Monday, July 14, 2008

Who’s on First?

To continue with the series of building a credit policy, identifying who is on first is the initial step in beginning to gel the entire policy into a workable procedure. Previously, we outlined the mission of credit within the organization, and then we examined risk and the organization’s affinity to risk. This exercise has set the foundation for what is to follow, integrating the foundation into the structure.

Identifying and empowering the group who will transform the written policy to a way of life within the organization is the most important part of the credit policy. How the responsibility and authority is divided will either produce a highly effective credit department or a serious cost burden on the organization. Senior management, at this point, must clearly define the credit authority and responsibility of the chosen individual or group. Once established, management must uphold the decision of the credit group throughout the entire management infrastructure. If the credit responsibility and authority is not held steadfast by senior management, the credit function will be riddled with squabbling, poor morale, and horrid results.

Ideally, the credit function should report to the most senior of management; treasurer and / or finance committee. At this level of authority, the decision makers have already established the organization’s affinity for risk. Therefore, they must be the body that determines if the organization should accept an engagement for a client which poses a higher than acceptable amount of credit risk. Following are examples of how the credit responsibility section of the credit policy can be worded.

The credit department reports to the office of the treasurer (managing partner); it includes all functions relating to the extension of credit, collections and cash application. The credit manager establishes all credit limits, has final authority to hold or release all engagements when credit problems exist, decides when credit privileges should be revoked and decides when formal credit activity should be initiated.

Recognizing that certain engagements can be beneficial to the organization, the policy could carve out sections that cap credit limits to the credit department and permit management some slack in accepting the engagement. An example for which as follows:

The credit department reports to the office of the treasurer (managing partner). The credit manager may establish credit limits up to $ XX,XXX, and the manager may delegate up to $X,XXX of authority to other credit personnel. Higher limits MUST be approved by the office of the treasurer (managing partner). Those parties requesting higher credit limits than established by the credit department must submit a comprehensive business model as the amount of credit requested, terms of payment and means by which the credit risk is mitigated to firm established limits. In the event an engagement is being withheld because of credit problems, all parties including the office of the treasurer (managing partner), must meet to gain consensus on a solution.

The clarity and authority by which this section of the policy is written will determine the effectiveness of the credit function in the organization. Organizations need to realize that they needn’t accept every engagement. It is interesting to witness the number of organizations that accept engagements from clients who have a higher probability of default than making payment terms. Organizations fail to internalize that doing work for which no payment will be received is known as ‘charity’. As mentioned previously and will be again, the suggestion isn’t to shun these engagements, but rather build a payment arrangement, through retainers, COD etcetera that will allow the organization to accept the engagement through the mitigation of risk to an acceptable level.

There are many tools available to the credit manager and the organization that will allow them to mitigate credit risk while accepting less than sterling engagements. However, the first step is to relinquish any ambiguity of credit responsibility and know definitively ‘who’ is on first!

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