Credit management is the process by which businesses oversee credit that is extended to customers for the purchase of goods and services.
The process involves much more than just the extension of credit. Prior to extending the credit, the business will establish policies, practices, and terms that guide the process.
They determine which customers will be permitted to purchase on credit, how much they receive, and how they will repay their purchases.
The process also includes ongoing review and analysis to evaluate credit that has been extended and how effectively it is being repaid.
Not all customers are able, nor do they prefer, to pay in cash. Credit, which is the purchase of goods and service on the promise of payment at a later time, gives them more flexibility.
Most businesses will extend credit in some fashion to at least some of their customers.
By extending credit, the business expands the form of payment options available to customers, and in doing so, increases the range of potential customers available to engage with the business.
On the other hand, allowing customers to purchase on credit also carries risk. Businesses must have an effective process for managing credit to keep failed payments to a minimum and to ensure that it gets the most out of its credit payment options.
The first step in an effective credit management process is to establish credit policies.
They will provide guidance to customers and the business for how credit is to be extended and managed, and they will contain several elements:
Credit policies consist of established criteria for evaluating a customer’s credit worthiness
The policies will set limits for how much credit can be extended
Policies will define the terms for how credit is to be repaid, including penalties and interest that will accrue on unpaid balances
Guided by these policies, an effective credit management process will follow certain steps:
The managing director will determine a customer’s credit rating before credit is extended
A business will take several factors into consideration when calculating the terms of credit extended to a customer
The strength of the product being sold is a primary concern—a low-value or low-cost product may not be worth the risk, or cost, of the credit to be extended to a customer
The financial strength of the customer is also an important factor—much of the information about the customer will be provided by credit reporting agencies, and payment performance, financial statements, and purchase patterns are factored into the overall evaluation
Once credit is extended, the business will have a process in place for regularly scanning and monitoring customers to determine if any new risks have emerged
Some customers may request an adjustment to their payment options.
They may ask for an extension or adjustment in the credit that has already been given to them because they are experiencing a hardship or their circumstances have otherwise changed.
Each case is unique, and the business will have to make a determination. Extending credit or adjusting payment terms has risks and rewards.
It builds goodwill with customers and can demonstrate a financially healthy organization that can afford to be flexible.
On the other hand, a business exposes itself to greater risk if customers are unreliable.
Beyond adjustments, some customers may not be able to pay off their debt. For these situations, a business will have a collections process in place. This process itself is comprised of many elements. For example, businesses use accounting automation to identify and categorize past due payments by the number of days they are overdue. Automation will generate and send dunning letters to customers reminding them of their overdue payments.
Businesses must move quickly on overdue accounts to avoid letting them go uncollected for a longer period of time.
Discounts for early payments, payment plans, and offering diversified options for transmittal of remittance also help the business manage collections and keep uncollected payments to a minimum.
Credit management is important because it expands sales for the business:
Effective credit increases the customer base and purchasing activity
Extending credit increases payment options and encourages customers to make more purchases
Credit management increases trust between the business and its customers, and this builds customer loyalty
Having an expanded and loyal customer base gives the business a competitive advantage
Poor credit management can impact the business’s revenue stream. It can reduce cash flow and increase the metric known as Days Sales Outstanding (DSO), which is a measure of the average number of days that it takes a company to collect payment for a sale.
The larger the DSO, the more poorly the business is collecting payment. If it takes too long for the business to convert sales to cash, this may be an indication that the business is being too lenient with the extension of credit or is otherwise ineffective at collecting payments, and its cash conversion its suffering. Ideally, the business will want to extend credit while still maintaining a low DSO.
Request a demo with us and we will show you how credit and risk management software can increase capacity by 25% as AR automation gives time back to your team to focus on actions that drive results.