How to Create a Smart Credit Policy

An entrepreneur's guide to offering trade credit, crafting a credit application, and evaluating a customer's credit-worthiness

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Long ago, merchants figured out how to create customers where none existed: credit. "A customer with $10,000 cash and $25,000 of available credit is a potential $35,000 customer," says Jerry Kobre, a retired garment manufacturer who advises companies for New York State Small Business Development Centers. For most companies, offering trade credit isn't optional: When your competitors do it, you are at a disadvantage if you don't -- and on similar terms.

Of course, granting credit has costs. There is the expense of capital -- either the actual cost of borrowing or the opportunity cost of lending, given that money advanced to the client could be put to other uses. There are the administrative costs of creating statements and collecting. Finally, some customer debt will go bad. A business can mitigate these costs by establishing a smart credit policy and then carefully managing accounts receivable. "If you're not turning receivables into cash, it affects the way you pay your vendors and affects your vendors' credit decisions toward your company," says Doug Swafford, credit and collections manager for U.S. Xpress Enterprises, a trucking company in Chattanooga, Tennessee.

The pages that follow will get you started. You may find yourself mediating between a sales team that's pushing to extend more credit and an accounting department urging prudence. "Ultimately," says Russ Sorkness, president of Sorkness Aviation, a parts broker, "the owner decides how much risk the company will take offering credit."

Offering Trade Credit

1. Get a Handle on the Basics

Credit policy should be tied to your sales strategy, says Doug Swafford -- more aggressive goals demand a looser spigot. Whatever your goals, the particulars will need to at least match the standards that prevail in your market for your business to be competitive.

Set the terms of sale. Two kinds of credit predominate in the business-to-business world. Open credit requires no down payment and levies no interest or carrying charges. The payment is simply due in full on the specified date, typically 30 days after the goods are delivered (widely denoted as "Net 30" on an invoice). Revolving credit, on the other hand, sets a limit on how much a customer can borrow. The customer pays interest only on the principal actually borrowed; as the debt is repaid, the credit available increases. (Credit cards are the most common example of revolving credit.)

These basics are among the "terms of sale" stipulated in a purchasing contract. In addition, the terms typically include discounts for early payment; a common incentive reduces the bill by 2 percent for full payment within 10 days. (In a 30-day cycle, this is denoted as "2% 10, Net 30.") Or you may demand a penalty or interest payment when a due date is missed.

Establish other conditions. You will also want to stipulate other aspects of the transaction, such as delivery obligations or remedies if a customer fails to pay the debt. Conditions typically include the right to pass on legal fees and collection costs to the customer, as well as the right to establish the venue and jurisdiction for legal action. Requiring the customer to inspect merchandise upon delivery and make objections promptly also strengthens your hand should the account go bad.

Commit your policies to writing. This offers some protection against lawsuits. Federal law prohibits manipulating credit terms as a means of indirect price discrimination. That said, "You're on safe ground in treating customers differently in credit terms if you're judging them by creditworthiness," says attorney Bruce McDiarmid, a partner with Pillsbury Winthrop Shaw Pittman in San Francisco. Courts, he says, rarely second-guess credit decisions made in good faith.

2. Create Guidelines for Granting Credit

The amount of credit you grant -- and who gets it -- reflects your tolerance for risk. Why take any risk at all, especially now? Because doing so may increase your market share or win customers that will eventually bring you more business. And if the profit margin is high enough, you might come out ahead even if the customer later defaults. Swafford recalls one high-risk customer who defaulted eight or 10 months after being approved. "But in that time, my profits were something like 10 times the loss," he says.

Check the customer's history. Federal law obliges you to judge all applicants against the same standards, but you need not always go to the same length to verify creditworthiness. A small company, says Kobre, can rely on the CEO's judgment. As more buyers apply for credit, it's a good idea to standardize your evaluations.

The easiest way to check a customer's creditworthiness is to call two or three of its other trade creditors -- ideally in your industry -- and ask how promptly the customer pays. Ask the customer's banker if the company's lines of credit are in good standing. (You will get permission for this in the credit application; see "Craft a Credit Application," last page.) Then look at credit reports and scores. If you are talking about a very large credit limit, require financial statements and written bank and trade references.

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