It is called credit management and encompasses credit granting, terms setting, debt recovery, and maintaining the appropriate cash inflow levels of the company. Like a guardian who keeps the company’s financial health in order, this guarantees business continuity while customers are granted credit. In this comprehensive guide, we will dive into the world of credit management, its importance, and how you can effectively institute strategies to keep your business healthy.
Fundamentals of Credit Management
What Is Credit Management?
In general, credit management will involve the following major tasks:
- Assessment of the creditworthiness of new customers
- Establishment of credit limits and terms of credit
- Accounting and surveillance of the outstanding debts
- Follow-up on receipts
- Bad debts and write-offs management
In a nutshell, credit management is one big balancing act. On the one side, you have to encourage sales by giving credit to customers. Conversely, you must ensure those customers will actually pay you back. It’s finding the sweet spot between being too lenient, which may cause cash flow problems, and being too strict, which may turn off potential customers.
Why is Credit Management Important?
You might ask yourself, “Can’t I just extend credit and hope for the best?” Well, not if you want your business to be really successful over the long term. Here’s why credit management is so critical:
- Cash Flow: Good credit management ensures that cash flows into your business. Poor credit management could put you in a spot where you are making lots of sales but have no cash to pay your own bills.
- Risk Reduction: Pre-assessment of customers before giving credit reduces the risk of bad debts and write-offs.
- Customer Relationships: Good credit management builds customer trust and encourages them to continue the relationship. It actually shows that you are professional and efficient, and this will bring in repeated business.
- Financial Stability: A well-run credit system can improve your business’s overall financial stability. This often makes your business a more attractive investment opportunity or a better credit risk for potential lenders.
- Competitive Advantage: Providing credit to customers provides a competitive edge in the market over those who can only be pre-paid.
Key Components of Credit Management
From this basic understanding, we shall explain the key components of an effective credit management system.
Credit Policy
A credit policy acts like a route map for your journey of credit management. It lays down rules and procedures on how credit is granted to customers. A good credit policy should encompass the following:
- Criteria for selection of creditworthiness
- Limits and terms of credit
- Expectation and mode of payment
- Penalty for late payment
- Collection procedures
Having a clearly defined, written credit policy ensures consistency in credit decisions and minimizes misunderstandings with customers.
Credit Assessment
Before giving credit to your customers, you need to know their ability to repay you. Credit assessment is gathering facts required to judge a customer’s creditworthiness. Information may be:
- Gathering Information: This includes but is not limited to financial statements, bank references, and credit reports from agencies such as Dun & Bradstreet or Experian.
- Analysis of Data: Verify the customer’s payment history, current debt, and cash flow to analyze the degree of risk involved.
- Decision Making: Based on the analysis, decide whether to extend credit and, if so, to what extent and on what terms.
Remember that the credit assessment process is continuous. Customers’ creditworthiness must be rechecked regularly because their financial condition may change over time.
Credit Limits and Terms
Once you have decided to grant credit, you need to set an appropriate limit and terms. This includes:
- Credit Limit refers to the maximum amount of credit you will extend to a customer.
- Payment Terms: This is the period within which a client is required to pay their invoice. General examples include “Net 30” or “2/10 Net 30.”
- Interest Rates: How much interest you will charge on late payments.
It is a question of setting the right limits and terms. Be too generous, and you jeopardize your cash flow. Be too harsh, and you will drive your customers into the hands of your rivals who may be offering better terms.
Invoice Management
Effective credit management calls for good invoice management, which entails:
- Timely Invoicing: Issue invoices in due time after the goods or services have been provided.
- Clearly Communicate: Your invoices must outline the amount owed, when the payment is due, and how the customer should pay you.
- Follow-up: If payment has not been received, send reminders before or after the due date.
- Record Keeping: Ensure that all invoices and payments are recorded appropriately.
Good invoicing guarantees a steady cash flow and minimizes the risk of dispute or late payment.
Effective Credit Management Strategies
With the basics covered, some strategies to make your credit management effective will now be considered.
Make Full Use of Technology
Like most areas of business life in the twenty-first century, credit management benefits from this plethora of software designed to make life easier. Common tasks that these applications can facilitate include:
- The automation of credit checks
- Creation and dispatch of invoices
- Tracking of payments and overdue accounts
- Production of reports on credit performance
Applying technology will save time, reduce errors, and deliver insight into your credit management performance.
Credit Scoring System to be Implemented
A credit scoring system allocates points for various factors that represent creditworthiness. Example:
- Years in business: 0-2 years (1 point), 3-5 years (2 points), 5+ years (3 points)
- Payment history: Always on time (3 points), Occasionally late (2 points), Frequently late (1 point)
- Financial stability: Strong (3 points), Average (2 points), Weak (1 point)
Applying the system of scores will help you make more objective and consistent decisions about granting credit.
Provide Early Payment Incentives
By encouraging customers to pay early, you may be able to improve your cash flow and reduce the risk of late or non-payment. You could offer a discount for early payment, such as the “2/10 Net 30” terms described above.
Diversify Your Customer Base
Don’t put all your eggs in one basket. Having a diverse range of customers spreads your risk. If one customer goes bad and fails to pay, it won’t have a catastrophic effect on your business.
Monitor and Review Regularly
Credit management is not set-and-forget. Regularly review your credit policies, the creditworthiness of your customers, and the overall performance of credit being granted. This will allow you to identify potential problems well in advance and make any necessary adjustments.
Late Payments and Bad Debts
No matter how good a watch you keep on accounts receivable, there’s still a risk that those payments come in late – or not at all. Here’s what you do:
Late Payment Follow-up
- Reminders: Start off with friendly reminders via telephone or email.
- Escalate Gradually: If the account remains outstanding, gradually escalate these to more formal written demands.
- Negotiate: If a customer faces temporary problems but is otherwise a healthy client, consider offering a negotiated payment plan.
Dealing with Bad Debts
If a debt becomes uncollectible:
- Take Legal Action: For larger sums, it may be worth taking legal action against the debtor.
- Refer to a Collection Agency: They can often collect debts you cannot.
- Write it off: You may be forced to write the debt off and take it as a tax deduction.
Remember, your goal is always to collect as much as possible without hurting your working relationship with the customer.
Credit Management across Industries
While the concept of credit management is generic, there are often subtle differences between various industries. Here are a few examples.
Retail
In retail, credit management could involve:
- Store credit card management
- Layaway plans
- Returned merchandise, refunds
Manufacturing
Manufacturers might involve:
- Trade credit to distributors/retailers
- Long payment terms for large orders
- International customers, currency risk
Service Industries
Service-based companies may want to consider retainers for ongoing services, milestone payments for long projects, and subscription or recurring payment management.
Understanding your industry’s unique credit challenges will put you in the best position to implement the best strategies.
The Future of Credit Management
The future of credit management is colored by several trends:
- Artificial Intelligence: AI and machine learning are used to make more accurate credit decisions by analyzing large volumes of data.
- Blockchain Technology may be a game-changer in storing and distributing credit information, enabling faster and more secure credit checks.
- Real-time Credit Monitoring: Advances in technology enable credit risk to be monitored in real time, allowing quick responses to shifts in circumstances.
- Sustainability Considerations: Today, environmental, social, and governance factors are increasingly considered in credit decisions.
Knowing what’s happening now and what’s coming up next will help your business remain competitive in credit management.
However, this is a very important function to provide by any firm that grants credit to its customers. There is a fine line between encouraging sales and controlling risk, being friendly, and looking after the interests of your business. With an effective system for managing credit, you can enhance your cash flow, reduce bad debts, and maintain a healthy relationship with your customers.
Effective credit management is not about risk but rather about managing risk intelligently. It requires a combination of clearly articulated policies, careful assessments, ongoing monitoring, and agility for changing conditions.
Whether you are a small businessperson just starting to provide credit or a large corporation desiring to optimize your credit management processes, the principles discussed herein can help navigate you through the complex world of credit management.
Good credit management is the difference between prospering and merely surviving in today’s high-pressure, high-speed business environment. So, take the time to develop and then implement a solid credit management strategy. Your future self and your accountant will thank you for it.
