Are Your Credit & Collection Policies Aligned with Company Goals?
The Role of Credit in a B2B Commercial Enterprise
At many companies, credit policy is an afterthought. When sales and production goals are set, and then the budget formalized, scant consideration is given to the impact on credit policy. In most companies, sales are given a strong priority over the risk of slow payments and bad debts regardless of gross margins and the resources the credit and collection function can provide to mitigate risk.
Too often, credit and collections are an afterthought. When the accounts receivable (AR) start growing and aging, thereby impacting cash flow, a credit and collections function is called upon to stop the bleeding. This illustrates why a sustained, proactive mindset towards AR management is vital. Indecision, delays, poor management, and bad policy will surely come back to haunt you.
To fix the problem of a bloated AR, credit policy may be tightened, impacting the order flow. In any case, it’s common to ramp up collection efforts, which necessitate credit holds and the eventuality of placing customers with a collection agency or taking legal action. All this causes friction with customers and puts the credit function in the unfortunate position of being accused of becoming '“the stop sales department.”
The Role of Credit in a Commercial Enterprise
If you grant credit to your business customers, it is also imperative that credit, collections, and AR management issues be addressed. Credit management takes center stage when:
New customers apply for credit terms. There needs to be a determination of the risk of the new account going delinquent or defaulting in accordance with your firm’s tolerance for credit risk. There are essentially three options for credit to choose from: denying credit and demanding a cash payment, granting open credit terms (usually under a specified limit), or requiring some form or security or collateral to back up the sale.
Orders need to be quickly approved for open terms. Delays create customer service issues that will consume multiple stakeholders’ time and put this and future sales at risk.
There are invoice disputes. These cause slow payments, often unnecessarily when there has been a mistake made on the billing. Pricing, quality, fulfillment, tax, and logistics are common causes of billing errors, and too often, the same mistakes are regularly repeated, adding insult to injury.
Customers don’t pay on time. This not only impacts your cash flow but also diverts attention from business growth activities, thus creating a collection cost. Also, borrowing costs often increase to compensate for customer late payments.
Customers default. The inability to recover the costs incurred in delivering goods and services (plus a profit margin) is a serious drain on working capital, especially when a large amount is involved, and margins are low. The resulting cash flow stress can cause a company to fail.
These activities directly affect the sales process as well as order fulfillment. Problems within the order-to-cash (O2C) process also affect the accounting, regulatory and compliance, and financial services areas. If you don’t do things right the first time, there is a very strong tendency for any lapses to require attention at some point downstream in the O2C process. In other words, your collection efforts will have to deal with all the garbage.
To prevent that from happening, it’s essential to understand the role of credit in a commercial organization. It’s not stopping sales. In fact, there is another old saying that “the sale isn’t complete until the money has been collected.” That’s the key to understanding credit’s role. The goal of credit is very straightforward—maximizing profits from sales.
There aren’t many situations where credit should be stopping sales. When an order appears to be fraudulent or a customer is likely to default, illustrate two situations where credit terms should be denied. However, cash sales are always an option, and even when a company’s bankruptcy is imminent, there are sometimes still ways to mitigate the risk and make the sale. And therein lies the key to credit’s role, which is finding a way to make profitable sales.
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Determining Credit Policy
There are several factors to consider when you set your company’s credit policy. Selling margins, production capacity, sales goals, market risk, and overall risk tolerance are the key factors. Once those factors are understood, credit and collection policy can be more nuanced. For example, more liberal credit extensions can be balanced out with a very aggressive collections posture.
Here then are the key factors to consider when balancing your overall credit policy:
Gross Margins: The higher your sales margins, the more liberal your credit policy can be. If your margins are low, often the case in competitive markets or when a commodity rather than a customized product is being sold, you need tighter credit controls.
Production Capacity: The more capacity you have for additional production, the looser your credit controls can be. In contrast, with limited or no additional production capacity available, you can tilt the scale towards a more conservative credit policy.
Sales Goals: If your sales objectives are aggressive, you may need to adopt a more liberal credit policy.
Market Risk: Some industries are more challenging that others. Restuarants are a good example—same banks avoid lending to these businesses because they tend to be more volatile. In addition, markets are affected by the economy. As market risks increase, credit policies need to be tightened.
Risk Tolerance: As with personal investing, companies have different attitudes towards risk, which are often reflected in their culture. A higher tolerance for risk is associated with more liberal credit policies. Companies that are risk adverse will want to have stricter policies.
Implementation Issues Associated with Credit Policies
Setting credit policy is one thing. Implementing your policy is another. There are different factors that will come into play if your policy is restrictive rather than more permissive. A liberal policy will tend to create more collection issues while a conservative credit policy can require more risk mitigation prior to the sale. The implication of implementing a liberal versus a conservative credit policy follow:
Liberal Credit Policy
For companies that have chosen to have a liberal credit policy and thereby grant open credit terms to marginally creditworthy customers, credit and collections will require significant time and resources:
Significant credit control administration is necessary to assess the credit risk of every customer and to enact credit controls to limit bad debt exposure in your AR portfolio. With a loose credit posture, it is very worthwhile to explore getting third-party security to back up your extension of credit, such as Credit Insurance, an Irrevocable Letter of Credit, a Third Party Guaranty, or a UCC Security Agreement, such as a Purchase Money Security Interest (PMSI). You might also want to look at invoice financing offered through a third party willing to assume your customers' debt. Check out this post for more risk mitigation tools.
You will also need a significant collections oversight to monitor the AR of every customer and perform collection activities to collect past due amounts as quickly as possible. It is also probably worthwhile to look at a collection automation tool or even outsourcing collections to an external partner.
Deduction and dispute-handling process can be an increased burden when your credit policy tends to be more liberal. The tendency is for marginal customers to raise a higher volume of disputes than more creditworthy accounts.
Conservative Credit Policy
For companies that extend credit only to financially strong, creditworthy customers, Credit and Collections Management will require less time and effort than necessary with a liberal credit policy:
A thorough credit review is required to identify customers worthy of credit terms as opposed to those that are likely to pay slow. Here’s a post covering The ABCs of Credit Evaluations.
Closely monitor the AR aging to quickly address any past due balances and put orders on credit hold pending payment of all past due balances.
Diagnose and correct any situation where your company may be facilitating invoicing errors that in turn cause customer disputes that slow payments. Keep an eye out for excessive payment deductions. If more than a few customers are claiming the same type of deduction, it indicates a fulfillment or pricing problem. An individual customer taking a large number of deductions may indicate a deteriorating financial condition.
If you have an account that regularly pays well beyond the due date, reassess the financial condition of the customer. If it has weakened, you will need to reduce (or even revoke) their credit limit or employ credit enhancements (e.g., guarnetees, security, collateral) and thereby control your exposure to avoid expending an unnecessary amount of time on collections.
Final Thoughts . . .
Credit Policies provide guidelines and as such are good for helping align credit and collection activities with sales and company goals. Implementation of those policies is critical, and that is where a little innovation and flexibility can go a long way.
For example, the sales team at a company with decent margins and unused production capacity wanted to sell on open terms a number of accounts that were high credit risks. Based on policy, these accounts would not be approved without substantial collateral. Instead, the credit mananger created a high risk AR segment. Sales to customers falling into that segment were capped. The credit manager approved individual sales until the cumulative sales amount reached that cap, at which point additional sales were declined until payments were received opening up availability under that cap. While the bad debt loss percentage for this AR portfolio segment was significantly higher than the rest of the portfolio, the company made a profit on these sales, making this program a success and helping the company exceed it sales and profit objectives.
Dealing with large numbers of small customers is another challenge many companies face that should be a policy consideration. One solution involves requiring payment at the point of sale for all orders under a certain threshold. The expanded use of credit cards by SMBs makes this a viable option. Another approach is to push all orders below a specified threshold off on distributors. In both these situations you limit the number of accounts and invoices you need to monitor and collect. Keep in mind, collecting a small debt will usually take as much time as collecting a large debt.
Setting credit policies is a balancing act. Whether a liberal or conservative policy aligns with your company’s objectives, implementation of the policy requires flexibility and innovation. When credit works with sales to ensure a profitable outcome, everyone benefits.