Credit management is the process by which businesses extend and monitor credit that is afforded to customers for the purchase of goods and services.
Not all customers are able, nor do they prefer, to pay in cash. Credit, which is the purchase of goods and services on the promise of payment at a later time, gives them more flexibility.
By extending credit, the business expands the form of payment options available to customers, and in doing so, also expands the pool of potential customers. Credit gives customers more purchasing power which can also lead to more purchases. Finally, extending credit helps a business build trust with its customers, which can increase loyalty and improve customer retention.
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 make the most out of the credit that it extends to its customers.
The process of extending credit involves much more than just letting customers pay over time. For it to be effective, the business must put careful thought and calibration into its credit management system. Prior to extending credit, the business will establish policies, practices, and terms that guide the process, to allow maximum benefit and minimize risk.
A good credit management system helps the business determine which customers will be permitted to purchase on credit, how much credit can be given to them, how they will be allowed to repay their purchases, how much time they will be given to pay off their debt, and how much interest and fees they will be charged.
The process also includes ongoing review and analysis to evaluate credit that has been extended and how effectively it is being repaid.
The first step in an effective credit management process is to establish credit policies.
They will provide guidance to customers and the business on 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 creditworthiness
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
A business should have a standard system in place for approving credit that is to be extended to its customers.
The process will involve a standardized application which will be written in such a way as to gather all the necessary information for the business to make a thorough and accurate evaluation of the customer's creditworthiness.
The business will also have a system or workflow in place to verify the information that is provided to ensure that it is accurate and to detect fraudulent applications.
Next, the business will evaluate the credit application. A well-structured application will provide the business with all the pertinent information it needs to make an evaluation according to its own credit guidelines.
Credit scores provided by the reporting agencies will provide much of the information needed to perform this evaluation.
Once an applicant is approved, the business will want to have a formal process in place for formalizing the extension of credit to the customer. This should include a letter or agreement to be signed by the customer, and it should include all the terms of the credit program, to avoid any contract disputes.
These terms should include credit limits, deadlines, interest rates, fines, penalties, and all other pertinent details. Furthermore, accurate and detailed invoicing will also help reinforce credit guidelines and purchase amounts. All this information serves to make sure the customer is fully informed of the guidelines of credit to be extended and of the costs that have been incurred.
After credit has been extended, businesses will want to continually monitor their customers' payment histories and ongoing ability to meet payment obligations. The business will track delinquencies and have a process in place for regularly scanning and monitoring customers to determine if any new risks have emerged. Updated files ensure that the customer's credit profile is current and accurate.
A strong customer relations management system (CRM) will ensure that the customer is well informed about the status of their credit, and it facilitates the ongoing, timely collection of outstanding debt. Proper communications, including notices, statements, and dunning letters help to remind customers of their payment obligations and help avoid payments falling into arrears.
Additionally, automation can be useful in generating workflow items for controllers using the wide array of data available.
A company’s own internal customer information (captured from the cash application process) can be overlaid with Credit Reference Agency (CRA) and Credit Insurer data to produce payment forecasts and trends to ensure that those customers that need focused attention (because of an erratic payment history, for example) get it, while those customers who routinely pay on time without being chased don’t.
This ensures that collections teams remain focused in the knowledge that the system will continue to monitor data in the background for any subtle changes that may need attention – e.g., customers who pay routinely starting to slip by 2/3/4 days.
In a perfect world, all customers pay on time. In reality, this does not happen all the time. 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 hardship or their circumstances have otherwise changed.
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. Each case is unique, and the business will have to make determinations about what adjustments to make, if any. Extending credit or adjusting payment terms has risks and rewards.
Most businesses would prefer to have all their customers' payments made upfront, at the time of the transaction. This would increase their cash flow and dramatically simplify the accounting process. However, this is not the norm, as most businesses do not operate on a cash-only model.
In contrast, most businesses will extend credit to their customers, and very likely, this will represent a significant portion of the revenue they collect.
Having an effective credit management system including policies and procedures for communicating with and collecting payment from customers in a timely manner, affords the business all the benefits of extending credit while minimizing its risks. In short, they can attract more customers, increase sales volume, and build customer loyalty but minimize unpaid invoices.
When it comes to a credit management system, the expression "one size does not fit all" clearly applies. Just as there are so many different types and sizes of businesses and customers, there will also be a variety of systems to manage credit.
Businesses will choose and define their credit management system based on their unique needs. The size of the business, the nature of its customers, and the type and cost of service or product it provides will all factor into consideration. For example, a small family-owned restaurant will have an entirely different set of circumstances compared to a large retail business, like a department store.
What type of customer the business engages in will also affect credit. If a business engages with other businesses, for example, the credit policies will differ greatly from one whose customers are composed mostly of retail consumers.
Finally, a business should consider the pros and cons of a cloud-based credit management system versus one that is composed mostly of manual steps. A cloud-based system affords many advantages to a business, including reduced costs and manpower, greater efficiency, and reliability.
A business must follow several steps to implement a credit management system.
First, the business must identify its needs, which will be shaped by its budget, product, staff, customers, product, and history with credit. A thorough evaluation of these factors will help it determine the best system to adopt.
This careful thought process will facilitate the next step, which is to design and develop a credit management system. That system will reflect the workings of the business and its relationships with its customers.
After a system has been designed, the credit management system should be tested and evaluated. If all goes well, the system can then be deployed. Proper training of staff is required. If a cloud solution is adopted, the appropriate staff should be educated on the use of the software. Finally, the system should under ongoing monitoring and evaluation to ensure that it continues to function properly and serve the credit management needs of the business.
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