Credit policy basics.(Small Business Corner)

Whether you're just starting to extend credit or you've got a bit of experience and are looking to make a change, it's important every now and then to get back to the basics of business credit.

A credit policy is a set of guidelines used to drive credit decisions. For instance, how much credit you extend, how you plan to get paid and with whom you're willing to do business. It isn't meant to be a rulebook that dictates exactly what to do in each specific situation, but a guide to navigating your way into a profitable business credit venture.

Scenarios

Any extension of credit involves risk and it's up to the organization to decide when and how much risk it's willing to take, along with when to adapt that policy to different situations. Here are four different schools of thought:

1. Strict Analysis of Risk and Liberal Collection: In this case, a company extends credit only to the most worthy customers and presumes that if you take precautions up front, that the good credit risks will inevitably pay on time. This is the type of policy that is most commonly used and most effective in normal day-to-day operation.

2. Liberal Analysis of Risk and Heightened Collection: A company with this policy would extend credit to nearly everyone that applied for it, but would monitor payment practices rigorously. Costs of collection would be higher.

3. Liberal Analysis of Risk and Liberal Collection: As one would imagine, this scenario is rarely profitable. Credit costs would be low but so would returns. A company would wind up carrying receivables for a long period of time and would probably wind up with a number of bad debts (losses), which would offset any savings made by spending little on credit extension. Some companies adhere to this policy to avoid offending their customers and some use it in times of surplus.