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Six Essential Elements of an Effective Credit and Collections Policy

Originally published: Apr-28-2008

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Man Signing Credit Application

by Riki-Lee Ritz
Senior Account Executive
International, ABC-Amega Inc.

Receivables represent the largest single liquid asset of most companies. On a good day, efficiently turning these accounts into cash flow is a tough job. In the current business climate – with reduced sales potential and the threat of recession – credit professionals are under increased pressure to productively manage this key responsibility.

What’s the secret to successfully tackling this challenge? Consistent operational processes.

Effectively managing accounts receivable is all about well-ordered processes from beginning to end. Yet, surveys have shown that only about half of all credit departments have a written credit policy in place – and only one-quarter of those regularly review that policy.

If you’ve been putting off drafting a credit and collections policy - or haven’t updated yours in awhile – this is an excellent time to do just that. Following are six essential elements you should include to ensure you’re taking a consistent and structured approach to limiting bad debt and improving the cash flow position of your company.

Elements of an Effective Credit and Collection Policy

1. Mission Statement

A thoughtfully designed mission statement is basic to a functional credit and collection policy. The mission statement should define the purpose of the credit department and express the long-range focus of the policy within the framework of the organization’s mission as a whole.

A key point to consider when developing the Mission Statement: the primary purpose of every credit department should be to maximize sales … within the framework of the organization’s “appetite for risk”.

2. Statement of Goals

Goals should track with current market conditions and the strategic direction of your organization. In addition, they should function as drivers to improve receivable management. Therefore, goals must be linked to targets and monitored and measured against established metrics.

Many credit departments utilize the following metrics in establishing goals:

  • DSO – Days Sales Outstanding
  • CEI – Collection Effectiveness Index
  • Aging Bucket Performance
  • Percent Current
  • Bad Debt Write-off Percentage (see Accounting for Uncollectible Accounts)

Benchmarking statistics – by industry – can be found in the Credit Research Foundation’s Quarterly National Summary of Domestic Trade Receivables.

3. Credit Department Organization

Including a section in the policy that spells out specific roles, responsibilities and especially levels of authority of the various credit and collections staff streamlines operations, prevents redundancy and improves productivity.

4. Credit Evaluation and Approval Process

The most important function of this section of the policy should be to:

  1. Define what your company considers an “acceptable” credit risk.
  2. Outline a credit evaluation process that allows for quick, consistent and objective decision making and, thus, delays as few orders as possible.
  3. Assign credit limits to every acceptable account to minimize the need for manual intervention to release orders.

Items that should be covered:

  • Credit terms. Your terms may differ by product line and location of the customer (domestic or international, country by country). However, keep exceptions to the minimum and ensure they are based on competitive practices and generate a satisfactory return on investment.
  • Credit evaluation process.
  • Credit limits. How are credit limits calculated and assigned? (See Setting a Reasonable Credit Limit).
  • Substandard and unacceptable credit risks. Saying “no” to credit should not negate the sale. Have a plan in place to: (1) notify the customer and the sales department; (2) outline acceptable forms of security or collateral; (3) offer alternative methods of payment; and especially, (4) describe when you will reevaluate the account, and how the customer can become creditworthy.

5. Credit Continuation Procedures

Granting, or withholding credit facilities should never be considered a one-time decision. Today's business climate is erratic, to say the least. Companies that appeared secure six months ago may now be on the verge of collapse. It’s essential to continually monitor your receivables portfolio to ensure you are maintaining an overall appropriate level of risk. Items to cover in this section:

  • Incentives for prompt payment. If you find your DSO (days sales outstanding) isn’t tracking where you’d like, you might consider discounting invoices for early payment, or charging interest on late payment.
  • Frequency of and procedures for credit re-evaluation. It’s good practice to schedule all or a portion of your larger accounts (using the 80:20 rule) for routine review, so you can quickly revise limits based on changing levels of creditworthiness.
  • Procedures for approving orders when a customer has reached its credit limit.

6. Collection

Uncollected dollars nibble away at your company’s cash flow and profitability, and can ultimately threaten its very survival. A survey by the Commercial Law League of America revealed that after three months, the probability of collecting delinquent accounts drops to 73%. After 6 months, collectability drops to 50%. And after 1 year, collectability is just 25%. It’s essential that you have a plan in place to follow up on every past due account.

  • When and how to contact a delinquent debtor. You'll be best served by developing a treatment plan matrix (sample below), which can be customized by account size, or product, etc. Phone scripts, collection letters, escalation plans for each level should also be included.

Sample Collection Treatment Plan Matrix

Oldest Invoice Date Portfolio A Portfolio B Portfolio C Portfolio <$500
0-30 Current Current Current Current
35 Collection Call Collection Call Reminder Letter Letter Series #1
45 Collection Call      
55 Collection Call Collection Call Collection Letter Letter Series #2
65 Escalation #1      
75   Escalation #1 Final Demand Call Letter Series #3
80 Escalation #2      
90   Escalation #2    
91 Refer to 3rd-party Refer to 3rd-party Refer to 3rd-party Refer to 3rd-party
  • Disputes and deductions. How to respond, who has authority to approve.
  • Credit holds. When to place an account on credit hold. Who authorizes credit holds?
  • Payment plans. Who can propose and approve payment restructuring plans.
  • Bad debt. When to write off an account to bad debt.
  • 3rd-party handling. When to turn over accounts to a collection agency or attorney. Authority levels for 3rd-parties. Reporting required to ensure proper handling.
  • Suit Requirements. How you will determine whether to sue.

Link Your Credit and Collection Policy to Organizational Goals

A credit and collection policy can create a structured environment that safeguards your organization’s most precious asset – its accounts receivable. When formulating your policy, keep these thoughts in mind to ensure it achieves your organization’s goals:

  1. The policy must be a living document, routinely updated in response to the changing economy, market conditions, and competitive environment.
  2. It must be applicable to all of your customers, with limited exceptions.
  3. It must incorporate the needs and help to accomplish the goals of management, finance and sales.

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This information is provided by ABC-Amega Inc. -- providing 1st and 3rd party commercial collection services since 1929, and collecting in more than 200 countries worldwide. For further information, contact info@abc-amega.com.