Procedures and Guidelines for issuing credit and collecting debt to manage credit risk
Written byGabriel Lip
Reviewed byKyle Peterdy
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What is a Credit Policy?
An organization that advances credit and lends to others must consistently ensure that new business aligns with its credit risk tolerance. Similarly, it must effectively collect debts to limit credit losses and safeguard its assets. A credit policy is the complete guidelines and processes for executing this corporate credit strategy.
Credit risk analysis assesses the effectiveness of a company’s policy and balances various interests (for example, sales goals and customer demand) to achieve its goals. Policies are uniquely tailored to the organization’s specific needs, from small businesses selling to customers on credit, to large financial institutions lending directly to corporations.
Key Highlights
- Credit policy is a firm-specific framework, designed by management, to standardize lending decisions in accordance with the firm’s risk appetite.
- Types of credit policies span from a great willingness to extend credit (loose credit) to low or unwillingness to extend credit (tight credit or no credit).
- Components of credit policy include the credit application process, types, limits and terms of credit, collection, monitoring and control, and risk management.
Types of Credit Policy
One way to categorize credit policies is by how loose or stringent a policy is toward advancing credit and managing credit risk, no matter if the goal is credit sales or asset-based lending.
The type of policy is based on firm-level goals and the business environment, so it should adjust dynamically. The ABA report on credit conditions is an example index that measures the general type of credit policy for financial institutions.
Loose credit
Represents a greater willingness to extend credit to grow the business; a strategy to take on higher credit risk and reap the rewards. Examples include granting credit to below-average credit profiles with worse risk ratings, more limited access to capital, and weaker capacity.
Flexible credit
Represents a willingness to extend credit depending on circ*mstances. It’s generally a neutral strategy that does not aggressively grow or restrict access to credit for clients. Examples include granting credit to a broader range of average credit profiles with a process for exceptional approval to policy for clients that may fall outside a diverse risk range.
Tight credit
Generally means less willingness to extend credit to support revenue growth. This is a strategy of restraint often implemented to limit credit losses and/or replenish capital. Examples include only granting credit to above-average credit risks, such as better risk ratings, greater access to capital, and more robust capacity.
No credit
This is an unwillingness to extend credit, as a company is highly risk-averse or has no business case to support the cost/benefit of extending credit. Examples include “cash only” small-dollar consumable goods or businesses with slim margins and insufficient capital to extend trade credit.
Components of a Credit Policy
Rigorously applying the Cs of credit along with tight administration practices throughout the sales and collection cycle is what usually forms the components of a sound credit policy. As a firm grows and gains the capacity to serve a broader range of clients, it assesses and evolves its policy.
Credit application process
Describes the evaluation and approval of credit. Due diligence may include reviewing the client’s financial picture against specific metrics, past performance with credit, and collateral (if any) pledged to support the request. Amendment, renewal, and refinancing of existing credit also play a pivotal role in this process.
Credit types, limits, and terms
Cover the types of credit, the amount available, and their repayment terms. For simple trade credit, it may be “2/10 net 30”, which provides a discount for prompt payment, with full payment due after a grace period of 30 days. More complex examples, such as forms of AR financing or asset-based financing, carry conditional terms linked to specific company performance.
Collection
Administers credit post-advance. The collection process may involve an internal team and systems, or it may require external means (such as collection agencies and other legal remedies). These all serve to recover the credit in full and in the manner agreed upon. A useful measure is the average collection period.
Monitoring and control
Assess the effectiveness of the credit policy and cover the entire gamut of credit decisions and performance of the credit portfolio. Examples include the growth in credit sales, days sales outstanding, delinquencies, and provisions for credit losses. The process gauges and controls the achievement of its credit strategy or provides evidence to adjust the policy if conditions warrant.
Risk management
Includes tools and processes to support crafting the credit policy and mitigating portfolio risk. Portfolio-wide risk mitigation techniques include an internal risk rating system, customer concentration limits, and industry diversification.
Other examples are layers of approval when tailoring to complex terms of advance and repayment, sourcing insurance (such as trade credit insurance), letters of credit, and other products that protect against the deterioration in the performance of credit and the credit portfolio.
Examples of Credit Policy
Generally, a credit policy covers the purpose, the scope (e.g., parties and circ*mstances that it covers), terms that are available, clear responsibilities, and administrative process (application, renewal, monitoring, etc.).
For financial institutions, the Basel Committee on Banking Supervision at BIS has an excellent guide detailing the principles of management of credit risks when developing policies.
The Federal Board of Governors’ supervisory policy and guidance topics offer various policy letters in credit risk management covering the banking sector it supervises.
For trade credit, Wolters Kluwer offers an article on building a credit policy that works.
