This article explores the essentials of effective credit management. Indeed, credit management is a core finance function in every organization. A sale is not considered effective unless you are sure it can be collected or paid for within an acceptable time period.
The collection system, if not well coordinated, can pose significant cash flow and by extension liquidity problems to the organization.
Such an organization might be forced to lean towards its partners and business associates, like bankers and other creditors. If not well addressed at this point, it could eventually lead to business failure.
However, when basic credit management principles and best practices are well observed, there is adequate business cash flow which enables the business to grow and gives it the muscle to compete effectively.
The following tips and best practices will assist every credit controller or organization in developing a framework which, if well observed and followed guarantees collection and the creditor trap is avoided.
They are meant to make collection processes seamless in such a way as to avoid hassle and therefore distinguish the ‘credit controller’ from the ‘debt collector’. The difference between the two is the hassle involved in meeting their goals.
Essentials of effective credit management
Develop a credit policy
Develop a plan beforehand on how the credit function should operate. Formulation of this policy may be a boring activity, but it’s worth every minute spent on it. The elements should include;
Outline the kind of businesses to extend credit to, the circumstances under which the same is to be extended, how much credit is to be extended, the terms of payment, and the triggers to the revocation of the credit lines. This forms the baseline for effective credit management.
Credit approval process.
Identify the internal steps of approving new debtors, and how to assess creditworthiness of each debtor. Set durations to review the creditworthiness, as this may change from time to time.
Set credit limits
Set a criterion for allocating credit limits to each client. This may be based on either volume or time. You may for instance offer a preset limit for all clients until you have been with them for a particular period, or they have paid for a certain volume of business (or number of invoices) on time, or even according to their industry risk rating.
However, this limit should not be set too low in a manner which would constrain the customer in terms of volume which may necessitate a search for another vendor. Effective credit management should considerably satisfy the client’s needs to ensure that they treasure the relationship.
Establish credit terms
This should cover the precise period of payment after delivery of goods and accompanying invoices. For instance “within 30 days after invoice delivery”. It should also include incentives for prompt payment (if any) and disincentives of late payment, like penalties and interest. For effective credit management, these MUST be well understood and acknowledged by the client.
Monitoring and escalation procedure
Set procedures of monitoring growing account balances and escalation to the relevant authorities in your organization for a decision to be reached. For instance, red flagging all invoices over 60 days and forwarding to the credit manager/director for further investigation and appropriate action.
Response to bad debts
Internally decide beforehand on how to deal with accounts which have fallen in arrears. This may include shortening credit terms, reducing credit limits, closer monitoring and weekly analysis, a warning letter to the client all aimed at reducing exposure. If you can’t be paid for outstanding invoices, don’t let the account grow further.
In extreme circumstances, you may consider using a debt collection agency or even litigation. You should also consider writing off bad debts periodically to make your ‘receivable account’ realistic.
Having a watertight credit policy keeps you vigilant and shows your customer that you are serious about payment, setting out the terms of engagement early enough, in addition to managing their expectations.
2. Know your customer
Knowledge is power – don’t let your customer become a liability to your business.
Even in seasons of low demand, don’t overlook this step and accept new customers blindly. Effective credit management requires you to get background information about your customers, which may not be the easiest task.
But it’s first important to establish if this is a legitimate registered business. The company’s registry can provide that information, and the emergence of credit reference bureaus is a great relief for information on would-be debtors.
Assessing customers using the 5 C’s approach for effective credit management
Assess the organization’s general willingness to pay based on their overall attitude during the negotiations, their company values, their financial track record and its directors. Factors such as court actions and a dark financial past may be a pointer to the ethical and financial standing of the organization.
A previous supplier, and even the internet may also offer credible information on their track record, but this must be vouched for accuracy. The character of the customer helps you set credit limits and terms.
From the prospective customer’s financial track record, make a decision on whether the organization is able to generate enough cash flows to meet its financial obligations including your dues as well as cover its other expenses.
Understand the organization’s core capital base, the nature of liability for debts, the assets they hold and even shareholder commitments. Effective credit management will clearly show you whether the organization is committed and able to pay its debts within specified time intervals.
Cash flow is considered the ‘back bone’ of the business, far more important than profitability (an organization can survive several years without profitability but without cash flow it can’t sustain operations). Consider the cash cycles of the business as well as the other obligations that the organization may have, such as payment of salaries.
Through this it’s possible to judge whether the organization will meet its obligations in the prospective contract. For donor funded organizations like NGO’s it’s important to be assured that funding will be available during the period of engagement.
Consider the economic conditions in the particular industry, which may require your adjustment or may affect the ability to pay, including international economic conditions which may have an effect on the domestic market and fluctuations in exchange rates. For instance, many donor funded organizations were starved of funding during the economic crisis in Europe and USA, which by extension affected their ability to pay.
Effective credit management or principles state that debtor assessment should be continuous and changes in the payment cycles should be monitored closely. This is to ensure that the client’s financial position is still intact.
3. Invoice correctly, clearly and promptly
Any delay or error in invoicing automatically translates into delays in payment. Extending the time before the invoice reaches the client also extends payment terms by the same period.
The agreement with the client or order should cover issues regarding invoicing. It should specify to whom the invoices should be sent, when and how.
Factors to consider when sending invoices to customers for effective credit management
Ensure the following:
- Invoices are raised correctly and promptly. The correct company name should be used, the goods well specified, and where there are specific order numbers or references, they should be quoted.
- Invoices are sent to the right person in the organization, and that a confirmation of receipt is signed. Don’t send the invoice to a busy chief executive if it should be going to his or her personal assistant or a payables accountant. Confirm if necessary.
- The invoice states how and when payment should be made, which had been agreed and signed by the customer before credit was approved.
- Follow up with a call or email to ensure that there are no disputes regarding the invoices. This also allows the customer to give feedback on the work invoiced. Where there are disputes, solve them immediately, as some customers will withhold payment for other invoices unless a dispute on a certain invoice is sorted. Let the customer have no excuse for non-payment.
To ensure correct details are captured on the invoice, you should have someone verify the invoice details against the order, so that before dispatch any corrections are made.
Conclusion to effective credit management
These best practices and credit management measures are designed to ensure that the client pays you promptly. If you have followed up and still the client has refused to pay, you may consider taking legal action against them or engaging a collection agency.
However, always consider the commercial reality of the situation. For instance, if the customer is bankrupt, further action is not likely to help, so the business should weigh the costs of follow up against the size of the debt. Nevertheless, the above tips are meant to help you avoid bad debts.