You can never get a perfect sales credit policy. A Credit approach working well today could become a risky one, with a change in the market scenario, saleability of your product, changes in your working capital financing, etc. There are many dynamic factors that demand constant review and revision of a sales credit policy. In this article, we will share the top 10 factors that should determine what kind of credit policy you will make and How these factors impact policy decisions?
Credit Policy Factor #1: Market Practice on Cash vs. Credit
Factor- Generally any market has some common trends, in terms of sales credit terms. You have to go along with these common practices. If you are a strong brand and have a ‘Pull Sales’ (Customer asking for your product). However, if you are a company relying more on push sales, you may need to go along with similar Credit days, as others. Every company wants to move towards cash sales. So how one maintains a balance between market practice and cash sales?
Suggested Approach- Answer is that a Sales Credit policy should constantly push for moving towards cash sales, by pushing on boundaries of market practice. For example, if the market practice is for 60-90 Days Credit, a good credit policy will push for 50-60 days.
Credit Policy Factor #2: Saleability of your product/brand
Factor- If your product is selling well, you can go for more cash-oriented or low sales credit policy. If your product needs a significant push, you have to relax your credit policy accordingly. It is also possible that you could have a different credit policy for High-Selling Product, and a different one for Low-Selling one.
Suggested Approach- It could be worth-while to consider having a cash-sales/low-credit approach for fast-selling/hot product, and higher credit approach for low-selling products. This will help you to balance out the risk.
Credit Policy Factor #3: Product Sales Margin
Factor: ‘Total Cost of Sales Credit’ has four costs
- Working Capital Cost
- Risk cost of Defaults
- Collections Cost for Delayed Payments (Effort needed to collect the monies)
- Management Time spent in chasing Receivables
If your product has a good sales margin, you could afford these costs, as you can build them in your price. At the same time, if you have a low margin product, selling it as high sales credit can significantly harm your business sustainability.
Suggested Approach- If you are selling on Sales Credit, you should be very careful in calculating the ‘Total Cost of Collections’. Every one week of additional Sales Credit increases all the mentioned costs. After a realistic assessment, you should make the right balance between product price, expected revenue and days of Credit.
Credit Policy Factor #4: Working Capital Availability
Factor- Sometimes CFO makes Sales Credit Decisions simpler. Before you make a sales credit policy, you need to be very careful in terms of projections of revenue, margins and risk to come out with realistic requirements on working capital (as WC is not only on sales but also on the supply side in terms of vendor advances, inventory, credit by vendors) for Sales. CFO needs to ensure availability. The last situation, which a company wants to be in is to run out of money.
Suggested Approach- As mentioned earlier- A Sales Credit Policy is all about pushing the boundaries in the favor of shareholders. So two-point approach here:
- Ensure that your Sales Credit Policy is comfortably within the boundaries of working capital available. If not, either raise more working capital or tighten your credit norms.
- Even if the working capital is available, good companies push hard to limit work-capital lock-up in sales credit. They put extra self-restraint in not using working capital and instead work on their sales machinery, products, brand building and other methods to ensure their sales. It’s easy to sell on credit, and difficult to do what is right.
Credit Policy Factor #5: Customer Level Payment History
Factor- Credit policy is not only about general norms and approval matrix. It also needs to lay down rules on how to treat individual customers with different payment track record. So a good credit policy will have principles of how much credit to give for how long based on how well a customer has behaved in the past.
Suggested Approach– A policy document should be very clear and should ideally do not leave much room on customer-level discretion in the hands of Sales or Credit Operations. It should also have a detailed situation description in terms of what to do in what event. For example, what if a customer who has been paying well, had delayed payment due to a sudden change in market condition.
Credit Policy Factor #6: Target Market Risks
Factor- Your risk management to a great extent depends on your customer’s risk management. If your customer is reckless in selling on credit, he is a risk to you. If your customer’s customer does not pay, he may not be able to pay you (even with the best of the intentions). When you sell to your customers on credit, a big factor is the markets (sectors and geographies), in which they operate. Some smart companies, not only look at the customer’s market but their customer’s customer market. For example,
- A diligent company selling hydrocarbons to lubricant manufacturers will first look at the overall economy and state of the lubricant industry.
- At the same time, they will go the next step to which sectors their customers are selling. if a customer is selling to the shipping industry, you will keep a check on the trends of shipping in the customer’s target segment.
Suggested Approach- You have to develop a mindset of a lender, and maintain a close watch on customers, who are:
- Who is selling to potential risky locations/countries
- Who is selling to potentially risky sectors
- Who is selling to potentially risky customers?
The best people to do this job is sales, as they are interacting with the customers on a regular basis. Credit and Sales have to work closely in terms of exchanging information. Credit function should have someone who is scanning markets & customers, and sharing trends & reports to sales, and sales should validate.
Credit Policy Factor #7: Seasonality and Business Cycles
Factor- To a large extent, a customer’s ability to pay back is on how quickly he is able to sell the material you have sold to him. More than 60% of businesses worldwide have some seasonality in sales. The level of a spike in ‘high-season(s)’ and the duration of ‘High-Season’ can significantly impact your credit policies. A defaulting customer in low-season could be a well-paying customer in high-season, as he is able to clear his inventory. Your credit policy should include consideration of the same. Apart from that High-Season time not only enables customers to pay on time but pays faster. Many businesses, even shift from Credit to ‘Cash & Carry’
Suggested Approach- Credit Policy should be structured in a way, that it becomes more or less like a process to change customer-level (or customer segment level) credit limited and credit days. This avoids the situation of ‘Deviations to Policy’ every season time.
Credit Policy Factor #8: Management’s Risk Appetite
Factor– Lot of risk in Sales Credit Policy, is a calculated risk and not a certainty. There are lot many economic and sectorial factors which can only be projected with a limited level of confidence. So in a big way, a sales credit policy is governed by the risk appetite and also the optimistic or pessimistic mindset of management.
Suggested Approach- A Risk model and assessment, has to be as objective as possible. It should assign risk-weights and mark probabilities based on the detailed data on the economy, sectors, customers, customer’s customers, product margins and so on. Credit function should present a strong numbers-based proposal to the management, which should leave minimum room for discretion, or subjectivity. That being said, a certain level of subjectivity and ‘Gut’ is important to run a business.
Credit Policy Factor #9: Collections- Receivables Management Capability
Factor- With everything else remaining the same,
Your credit policy could be relatively liberal for Customers who are close to you geographically, and you can physically approach them
- If there are strong regulations and legal recourse in the favor the lender
- You have a strong collections team
- You have greater confidence in Sales Team maturity.
At the same time, your credit policy will be more conservative, if:
- Your Customers are beyond your physical reach
- You are not expecting swift and favorable decisions, in case you take legal recourse.
- Your receivables management is weak
- The sales team does not take the needed ownership of collections.
Suggested Approach- In Sales Credit, there should not be any Ifs and Buts. Before you set (and constantly revise) your Credit Policy, a solid receivables management machinery, sales ownership for collections, and strength of contracts/Credit terms & conditions- should be on a strong footing.
END-NOTE: Overall- a solid Sales Credit management capability can be a strong driver to boost your sales, to strengthen relationships with your customers, to have higher confidence in your sales forecasts and to ensure sustainable revenue. A sound sales credit policy forms the foundation of the ‘Credit Management’ ecosystem which you need to establish for this purpose.