a training aid for the development of credit personnel. It provides the latitude to plan departmental operations within the scope of the company policy, to create effective procedures and techniques to implement that policy, and to establish adequate controls. It can assure that there is consistency in the company’s dealings and interactions with its customers, and it provides a means of recognizing the importance of the credit function to the company.
In general, there are several key questions that should be answered when developing a credit policy.

What is the credit department’s mission? This also can be called a vision or purpose. It states the overall objective for the credit function.
What are the goals? Goals can be specifically stated, such as a quantifiable measure, or more generally as an expressed desire to achieve improvement in a specific area.
What are the roles and specific authorities of the credit department management and staff? This defines the boundaries of the credit function, often in terms of interactions with other departments.
What are the primary criteria for evaluating customer credit? This describes credit procedures in more detail, listing key aspects of the credit review and analysis processes.
What are the normal collection procedures? This describes the steps to be taken in customer collection activities.
What are the company’s terms of sale? Terms should be spelled out by major product line, with any qualifications or restrictions included.

Credit Policy Focal Points

When a company is developing a new credit policy or is reviewing an existing one, a number of factors should be considered. Some of these are internal in nature while others are external. Depending on the company, they vary in relative importance. All of them together establish the context within which credit policy must operate. There are four major focal points.

• Credit policies and procedures that focus upon development of an optimal level of sales:

a.New customer policy and procedures:
1.a credit application with each request (sample in manual)
2. procedures that outline expected turnaround time for making a credit decision on new accounts
3. procedures that outline the specific mode for communicating the request for credit and the credit decision
4. responsibility for establishing and keeping current credit department files (includes nature of contents to be included in file)
5.a policy for authorizing and communicating credit limits

b.Policies and procedures that relate to terms of sale:
1.terms established by industry; clear communication internally and to customers
2. a discount chargeback policy; procedures for follow-up consistently applied and monitored
3. a late payment service charge policy; procedures for follow-up consistently applied and monitored
4. a policy for requests for extended term arrangements; necessary approvals clearly specified
5. a blanket approval policy (Small orders below a specified amount are either cash or automatically approved)
6.a policy and procedure for consignment sales
7.a policy for export sales and letters of credit
8.a policy for terms for sales to a debtor in possession in Chapter 11 bankruptcies

c.Policy and procedures that govern credit investigations:
1. a sign-off policy for responsibility of the control of the account developed by the size of the account
2. use of credit-reporting agencies clarified by the requirements for types of reports to be utilized
3. a policy and procedure that outlines obtaining bank references detailing the type of information needed
4. a policy and procedure that outlines obtaining trade references with details of information needed
5. financial statement requests from customers and procedures for the analysis of statements with key focal points
6. policies and procedures that govern the use of collateral (include sample documentation, specify authorized signatures and clarify the safeguarding of documents held in storage)
7.perfecting liens under Article 9 of the Uniform Commercial Code
8.guarantees (personal and corporate)
9.warehouse receipts
10.letters of credit (details by types of L/C)
11.subordination agreements
12.lien searches
13.pledge of stocks, bonds or certificates of deposit

• Credit policies and procedures that focus upon minimizing the carrying costs of receivables:

a.follow-up system for past-due accounts:
1.responsibility and time interval for initial follow up
2.a systematic program for additional follow up
3.use of the computer for monthly statements or automated dunning letters
4.a policy and procedure for holding orders
5.a policy for deductions and open credits
6.a policy for personal visits (written summary report required)
7. a policy for the exchange of credit information related to customer payment experience
8.a policy for unauthorized shipments
9.a policy and procedure for cash application

b. internal credit department reports (assign responsibility, clarify timing and include a distribution list for each report):
1.aging of receivables (Do all items age out?)
2.an over credit limits report
3. a response on open items by category and age (deductions, credits, unearned discounts, service charges)
4.a highly leveraged transaction report
5.a report for accounts with collection agencies or in litigation
6.a bad debt write-off report
7.travel and expense reports

• Credit policies and procedures that focus upon minimizing bad debt losses:

a. a policy for conversion of an open account to a note (interest bearing? collateralized?)
b.policies and procedures governing customer counseling
c.a policy for use of collection agencies
d.a policy related to the use of outside attorneys and lawsuits
e. policies and procedures related to customer bankruptcy, bulk sales and assignments for the benefit of creditors
f.a policy for credit manager participation on creditors’ committees
g.authorization for accounts written off to bad debts

• Credit policies and procedures that focus upon credit department organization and cost containment:

a. a formal organization chart that clarifies the positions of each member of the credit department (authority and responsibility should be clear)

b. policies and procedures that govern human resources within the credit department:

1.recruiting and hiring guidelines
2.educational requirements by position
3.experience requirements by position
4.training and development guidelines

c. performance review criteria with procedures for a regular periodic performance review

d.membership in professional organizations

e.workshop and tuition reimbursement guidelines

f.promotion and termination guidelines

g.credit department budget guidelines:

1.responsibility for preparation and content
2. specific items for which policies and procedures need to be developed, including salaries/incentives, space and equipment, supplies, training and education, travel and entertainment, and collection and investigation expenses

Other Influences on Credit Policy

Credit practices within the industry also bear upon the credit policy of an individual company. Depending upon the industry, competitive conditions place a high degree of importance on credit availability.

Where credit is a fundamental factor in competition within the industry, the credit policy of a company is important for maintaining or improving its competitive position. Even where credit is not generally a competitive tool, an individual company can use it in this way if it is willing to do so. In considering credit policy in relation to competitive conditions within the industry, the credit executive must also evaluate the company’s long-range ability to compete. This would include analysis of the company’s present position in the industry and its financial strength, as well as a general awareness of such factors as the strength of its marketing organization and its position in product development.

Within every industry some companies are leaders and others are followers. The relative standing of a company in its industry will, in many cases, influence the course of action it sets to meet credit problems. If its position is undisputed, a company may demand more from its customers. A company that is just getting started, on the other hand, may find it advantageous to be more lenient in its credit policy. This factor ties in with the marketing aspects of the company. The role of credit is influenced by a number of general factors, including tradition, the stability of demand for the industry’s products, and the rate of technological change.

The type of customer has a direct limiting influence on the credit policies of all companies in an industry. Where the buyers’ line of business is characteristically short of capital, it is unrealistic for credit policy to be unduly restrictive. A company that operates on that basis will not maintain its market. If an industry has many well capitalized customers, the company that takes additional risk must expect additional return for this added risk. With enough good credit risks available to provide adequate profits, there must be an added incentive to make sales to fair or marginal risks.

The number of different classes of customers will also have a direct bearing on the variations in credit terms offered. Credit terms affect the company’s credit policy in a number of ways. The market share a company has may affect the types of terms. For example, if the buyers are in control of the industry, the seller will probably have to offer longer terms. Also, if a seller is not a major market leader, it will have to match the best terms, instead of being in firmer control over what terms it offers.

The length of terms offered will also be a function of the product’s shelf life (for example, those that can spoil will require shorter terms, so terms are usually net 10 in the food industry), variations in demand (for example, seasonal products may have differing terms depending on the time of year), and cost/price of the product (for example, more expensive items such as jewelry may have longer terms while cheaper products may have shorter terms).

The type of merchandise affects the credit policy of the seller in a number of ways. There is a tendency to sell on a more liberal basis if the merchandise has a relatively high profit margin or there is intense competition for the sale among a large number of suppliers. Also, terms may be somewhat more liberal if the merchandise can be repossessed in the same condition as it was sold (rather than if the appearance of the merchandise were changed by the buyer). Yard goods in the bolt, for example, can be taken back if they have not been cut by the clothing manufacturer. Once they have been on the pattern table, however, they lose much of their repossession value. Similarly, steel fabricated to specification has less reclamation value than that prepared in an ordinary run.

The merchandising policy of a company often influences credit policy. For example, a company may be required to place machinery in the hands of a limited number of franchised dealers on some basis to enable them to sell a maximum volume during a relatively short retail buying season. This might involve long terms of sale to coordinate it with the problems of manufacturing and shipment.

Large extensions of credit may be required in relation to the financial responsibility of many dealers. Reliance is placed on the character and capacity of the dealer to a far greater extent than on capital. The essential factors are experience and proven ability in selling competitively, collecting effectively, and operating profitably.

Markup of the merchandise is important. When profit margins are slim, the credit department may be more careful in the selection of its accounts. High-markup goods entice credit executives to approve sales to fair and marginal accounts. On a percentage basis, they may find it more profitable to check orders and rely on overall profits to cover relatively large bad-debt losses.

Price range of merchandise similarly influences credit policy. It is generally easier to establish a uniform liberal policy that applies to all customers when the unit price of merchandise is relatively low. Even on a wrong decision, the dollar amount of risk is not great. On a big ticket item, however, credit exposure is greater. A more detailed analysis is usually conducted before a customer order is approved.

When merchandise can be obtained readily by the supplier, there is no need to restrict sales to customers unless warranted by financial or credit risks. When a particular item is scarce, however, credit policy may be influenced to the extent that stricter requirements are set for customers needing that item. This situation might occur during shortages of material because of production shutdowns, other restrictions, or in instances where supplies of materials may be scarce.

When goods have been stored in inventory for some time and an opportunity arises to dispose of them, credit policy should be sufficiently flexible to approve the transaction. An extreme example of this is the case of the shoe wholesaler that has stored some out-of-style shoes for a number of years, then receives an offer for the entire lot. Even if the customer wanted extra terms or was not a good credit risk, it is doubtful that the offer would be refused.

The geographical distribution of customers determines credit policy to some degree. Widely separated markets require particular modifications in credit analysis and in collection efforts. A highly concentrated selling and buying area, on the other hand, involves a special type of price competition and service requirements.

In the case of particular commodities, such as spirits and liquors, government regulations specify credit policies or procedures which must be followed by the seller. There, the overall policy must take the regulations into consideration. In a very general way, expected long-range trends in the economy also influence credit policy.

Economic or business conditions are of much greater significance, however, in determining how policy is to be applied over a shorter period of time. When times are prosperous, ability of debtors to pay their bills is somewhat improved; however, there is a danger that they may tend to overbuy. During slack business periods, debtors tend to delay payment of their bills and credit requirements may tend to be stricter. Concurrently, as sales drop, the company is faced with the problem of maintaining volume in the face of decreasing sales and more demanding selection of credit customers.

Formulating the Policy

The actual formulation of credit policy begins with the establishment of objectives. What does the company want to accomplish during the period of time for which policy is to be established? If these objectives are to be attained, what should be the role of the credit department? The next step is a thorough analysis of the context within which the credit policy must operate over this period of time. This includes those factors which, according to a realistic appraisal, will act in some way to define what the credit department will be able to do:

• the established company policies
• the objectives and policies of the other departments
• the primary industry characteristics, such as current credit practices, the role of the credit in competition, the company’s position in the industry, and the company’s financial resources.

After these steps have been completed, the credit policy can be formulated. Within the given context, it sets a course of action that is expected to lead to the accomplishment of the objectives.

Credit Policy Can Be Disseminated as an Implied Policy

This means that it exists but is not officially stated (or written). It has little or no official expression of approval and may be difficult to perceive and, therefore, be left to interpretation. It is protected from public view and dissemination is very informal.

The effects of an implied policy may be favorable or unfavorable. Implied policy is often used when the true policy is unlikely to obtain approval from one or more company groups.

Credit Policy Can Be a Stated Policy

This means that it is set forth in writing. It usually has the backing and authentication of senior management. There are usually fewer misunderstandings as the policy is available to everyone in the same form. A stated policy indicates a basic honesty and integrity in intentions. It generates confidence and stability and serves as a good training tool.
There are four essential components of credit policy:

• Establishing the credit standard. This describes the profile for an acceptable credit customer, including appropriate details and examples.
• Determining credit availability. This describes how the maximum amount of available credit is computed and managed, including decision criteria for reducing or increasing a customer’s availability of credit.
• Setting credit terms. This stipulates the exact terms of sale for each class of customer.
• Defining collection policy. This provides criteria for regular collections and exception collection procedures for past due amounts.

Reasons for a Written Policy

Careful consideration should be given to writing the credit policy. By definition, the understanding of unwritten policy depends on oral communication or on inference from the decisions made by senior credit personnel. Once established, a credit policy that is written has many advantages. It is thought through carefully, with the result that any vagueness in the unwritten policy becomes apparent and can be modified. Consideration of a written policy by the executives concerned also helps to reveal differences in their understanding of what the policy is and areas in which it is inadequate. A written policy is more useful because it can be a source of stability and continuity in the operation, not only of the credit department but of the company as a whole.

Individual credit executives and other administrators tend to vary unconsciously in their credit thinking as they interpret and react to the conditions and problems with which they work. Unwritten policy is thus subject to gradual, unnoticed changes while a written policy lessens the possibility of this kind of variability; it requires that changes in policy be conscious and intentional. In this way, policy becomes a more effective vehicle for review of the credit department’s total situation.

Removing credit policy from dependence on the knowledge and experience of one or a few individuals tends to ensure consistency regardless of changes in department personnel. There is a greater probability of consistent decisions under a written policy, especially in large and complex credit organizations, where many people are dealing with the same types of problems and where they may be separated organizationally or geographically. Customers can be shown a copy of the policy statement, so they can see that they are not being given unusual or discriminatory treatment.

A clearly stated credit policy is a valuable aid in training credit and sales personnel. The trainee in the credit department can enhance his or her learning by reviewing the written statement of policy, which provides orientation to the company’s point of view on credit and a frame of reference within which the trainee can proceed. Sales trainees can learn the credit framework that applies to sales.

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