November 18, 2014 Financial Management en_US Are you looking for ways to increase your sales? One method small-business owners don’t always think of is offering extended credit to your custome... How to create a credit policy for your business
Financial Management

How to create a credit policy for your business

By Suzanne Kearns November 18, 2014

Are you looking for ways to increase your sales? One method small-business owners don’t always think of is offering extended credit to your customers. There have been multiple studies showing that people spend more when they can pay with credit. One such study [PDF] showed that when MBA students were offered tickets to a sold-out basketball game, those allowed to pay with a credit card were willing to pay twice as much as those who paid with cash. In addition to getting your customers to spend more, offering them an opportunity to buy on credit may increase their loyalty to your business if it’s not available elsewhere. But if you go down this path, you should do it with absolute precision, because if done wrong, it can quickly mean financial trouble for your business. Here’s a four-step plan to creating a credit policy that works for you.

Determine how much credit you can afford to extend

Before you extend credit to your customers, you’ll need to determine just how much you can afford. Run a cash flow statement to evaluate how much working capital you have to play with. You should run this report at least monthly anyway to avoid extending yourself beyond what your cash flow will allow. Next, you’ll need to determine what kind of terms you can offer. Some business owners offer their customers 100 percent of the amount of the purchase, while others require a deposit and only finance 50 to 75 percent of the total. Base this decision on the financial health of your company. If things are tight, only extend the amount that you will make in profit and collect the cost of the product as a deposit. That way, if the customer defaults, you won’t be out your expenses, just the profit you would have made from the sale.

Decide which customers will qualify for credit

You’ll need to develop a credit evaluation procedure to know who is a good risk and who isn’t. Obviously you’ll only want to extend credit to those who have a good track record of paying their bills on time. If you make exceptions and give credit to risky debtors, you could risk increasing your overdue accounts receivable load. Here are the steps to determine applicants’ creditworthiness.

  • Have them fill out a credit application. It doesn’t need to be elaborate, but must provide you with enough information to make a good decision. You can download a free template for a retail credit application, or another template if you sell to businesses.
  • Contact all three credit reporting agencies (ExperianTransUnion, and Equifax) and run a credit check on each applicant. If you’re selling to a business, check to see whether they have a Dun & Bradstreet Data Universal Numbering System (D-U-N-S) number, and if so, get a report. You should also call the references included in the application and ask whether the customer pays on time. The Fair Credit Reporting Act [PDF] requires that you get permission to check someone’s credit, so make sure they give you that permission in writing on their application.
  • If the applicant has a history of paying bills on time and you decide to extend them credit, you’ll need to set a limit. Base this on their verified income and debt load as well as your available funds. Ask the customer how much they anticipate needing, and then determine whether or not you can afford it.

Create guidelines for terms

Next, you’ll need to create the guidelines and terms of your program. You will have to consider your business’ financial health for each of these areas, while still making the terms attractive to buyers. It’s important that you put your terms in writing and the applicant agrees to them in writing. Here are some things you’ll need to consider:

  • How long will you extend the credit? You can give your customers 30, 60, 90 days, or even a year, to pay for the product or service. The terms you set should be based on your ability to wait for payment and the amount of the credit line.
  • How often will you get paid? Do you want your customers to pay you monthly, or will you allow them to pay you in one bulk payment when the invoice comes due?
  • Will you charge interest? Extending credit to your customers will cost money because you won’t be able to use those funds for other productive ends. You’ll also have to pay to manage their account. Invoices, envelopes, and the like all add up. Some businesses charge interest or fees to make up for those costs, and others choose free online invoices. Others don’t charge interest unless the customer pays the invoice late. Check your state’s usury laws to determine what you’re allowed to do.

Collect overdue debt

Unfortunately, some of the customers to whom you extend credit won’t ever pay their invoices. In those cases, you’ll need to try to collect the debt so you won’t suffer a complete loss. Here are three ways to help encourage those customers to pay.

  • Contact them directly. If you’ve sent out repeat invoices and they still haven’t paid, give them a call to find out what the problem is. They could be experiencing a rough time and just need a slight extension, or you may find that they have no intention of paying. Use this information to decide on your next course of action.
  • Negotiate. Often, debtors will pay up if they are offered an incentive. Offer them a discount if they pay the debt now.
  • Pass it on. If the debtor still refuses to pay, consider hiring a collection agency. You won’t receive the total amount due, but the agency will give you a percentage of whatever it collects. Make sure you inform debtors that you will take this step and give them one last chance to make good on the debt.

The key to a successful credit policy is to create clear guidelines and stick to them. Done right, you may find that your existing customers are buying more from you and your competitors’ customers are now shopping with you.

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Suzanne has been a full-time freelance writer for 20 years. She’s written for numerous business and financial publications such as Entrepreneur, Reason Magazine, Home Business Magazine, and Money Crashers. Read more