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How to Create a Smart Credit Policy

If you deny credit, the law requires you to give an explanation if asked. "Point to objective data you used to evaluate the credit risk," says Scott Blakeley, a Los Angeles attorney who specializes in creditors' rights.

Ease into the relationship. A new customer should pay up front or on delivery. When you grant credit, keep the limit low initially and monitor the transactions in the first year. "If the customer is purchasing on a regular basis and makes timely payments," says Sorkness, "its credit limit should be increased in graduated increments."

3. Manage the Books

The key metric in managing accounts receivable is how long, on average, it takes your customers to pay their bills. In general, be concerned if your average collection period is a third longer than the period established in your credit terms (40 days for a 30-day period). For a quick snapshot of the average collection period (also called days sales outstanding), divide outstanding accounts receivable by average daily credit sales. This does not account for fluctuations over time, and there are more precise (and complicated) calculations for average collection period, but it is a good rule of thumb.

Seller beware. It's also crucial to zero in on individual customers. "All credit activities should be tracked regularly: purchase patterns, average days to pay, and a change in the payment pattern," says Kobre. "Early intervention can pay big rewards in either limiting exposure or getting paid sooner." Your sales and marketing teams have an important role here, he adds. Not only may they be more likely to spot and resolve problems early, but a strong relationship with the customer may smooth the intervention. Play it safe by updating and reviewing credit files for all accounts at least semiannually. If you require financial statements, get new ones every two years.

Collection calls. In the case of delinquency, be prompt and persistent. "If follow-up contacts are not timely, it sends the message that customers need not have a sense of urgency," says Swafford. Your written policy should specify contact at regular intervals, starting with a reminder five to seven days after the due date. Further notice should escalate: A second written reminder might be followed by a phone call, followed by a final notice from a lawyer. If you still haven't been paid 30 days after the due date, it's probably time to turn the matter over to a lawyer or a collection agency.

Craft a Credit Application
A credit application doesn't need to be long, but it should be carefully worded -- it is, after all, a legal contract.

Be sure the customer provides the company's legal name and entity type, as well as the names of principals. If the business structure shields the company's owners from liability, you may want to extract a personal guarantee.

Ask for the contact info -- telephone and fax numbers and e-mail and home addresses -- for the principals, as well as for the person who will probably be your main contact: the accounts payable manager.

Ask for trade references, ideally in your industry, who can speak to completed transactions with the prospect.

Seek bank account information and contacts. Some lawyers recommend including a form that authorizes a bank to release the customer's records.

Include the terms and conditions, written so that the customer has to acknowledge agreeing to them -- and require a dated signature.

Evaluating Creditworthiness

What to look for in a prospective borrower's balance sheet? Doug Swafford, who has spent more than three decades managing lines of credit, likes to keep it simple.

The bottom line: Is the company profitable?

The cash-flow statement: Is cash flow positive -- i.e., is the business taking in more than it is spending?

The receivables and payables balancing test: Calculate average collection and payment periods by comparing accounts receivable with operating revenue and accounts payable with costs. (This is all on the income statement.) Make sure the company's average collection period is roughly equal to its terms. Then, determine how fast the company pays its bills. "If its accounts receivable are turning over every 45 days, and it's paying bills in 50 or 55 days, then it has to wait to get paid before it pays you," Swafford says.