Determining your level of risk when extending credit

Part one of the credit management series, Developing a credit policy, discussed the benefits of extending credit to customers. Once you have decided to offer credit, the next question becomes one of who you provide that credit to and how you can do so. This involves determining who is a good or bad credit risk.

Part two of the credit management series shows you how to draw up a credit policy, how to determine your risk and what to watch out for.

A comprehensive credit policy is essentially the set of rules that you decide to follow in order to determine who you will provide credit to, how much credit you will provide and how you will monitor that credit once it has been provided.
The main thing to understand when establishing a credit policy is the level of your appetite for risk. graph2

This means determining how much credit your business can afford to provide and critically, how much you can afford to lose. Accepting losses and understanding what losses you can afford is critical to an effective credit policy, particularly for a small business.

At the outset, it may seem like a good credit policy is one that results in no bad debts. However the reality is that your level of bad debts reflects your risk appetite and impacts your long-term profitability.

The words 'bad debt' may have a negative connotation, but a credit policy that produces no bad debt is generally a sign of a credit policy that is too restrictive, meaning that you are probably refusing credit to creditworthy individuals and businesses.

For small businesses, refusing credit to potentially creditworthy customers can also adversely impact their operations. For example, a business that only accepts cash on delivery runs the risk of turning away sales that could lead to long-term customers and brand loyalty.

The challenging is identifying the level at which  you are providing credit to as many people as possible within a framework that results in bad debts that fit your risk appetite. A tight credit policy is fine, but just remember that if credit is central to business growth, then excessively limiting the amount of credit you provide has an impact on your growth.

Consider the following questions to help you understand how extending credit will impact your business variables:

  • Do you have the required cash flow to provide credit?
  • How much credit should you provide and what are the limits?
  • Do you have a system in place for account receivables?
  • How will you assess a customer's ability to pay?
  • What credit information organisation will you use to assist you in determining creditworthy customers?
  • How will you collect overdue accounts?
  • Is your product accurately priced to reflect the cost of granting credit (i.e. to reflect your income)?
  • What terms will you use in extending credit?

The first step towards developing an effective credit policy is understanding these questions have to be answered. For more information, order Dun & Bradstreet's Guide to Cash Flow and Credit Risk here.

Part three of the Credit Management Series shows you how to turn your credit policy into action.

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