How to Develop a Credit Policy: Protection is the name of the game

No one wants to be caught in a financial loss situation—but this can be a particularly acute concern for businesses that deal in perishable products, as their survival depends on receiving payment as agreed and on time.

So how can companies dealing in fresh produce or other perishables reduce risk and be wise about their financial health? One way is to create and rely on a formal credit policy to help ensure customers pay their bills in a diligent manner.

Benefits of Offering Credit

Extending credit can have many benefits; it can attract new customers and boost sales. But it’s crucial to have a sound credit policy in place for a variety of reasons, including helping a company reduce bad debt, better manage cash flow, maintain good customer relationships, and rein in collection costs.

The list is long of problems a company may encounter when its customers don’t pay. Looking longer term, it can affect an owner’s grander plans and dreams for the future. It’s hard to make plans for expansion, invest in new equipment, or hire new employees if finances are in disarray.

How much working capital is available? Are there sufficient funds to pay bills for the next few months, or is cash flow drying up? A credit policy can help answer these questions and lay the foundation to help build working capital and maintain steady cash flow.

Building a Credit Policy

A business credit policy is a set of guidelines and rules that enables a company to manage its credit-related activities. Its goal is very simple: to reduce the risk of nonpayment and bad debt while supporting positive cash flow.

While everyone would like to believe they can rely on a handshake and a customer’s goodwill to ensure a deal goes as planned, the reality is that businesses need to evaluate and understand the risks they take on when they extend credit to a customer.

Establishing a credit policy means not relying on one’s gut to make decisions, but to instead establish and follow a plan that relies on data to make better informed decisions—and possibly sleep better at night.

Before even considering what items a credit policy should cover, it’s important to note this should be a formal, written document. It’s also critical for staff to understand established protocols must be followed and credit shouldn’t be extended based on friendship or having a good feeling about someone or their business.

Getting specific

All business credit policies, regardless of the size of the company, should include a few specific elements. One of these is credit evaluation criteria, which is simply the means by which the creditworthiness of current or potential customer is assessed.

The type of information or data customers will be evaluated by may include a standard business credit report, financial statements, and bank and trade references. It’s also important to establish who holds credit approval authority, defining which department or staff members are responsible for the research and overseeing the credit application process.

If there’s a hierarchy for approval of different credit limits, this is where a delineation should be noted so everyone understands their duties and/or limitations.

Setting limits

Credit limits establish the maximum amount of credit to be extended to a customer based on its financial health, length of credit history, pay patterns, and other data.

Reasonable limits should be set for a specified period of time (i.e., six months or a year) and pay history reviewed before considering an increase requested by a customer.

Once a customer has proved its reliability—or the reverse, an inability to pay on time—the credit policy should spell out how and when there may be an increase or decrease in credit limit.

Most items used to evaluate and vet a potential business partner are familiar, because they’re the same types of information used to evaluate anyone applying for a credit card or a loan to buy a house or car.

Payment terms and collections

Every business credit policy should establish the terms under which credit will be offered, including the credit limit, payment due dates, discounts for early payment, and/or penalties for late payments. The policy may also specify whether partial payments or installment plans will be accepted and, if so, the circumstances and terms tied to such occurrences.

Having a policy is one thing, but making sure customers understand their obligations is another. The policy  must establish clear and concise guidelines for communicating credit terms to customers and provide transparency on the consequences of late pay or breaching the terms.

So what happens when a customer doesn’t pay as agreed? Rather than hoping a check is in the mail or on its way electronically, this portion of the policy lays out crucial information, including when the collections process begins.

A timeline from initiation to escalation for collection efforts should be firmly established, including but not limited to sending reminders, issuing warnings, and working with collection agencies. In addition, it should be clearly outlined in the credit policy when and how pay information about a customer (positive or negative) will be communicated to credit bureaus.

Maintenance and updates

Another key to successfully managing credit relationships is documentation and recordkeeping. This part of the policy outlines the documentation requirements for maintaining accurate records of credit transactions and emphasizes the need to keep thorough records for auditing and reporting purposes.

A final element of the business credit policy delves into legal considerations. It covers compliance with laws and regulations governing credit transactions and specifies the conditions under which legal action may be taken in case of a default.

Part of the overall maintenance process includes reviewing the credit policy on a regular or stipulated basis. It may be tempting to take a breather once a credit policy is established and in place, but there’s more to do.

As surely as winds change, so does the business climate—which makes it necessary to review and revise the policy to adapt to the current business landscape, ensuring it is not only effective but protects the company and its assets.

Federal Protections

When it comes to ensuring bills are paid, a business credit policy is a good place to start. But it’s useful to note that the fruit and vegetable industry also has federal protection from the U.S. Department of Agriculture (USDA) in the form of the Perishable Agricultural Commodities Act (PACA).

The Act was enacted in 1930 at the request of the produce industry to promote fair trade and resolve disputes involving perishables. Working PACA stipulations into a credit policy provides further protection against losses. The policy can insist credit will not be issued to any company without a PACA license.

A major objective of PACA is to help ensure dealers of fresh and frozen fruits and vegetables get what they pay for and get paid for what they sell, including when their customers go out of business, declare bankruptcy, or simply refuse to pay for received loads.

According to the USDA, a PACA license acts as a declaration to customers and suppliers that a produce company will operate in accordance with PACA and honor these terms of their contracts.

Beyond its value in enforcing PACA rules, the license provides information about a firm’s type of ownership, business history, location(s), and principals. In general, any business buying or selling wholesale quantities (2,000 pounds or more on any given day) of fresh or frozen fruits and vegetables must have a PACA license.

This includes shippers, wholesalers, brokers, retailers, processors, and many ecommerce firms. Growers or farmers are not required to have a PACA license unless they purchase wholesale quantities of fruits or vegetables from another grower or company.

As far as credit policies go, liability and risk increase exponentially if a company chooses to do business with a dealer without a valid PACA license, as these requirements provide an additional layer of accountability and enforcement for the industry.

Wrap-Up

All in all, when a business considers providing credit to customers, creating a credit policy is the first step; making adjustments as needed is the second. In between is careful consideration and vetting of any customers who wish to secure credit for future transactions.

Crucial components include the amount of credit per customer, clear payment terms, collection processes for slow or no pay, and the requirement to have a PACA license in good standing.

Subsequent steps include creating a credit application, selecting the staff who will oversee granting credit and the handling of payments, and thoroughly vetting customers seeking credit.

This article was originally published in the May/June 2024 edition.