Should You Extend Credit to Your Customers? A too-lenient credit policy can break your business, while one that's too strict can scare customers away. Here's how to craft a credit policy that's just right.

In their book Start Your Own Business, the Staff of Entrepreneur Media Inc. guides you through the critical steps to starting your business, then supports you in surviving the first three years as a business owner. In this edited excerpt, the authors offer tips to help you create a credit policy that attracts customers and protects your small business.

These days, there are more options than ever for accepting payment. Whether you're in a B2B or consumer-oriented industry, your choices can include extending credit, taking checks, and accepting credit or debit cards. And there are countless ways to accept payments that don't involve a card—or a cash register. From automatic bank transfers made easy to online services such as PayPal or devices such as Square and other smartphone-based card-payment options, there are many choices.

With so many options, it's easy for a new business owner to get caught up in the excitement of making sales and to forget the necessity of a well-thought-out credit policy. Deciding what forms of payment you'll accept, how you'll handle them, and what collection methods you'll use to ensure debts are paid is essential to any small business' success.

Credit can make or break a small business. A too-lenient credit policy can set the stage for collection and cash-flow problems later, while a creatively and carefully designed policy can attract customers and boost your business's cash flow.

Many small businesses are reluctant to establish a firm credit policy for fear of losing their customers. What they don't realize is that a consistent credit policy not only strengthens your company but also creates a more professional image in your customers' eyes.

A well-thought-out credit policy accomplishes four things:

1. Avoids both bad debts and hard feelings

2. Standardizes credit procedures, providing employees with clear and consistent directions

3. Demonstrates to employees and customers that the company is serious about managing credit

4. Helps the business owner define how credit fits into the overall sales and marketing plan

To establish a smart credit policy, start by investigating the way your competition handles credit. Your goal is to make it easy to buy your products. If your competition offers better terms, they have an advantage. You must meet your competitors' credit terms to attract customers.

At the same time, be cautious not to go too far with your credit policy. Novice entrepreneurs are often tempted to offer lower prices and longer payment terms to take business away from competitors. Credit is a double-edged sword. You want to attract customers with your credit policy, but you don't want to attract customers who aren't credit-worthy. Be aware that some troubled companies routinely switch from supplier to supplier whenever they reach their credit limit with one. Others are outright con artists that take advantage of new and naive entrepreneurs.

How to protect yourself? One good way to start is to write a short, simple statement that sums up the intent and spirit of your company's credit policy. For example, a liberal policy might read: "Our credit policy is to make every reasonable effort to extend credit to all customers recommended by sales management, provided a suitable credit basis can be developed."

A conservative policy might say: "Our company has a strict credit policy, and credit lines will be extended only to the most credit-worthy accounts. New customers who fail to meet our credit criteria will need to purchase using cash-on-delivery terms until they establish their ability and willingness to pay on our terms."

Base your policy selection—conservative or liberal—on your industry, the size and experience of your staff, the dollar amount of your transactions, your profit margins, and your tolerance for risk. Also consider the industry to which you're selling. If your customers are in "soft" industries such as construction or computers, for example, you would do well to use a conservative policy.

If you adopt a liberal credit policy for your business, make sure you are prepared to handle the collection calls. Liberal policies will require you to be aggressive when customers do not pay on time.

Give 'em credit

The simplest customer credit policy has two basic points: 1) limiting credit risk and 2) diligently investigating each company's credit-worthiness.

No matter how credit-worthy a customer is, never extend credit beyond your profit margin. This policy ensures that if you aren't paid, at least your expenses will be paid. For example, if you mark up your product or service 100 percent, you can then safely risk that amount without jeopardizing your company's cash flow. To gauge a company's credit-worthiness, draft a comprehensive credit application that contains the following:

• Name of business, address, phone, and fax number
• Names, addresses, and Social Security numbers of principals
• Type of business (corporation, partnership, sole proprietorship)
• Industry
• Number of employees
• Bank references
• Trade payment references
• Business/personal bankruptcy history
• Any other names under which the company does business
• A personal guarantee that the business owners promise to pay you if their corporation is unable to

Your credit application should also specify what your credit terms are and the consequences of failing to meet them. Indicate what late fees you'll charge, if any; that the customer is responsible for any attorney's fees or collection costs incurred at any time, either during or prior to a lawsuit; and the venue where such a suit would be filed. Have your credit application form reviewed by an attorney specializing in creditors' rights to make sure it is in line with your state's regulations.

Once a potential customer has completed the application, how do you investigate the information? One way to verify the facts and assess the company's credit history is to call credit-reporting agencies. Some companies' payment histories will also be available through D&B. Because credit agencies' reporting can be unreliable, however, it's also a good idea to call others in the industry and try to determine the company's payment record and reputation. Most industries have associations that trade credit information.

Also ask customers how much credit they think they'll need. This will help you estimate the volume of credit and the potential risk to your business. Finally, simply use your intuition. If someone doesn't look you straight in the eye, chances are they won't let you see what's in their wallet, either.