Three credit management best practices to help protect cashflow

piggy bank floating in water

A great deal of the literature around credit is focused on helping struggling debtors, so as businesses and creditors we often forget that giving credit where it isn’t due is an early part of the problem. Because the credit we extend is in the form of goods and services rather than money, many of us don’t realise that the longer we go unpaid, the more it affects our own cashflow and debts.

Here are three straightforward ways to avoid the creditor trap and better manage your credit.

1. Develop a credit policy

This is the ‘boring but important’ phase of credit management, but don’t be tempted to skip it, as it will make the rest of the credit management process a lot easier.

What should be in your credit policy?

  • Objectives: What is the purpose of this policy? Generally, to provide a reference on the businesses you will extend credit to, under what circumstances, how much, and under which terms.
  • Credit approval process: Set out the steps for how you will deal with new debtors, including assessing creditworthiness.
  • Credit limits: Define the factors that contribute to each customer’s credit limit. You may decide that all new customers will be held to a certain limit until they have paid a set number of invoices on time, or you may choose to set limits according to the customer’s risk rating.
  • Credit terms: Terms should include the length, for example ’30 days’, and any disincentives for late payment, such as interest charges. The debtor must declare in writing that s/he understands and agrees to these terms to make them enforceable.
  • Monitoring and reporting: Using CreditorWatch you can monitor your debtors for adverse information (court judgements, defaults and ASIC changes). Evaluate your debtors regularly, for example every quarter.
  • Response to bad debt: Set out the actions you will take if a debtor’s account falls in arrears. This may include a warning process, possible consequences—such as lowering credit limits or withholding credit, or shortening terms—and a collections process, for example refinancing the debt, mediation/arbitration, using a debt collection agency or litigation.

Providing a good credit policy will show your customers that you are serious about credit management and gives them transparent communication about what to expect from the credit relationship.

2. Assess your debtor

Especially in tight times when you are keen to make a sale, it is easy to overlook this step in favour of blindly and enthusiastically accepting a new customer. Debtor assessment is, however, probably the most important part of credit management as it tells you whether to extend credit, how much, and what to expect from the debtor. Don’t let a customer become a liability.

Firstly, run a check on the customer to make sure it is a legitimate business still trading. To do this, you need the customer’s Australian Business Number (ABN) or Australian Company Number (ACN) to determine the business name and any trading names it uses. Run those details through a credit reporting agency, CreditorWatch will alert you to any defaults or court actions that may be pending.

Credit testimonials, written statements that vouch for the relationship the debtor has with other creditors, can be useful if you can ask the right questions of the creditors that best match your business profile, but generally the debtor will choose to put its best relationships forward, which could give you a false impression.

Once you’ve determined the financial state of the potential customer, set a credit limit. Just because a business has had a few question marks against its payment record in the past doesn’t mean you should avoid it altogether. Start will small amounts of credit and only extend as much credit as you can afford; remember, you have expenses to pay too.

The length of your credit terms should come into play at this point. Every business needs to balance credit terms that are attractive to customers but also serve its cash flow cycle. On an industry level, it is typical to have longer credit terms in construction because of the nature of the work. The mistake many construction businesses make, however, is not being strict and enforcing these terms when an invoice falls due.

Identify how long you are willing to wait for debtors to pay their invoices and build in some time in case you need to chase. You may also be interested in developing penalties for late payments and incentives for early payments.

3. Manage risk

A proactive approach to risk management is the key to keeping your cashflow cycle in check as well as maintaining a good credit relationship with your customers. Be sure your credit manager and accounts receivable department are familiar with your business’ credit policy and refer to it regularly. Their role is to monitor changes against the debtor’s initial credit assessment and act accordingly if there are signs of trouble. In many cases, timely communication with the debtor is all it takes to keep the payments on track and the relationship in check.

Risk management is about allowing for contingencies that benefit you in the long term, so a good credit policy should allow for financial mishaps and offer solutions that help you avoid expensive, time consuming consequences like litigation while keeping the customer relationship intact.

These three practices should provide the backbone to any credit management process in any industry. You’ll find by remaining vigilant about credit you can keep both your suppliers and clients happy and maintain a healthy cashflow.