A credit policy is your business’s internal rulebook for deciding which customers can buy on credit, how much they can charge, what payment terms apply, and what happens when an invoice goes unpaid. Any business that invoices rather than collecting at the point of sale needs one in writing, even if the document runs only a few pages. The policy sits directly between sales growth and financial risk: too restrictive and you push customers to competitors, too loose and you absorb losses you could have prevented.
Where Your Policy Sits on the Risk Spectrum
Credit policies fall along a spectrum from restrictive to lenient, and where your business lands shapes sales volume, cash flow, and bad debt write-offs.
A conservative policy sets high approval thresholds, extends smaller credit lines, and enforces payment terms aggressively. Bad debt losses stay low and cash comes in faster, but you also turn away borderline applicants who might have paid reliably. Businesses running thin profit margins often lean conservative, because a single large default can wipe out months of earnings.
A liberal policy runs the other direction. You approve more applicants, offer larger credit lines, and tolerate slower payment. Sales grows. Finance suffers. More accounts go delinquent, cash sits in receivables longer, and bad debt expense climbs. Companies running liberal policies need margins wide enough to absorb those losses, and the math stops working faster than most owners expect.
Most businesses aim for a moderate policy that balances access against risk. The right position depends on your industry, your margins, and how much working capital you can afford to have tied up in unpaid invoices. A distributor on a 3% net margin cannot absorb the same default rate as a software company with 60% gross margins.
What Your Policy Has to Spell Out
Credit Standards
Credit standards are the minimum qualifications a customer must meet before you’ll extend credit at all. Common thresholds include a minimum credit score, a required number of years in business, or positive trade payment history. The standards act as a first-pass filter, screening out high-risk prospects before you invest time in a full evaluation. Set them too high and you turn away viable customers. Set them too low and your receivables fill with invoices that will eventually become write-offs.
Payment Terms
Payment terms specify when an invoice is due and whether a discount applies for early payment. Net 30, which gives the buyer 30 days from the invoice date to pay the full amount, is the most common arrangement in business-to-business sales. Some companies incentivize faster collection with an early-pay discount. “2/10 Net 30” means the buyer gets 2% off for paying within 10 days, with the full balance due at 30. Net 60 and Net 90 show up in industries where the buyer needs time to resell goods before generating the cash to pay you.
Credit Limits
A credit limit caps the total outstanding balance you’ll allow a single customer to carry at any point. A new applicant with limited history might start at $5,000, while a long-standing customer with a clean payment record could carry $100,000 or more. The point is concentration risk: you don’t want one customer’s default to create a cash flow crisis. Limits should reflect both the customer’s financial health and your own tolerance for exposure, and they need periodic adjustment as the relationship changes.
Evaluating a Credit Applicant
The Application
Every credit relationship starts with a formal application that collects identifying data and financial background. At minimum you need the applicant’s legal business name, tax identification number, principal officers, bank references, and authorization to verify the information through third parties. This document creates the baseline record for the entire relationship. If a dispute arises later, the application is the first thing your attorney will want to see.
Financial Statements
Reviewing an applicant’s financial statements gives you a direct look at their ability to pay. Trade creditors typically request a balance sheet and income statement covering the previous two to three fiscal years.1NCUA Examiner’s Guide. Financial Analysis and Credit Approval Document From those you can calculate ratios that reveal financial health: the debt-to-equity ratio shows how leveraged the business is, and the current ratio indicates whether the company can cover short-term obligations. Declining revenue or a current ratio below 1.0 is worth investigating before extending a credit line.
Credit Reports and Business Scores
Pulling a credit report provides an outside view of the applicant’s payment behavior. The Fair Credit Reporting Act governs how this information is collected and shared, and your business needs a permissible purpose to access it. Extending credit qualifies.2Office of the Law Revision Counsel. 15 U.S. Code 1681b – Permissible Purposes of Consumer Reports For commercial applicants, business credit scores such as the Dun & Bradstreet PAYDEX rate payment reliability on a 1-to-100 scale, where 80 or above signals on-time payments and low risk. Scores below 50 indicate the business is paying suppliers a month or more past terms, a pattern that should push you to tighten limits or require prepayment.
Trade References
Trade references are contact details for other suppliers who have already extended credit to the applicant. Calling them gives you real-world payment data that credit scores alone don’t always capture. A company can have a decent score and still consistently dispute invoices or stretch payments with smaller vendors. Two or three solid trade references confirming prompt payment over 12 months or more are worth more than any single score.
Approval and Applicant Notification
Once the application, financials, and credit data are in, the file moves to whoever makes credit decisions. In smaller businesses that’s the owner or controller. Larger organizations use a credit analyst, with a senior manager or credit committee reviewing high-dollar requests. That second layer isn’t bureaucracy. It prevents any one person’s relationship with a sales prospect from overriding sound credit judgment, and the accounts that blow up are almost always the ones where someone skipped the second look.
After approval, staff create a customer profile in the accounting system with the approved credit limit and payment terms. Most modern platforms will automatically block an order from shipping if it would push the customer past their limit. A miskeyed limit or wrong payment terms can cascade through invoicing, aging reports, and collection workflows for months before anyone catches it.
The Equal Credit Opportunity Act requires you to notify an applicant of your decision within 30 days of receiving a completed application.3Office of the Law Revision Counsel. 15 USC 1691 – Scope of Prohibition If you deny the application, the notice must include specific reasons. Saying the applicant “didn’t meet internal standards” isn’t enough.4eCFR. 12 CFR 1002.9 – Notifications Concrete reasons look like insufficient operating history, excessive existing debt, or unsatisfactory payment record with trade references. Skipping or delaying this notice exposes the business to regulatory penalties.
Measuring Whether the Policy Is Working
Days Sales Outstanding (DSO) is the single most useful metric for evaluating your policy. Divide your accounts receivable balance by total credit sales for a period, then multiply by the number of days in that period. A business with $150,000 in receivables and $500,000 in quarterly credit sales has a DSO of 27 days, meaning it takes about four weeks on average to collect after invoicing.
For most B2B companies, a DSO of 30 days or less signals healthy collections. If your standard terms are Net 30 and your DSO is 45, customers are paying two weeks late on average, and your credit policy or collection process has a gap somewhere. Rising DSO across consecutive quarters is an early warning that deserves attention before it becomes a cash flow problem. Tracking DSO by customer segment can reveal whether the issue is a handful of slow-paying accounts or a systemic problem across the portfolio.
Collecting Overdue Accounts
When a customer misses a due date, your policy should prescribe a specific sequence of actions tied to how many days the account has been past due. A common escalation looks like this:
- 5 to 7 days past due: an automated email reminder or account statement. Most late payments are oversights, and a polite nudge resolves the majority of them.
- 30 to 45 days past due: a phone call to the customer’s accounts payable department to get a firm payment date.
- 60 days past due: a formal demand letter sent by certified mail. The letter documents your efforts and puts the customer on notice that further escalation is coming.
- 90+ days past due: referral to a third-party collection agency or legal counsel.
The specific timelines matter less than having them written down and following them consistently. Selective enforcement undermines the entire policy.
Third-party collection agencies work on contingency, charging a percentage of whatever they recover. Newer accounts under 90 days old run around 20%, accounts aged beyond six months climb to 30–40%, and debts older than a year can cost close to 50% of the recovered amount. Those fees are why internal collection in the first 90 days matters so much.
One boundary worth naming: the Fair Debt Collection Practices Act restricts how debt collectors communicate with debtors, but it only applies to debts incurred for personal, family, or household purposes.5Office of the Law Revision Counsel. 15 U.S. Code 1692a – Definitions Business-to-business debts fall outside the statute.6Consumer Financial Protection Bureau. What Laws Limit What Debt Collectors Can Say or Do If your business sells to individual consumers on credit, both you and any collection agency you hire must comply with the FDCPA’s restrictions on call timing, harassment, and misrepresentation. The law also doesn’t cover collection efforts by the original creditor, only third-party collectors, so your own in-house calls are generally exempt.
Protecting High-Value Accounts
When a customer requests a large credit line, standard approval criteria may not give you enough protection. Two tools add security.
A personal guarantee is a separate agreement in which an owner or principal accepts personal liability for the business’s debt. Corporations, LLCs, and partnerships are separate legal entities, so the company’s obligations don’t automatically extend to the people running it. A signed personal guarantee changes that: if the business can’t pay, you can pursue the individual’s personal assets.7NCUA Examiner’s Guide. Personal Guarantees For high-limit accounts, an unlimited joint and several guarantee from the principal owners is the strongest form, because it lets you pursue any guarantor for the full amount owed.
A UCC-1 financing statement establishes your legal priority in specific assets the customer pledges as collateral. Filing it with the appropriate state office “perfects” your security interest, meaning that if the customer becomes insolvent, you have a recognized claim ahead of unsecured creditors.8Legal Information Institute. UCC Financing Statement Filings typically cover inventory, equipment, or receivables. Extending significant credit without either a personal guarantee or a UCC filing makes you an unsecured creditor, and in a bankruptcy, unsecured creditors are last in line.
Trade credit insurance is a third option if you extend credit to a large number of buyers. Policies pay out a percentage of the outstanding balance if a customer fails to pay due to insolvency or prolonged default. Coverage protects cash flow and can also make lenders more comfortable extending your own credit lines. Premiums vary based on your customer portfolio, industry, and claims history.
Tax Treatment of Uncollectible Accounts
When a customer genuinely cannot pay and you’ve exhausted reasonable collection efforts, the IRS allows you to deduct the uncollectible amount as a bad debt, but only if you previously included that revenue in your gross income.9Internal Revenue Service. Bad Debt Deduction Cash-basis businesses that never reported the income cannot take the deduction, since they never paid tax on the revenue in the first place. Accrual-basis businesses, which record revenue when the sale occurs, qualify for the write-off.
The deduction is available for debts that are wholly or partially worthless, and you must take it in the tax year the debt becomes uncollectible.10Office of the Law Revision Counsel. 26 USC 166 – Bad Debts You don’t need a court judgment to prove worthlessness, but you do need to show you took reasonable steps to collect. Keep your collection correspondence, phone notes, and any written payment commitments the customer made. That documentation is your evidence if the deduction is questioned.
If you cancel $600 or more of a customer’s debt, you may also be required to file Form 1099-C reporting the cancellation to the IRS.11Internal Revenue Service. Instructions for Forms 1099-A and 1099-C This requirement applies primarily to financial institutions and businesses whose significant activity is lending, but confirm whether yours qualifies. Penalties for failing to file information returns add up quickly.
Keeping the Policy Current
A credit policy written three years ago and left in a drawer is barely better than no policy at all. Review the document annually at minimum, and reassess immediately after certain events: a spike in late payments, a shift in your customer base, entry into a new market, or a meaningful change in interest rates or economic conditions.
The review should focus on concrete questions. Are your credit limits appropriate given current customer volumes? Do your payment terms still align with industry norms and your own cash flow needs? Has your default rate changed, and if so, is the problem concentrated in a particular customer segment? Are collection procedures actually being followed, or has the team drifted from the written process? Regulatory changes, particularly to the ECOA, FCRA, or state-level commercial collection laws, belong in the annual check as well.
The businesses that manage receivables well treat the policy as a working document, not a compliance checkbox. If your DSO is creeping up, the policy is the first place to look.