Credit management is the process of managing the credit risk associated with extending credit to customers or clients. Its main purpose is to ensure that businesses can collect payments for goods or services provided to customers within a reasonable period of time, while minimising the risk of late payments, defaults and bad debts.

What is credit risk?

Credit risk refers to the potential financial loss that a business extending credit may face when a customer or client fails to meet their payment obligations. This is known as a default.

Credit risk can be affected by various factors, including the creditworthiness of the borrower, the economic environment and changes in interest rates or currency exchange rates.

To adequately manage credit risk, businesses lenders must perform proper due diligence to assess the creditworthiness of the counterparty before extending credit, set appropriate credit limits and terms, and monitor the ongoing creditworthiness and payment behaviour of the counterparties regularly. They may also use credit insurance, hedging strategies, or other risk mitigation techniques to reduce credit risk.

What is the purpose of credit management?

The ultimate purpose of credit management is to protect the cash flow of a business. Uneven and irregular cash flow prevents a business from operating efficiently, paying its own debts, planning for the future and, in extreme cases, can force a business to close down.

Effective credit management involves developing clear credit policies, establishing credit limits, monitoring customer payment behaviour, and following up on overdue payments, ideally with automated solutions. It can also involve working with customers to negotiate payment plans or restructuring debts to help them meet their obligations.

Any business that extends credit to customers should be using credit management practices, regardless of its size or industry. This includes small businesses, startups, and large corporations. Effective credit management can help businesses improve their cash flow, reduce bad debt write-offs, and minimise the risk of financial losses due to unpaid bills.

What are the main components of credit management?

The main components of credit management are:

Credit Policy: A credit policy defines the criteria for granting credit, the terms and conditions of credit, and the actions that will be taken if a customer fails to meet their payment obligations.

• Credit Evaluation: Credit evaluation is the process of assessing a customer’s creditworthiness during the onboarding process and before granting credit. This includes reviewing credit history, payment history and financial position.
• Credit Limits: Credit limits are the maximum amount of credit that a customer is allowed to use. Credit limits are based on the customer’s creditworthiness and financial position.
• Credit Terms: Credit terms define the payment terms and conditions for credit. This includes the payment due date, payment frequency, and any other fees or charges.
• Credit Monitoring: Credit monitoring is the process of tracking customer credit usage and payment behaviour. This helps identify potential credit risks and enables proactive action to be taken. Ideally this process is automated, so you are alerted 24/7 if the customer engages in any adverse payment behaviour.
• Credit Collection: Credit collection is the process of collecting outstanding debts from customers who have not paid on time or in full. This includes setting up payment plans, issuing reminders, and taking legal action if necessary. Again, this process should be automated to ensure that nothing is missed and to free up your credit department to focus on higher value tasks.

What is a credit policy?

A credit policy is a set of guidelines and procedures that a company follows when extending credit to its customers. It defines the criteria for granting credit, the terms and conditions of credit and the actions that will be taken if a counterparty fails to meet its payment obligations.

A credit policy typically includes the following components:

• Credit evaluation criteria: The criteria that will be used to assess a customer’s creditworthiness, including their credit history, payment history, financial position, and other relevant factors.
• Credit terms and conditions: The terms and conditions under which credit will be granted, including the credit limit, interest rate, payment terms and any other fees or charges.
• Credit approval process: The credit policy should outline the process for approving credit applications, including the documentation required, the decision-making process and the individuals or committees responsible for making credit decisions.
• Credit monitoring and collection procedures: The procedures for monitoring customer credit usage and collecting outstanding debts, including the steps that will be taken if a customer fails to meet their payment obligations.

A well-designed credit policy can help a company manage credit risk, reduce bad debt losses, and improve its overall financial performance. It also ensures consistency and fairness in credit decisions and promotes transparency and accountability in credit management.

What are the benefits of credit management?

Effective credit risk management offers a range of significant benefits for businesses such as:

• Improved cash flow: By managing credit effectively, businesses can reduce the time it takes to collect outstanding debts, which can improve cash flow and reduce the need for expensive financing. Having cash on hand also allows businesses to take advantage of early payment discounts with their own suppliers. As mentioned, regular cash flow also means that businesses are better able to plan for the future.
• Reduced bad debt losses: Effective credit management can help businesses more easily identify high-risk customers and take proactive steps to minimise bad debt losses, such as offering credit insurance or reducing credit limits.
• Increased profitability: By minimising bad debt losses and improving cash flow, businesses can improve their overall profitability and financial performance.
• Enhanced customer relationships: By offering fair and transparent credit terms, businesses can build strong relationships with their customers and enhance their reputation in the market.
• Better decision-making: Effective credit management provides businesses with the data and insights they need to make informed credit decisions and optimise their credit policies and procedures.
• Competitive advantage: By offering more favourable credit terms than competitors, businesses can potentially attract more customers and gain a competitive advantage in the market.