The keys to a solid credit policy

A credit policy is a bit like a sports playbook. If well-written, it clarifies the plan of action in each type of trade credit situation, enabling all employees (or players) to know what they need to do, and when. 

Following my recent article on the importance of investing in credit management, I’ve had several discussions with industry contacts on the challenges of structuring and implementing a credit policy. My advice is to create a living document that evolves as the company’s size and objectives grow, but which clearly outlines the processes, KPIs and responsibilities throughout the credit management process. 

As a business grows and becomes more complex, there comes a point when the unwritten rules are no longer efficient, instead becoming an operational risk factor. Before this happens, it’s critical to design and implement a credit policy that clarifies the order-to-cash journey. This document needs to reflect the company’s risk appetite and take into consideration margins as well as the product/geography mix, cash flow and financing specificities. 

This policy will help protect and improve cash generation and support profitable sales growth – especially in an uncertain economic landscape.

Your policy’s level of sophistication can vary depending on the size of the business and of your teams allocated to credit management. But whatever its complexity level, your credit policy should clearly address the following topics:

Your document should include an authority matrix identifying the role and responsibility of any employee involved in credit management. It should answer questions including:

• “Who approves credit limits for each threshold?”

• “Who approves special terms and payment plans in case of overdues?” 

• “What is the role of the sales team?”

KYC, or Know Your Customer, is about identifying and verifying your customer’s identity when opening an account. In your credit policy, the KYC section should include the template of a comprehensive credit application form. It should outline required legal documents, verification processes, ownership structure, contact details, bank references, trade references, and details of any connected legal entities.

You’ll need to define how financial information is sourced, according to different sales thresholds. For example, at which point do you conduct a physical visit to your customer’s premises to assess the company’s operations, or seek out external information reports? In many jurisdictions, sourcing private companies’ financials is complicated. In this case, it’s even more important to understand ‘soft’ factors such as the company’s character (for example, its management profile and payment record in the market) and position in its sector’s supply chain, as well as political risk for international clients. When financials can be obtained, you’ll need to define how to assess their reliability and what may constitute a red flag. Perform a short-term liquidity and solvency test and peer analysis, especially for large credit requests. A best practice is to apply a risk category for every customer in your portfolio by channel and from low to high risk profile. This will help in setting payment terms and risk mitigators.

The longer the payment terms, the higher the impact on your cash cycle and on your potential risk. In addition to the expected payment timeline, this section should include accepted means of payment, with related risk treatment, and whether there’s a retention of title option (whether your company retains legal ownership of goods sold until certain obligations are fulfilled by the customer). You should also outline on which basis a customer may be converted from having to provide secured, up-front payment to being granted credit based on cycles and payment records. Your credit limit for each type of client should factor in the forecasted payment terms and volumes, but also the customer’s purchasing capacity based on the credit assessment. 

These terms all need to be aligned with your company’s management strategy, market practice and competitive position. Any exceptions need to be defined in the credit policy. 

How often do you re-assess customers and credit limits for each risk category? How do you monitor your concentration risk (your reliance on one company or market segment versus its financial outlook) and top customers’ risk exposure? How you handle red flags regarding your customers (such as slow payments, deteriorating financials, market fluctuations, and changes in management)? And how do you manage overdues or new orders from customers with an outstanding balance? You can incorporate a compliance report procedure to track quarterly outcomes of any exceptions approved by management that are not in line with your credit policy. 

Managing credit risk also means having clear procedures enabling you to act fast when things go wrong. Employees need to know which approach to use in communicating with your customers, as well as how to manage escalations and payment plan negotiation processes. Is it clear at which point they should send the account to a collection agency or enter into a legal process? Advanced credit policies also include guidelines on a set of quantitative KPIs to support credit management control. This includes:

• Day Sales Outstanding (DSO), or the average number of days that it takes your company to collect payments, broken down by risk category and measured over time

• Overdues evolution

• The level of disputes regarding receivables and bad debt provisions

• Your collection effectiveness index

Credit risk intelligence is essential to protect a company’s critical assets: its trade receivables. This requires sound market knowledge, with insights on the dynamics within domestic and export markets. Working with a global trade credit insurer like Euler Hermes offers expertise from agents worldwide. We partner with companies by providing coverage and advising on credit policy best practices, enabling you to focus on growing your business.