Setting Up Customer Credit Policies in Accounts Receivables (AR) / Order to Cash (O2C) Process in India

Mastering Accounts Receivable: A Best Practice Guide to Customer Credit Policies in India’s O2C Cycle

A well-defined customer credit policy is the backbone of a healthy Order-to-Cash (O2C) process. It is not merely a set of rules but a strategic framework that enables a business to extend credit to customers, thereby boosting sales, while simultaneously mitigating the risk of delayed payments and bad debt. In the dynamic and diverse Indian market, where business relationships and credit practices can vary significantly, a formal policy transforms credit management from a reactive, often chaotic function into a proactive, strategic asset.

The Core Philosophy: Balancing Sales Growth with Financial Prudence

At its heart, an effective credit policy is a balancing act. The fundamental philosophy is to empower the sales team to close deals by offering competitive credit terms while providing the finance and accounts receivable (AR) teams with the tools to protect the company’s cash flow and profitability. This is achieved through a set of principles:

• Risk-Based Differentiation: Not all customers are equal. The policy should enable you to treat customers differently based on their risk profile. A financially stable, long-term partner should receive more favourable terms than a new, unproven entity.
• Data-Driven Decision Making: Gut feelings and personal relationships have their place, but credit decisions must be rooted in objective data. This includes financial statements, third-party credit reports specific to the Indian context (e.g., CIBIL, CRIF High Mark), and the customer’s payment history.
• Clarity and Consistency: The policy must be clear, written, and applied consistently across the board. This eliminates ambiguity, reduces internal friction between sales and finance, and ensures fair treatment of all customers.
• Proactive Management: A credit policy is not a “set it and forget it” document. It’s a living framework that requires regular review and updates based on market conditions, company performance, and customer payment behaviours.

Unlocking Tangible Value: The Business Case for a Robust Credit Policy

Implementing a formal credit policy is an investment that yields significant returns. It moves the AR function from a cost centre to a value-creation hub.

Key Benefits and ROI

• Accelerated Cash Flow: By standardizing payment terms and streamlining collections, you reduce the time it takes to convert sales into cash. This directly improves your working capital position.
• Reduced Bad Debt: A systematic credit evaluation process weeds out high-risk customers before you engage with them, drastically cutting down on the amount of revenue you have to write off as uncollectible.
• Lower Days Sales Outstanding (DSO): A clear policy with proactive collection triggers helps in bringing down the average number of days it takes to collect payments, a critical health metric for any business.
• Improved Profitability: Reduced bad debt and lower financing costs (due to better cash flow) directly contribute to a healthier bottom line.
• Empowered Sales Teams: When the rules of engagement are clear, sales representatives can negotiate confidently, knowing the boundaries within which they can operate. It removes them from the uncomfortable position of being credit managers.

Competitive Advantage in the Indian Market

In a competitive landscape like India, a professional credit policy can be a differentiator. It signals to the market that you are a well-run, professional organization. It allows you to strategically offer more attractive credit terms to high-value, low-risk customers, potentially winning business from competitors who use a one-size-fits-all approach.

Your Implementation Roadmap: A Phased Approach to Building Your Credit Policy

Adopting a structured credit policy requires careful planning and execution. Follow this phased approach for a successful implementation.

Phase 1: Foundation and Assessment (Prerequisites)

Before you start writing, lay the groundwork. Your readiness assessment should confirm:

• Executive Buy-In: Secure commitment from senior leadership (CEO, CFO, Head of Sales). This is non-negotiable.
• Cross-Functional Team: Assemble a team with representatives from Sales, Finance/AR, Legal, and Operations.
• Clear Objectives: What are you trying to achieve? Is it reducing DSO by 15 days? Cutting bad debt in half? Define specific, measurable goals.
• Data Audit: Analyze your existing AR data. Who are your best and worst paying customers? What are your current average payment times?

Phase 2: Design and Documentation (The Core Build)

This is where you craft the policy document itself. It should be comprehensive and tailored to the Indian business environment.

1. Credit Application Process: Define the mandatory information and documents required from a new customer. This must include a formal application form, PAN, GSTIN, company registration documents, and trade references.
2. Credit Evaluation Criteria: Document how you will assess risk.
   • Financial Analysis: Reviewing balance sheets and profit & loss statements for larger customers.
   • Credit Bureau Reports: Subscribing to services like CIBIL or CRIF High Mark to pull company credit reports.
   • Trade References: Speaking to other suppliers to understand the applicant’s payment history.
   • Market Reputation & MCA Data: Checking the Ministry of Corporate Affairs (MCA) portal for company status and directorship details.
3. Setting Credit Limits & Payment Terms: Create a risk matrix. For example:
   • Low Risk (A-Rated): Credit limit up to ₹50 Lakhs, 60-day terms.
   • Medium Risk (B-Rated): Credit limit up to ₹10 Lakhs, 30-day terms.
   • High Risk (C-Rated): Advance payment or secured terms (e.g., Letter of Credit).

   This is the core of the policy and must be clearly defined.

4. Collections and Escalation Process: Detail the step-by-step actions for overdue accounts.
   • T+1 Day: Automated reminder email.
   • T+7 Days: Phone call from the AR team.
   • T+15 Days: Formal communication involving the sales representative.
   • T+30 Days: Stop-shipment/hold on new orders.
   • T+60 Days: Formal Letter of Demand from the legal department.
   • T+90 Days: Handover to a collection agency or initiation of legal proceedings under relevant Indian laws (e.g., Insolvency and Bankruptcy Code, 2016 for eligible cases).
5. Policy for Exceptions: No policy can cover every scenario. Define a clear process for handling exception requests, including who has the authority to approve them (e.g., CFO approval for exceeding a credit limit by more than 20%).

Phase 3: Rollout, Training, and Review

• Communication is Key: Announce the new policy internally with clear reasoning. Explain the “why” behind the change.
• Training Sessions: Conduct mandatory training for the sales and AR teams. They must understand the policy inside-out to implement it and explain it to customers.
• Phased Rollout: Consider rolling out the policy to new customers first, and then gradually applying it to existing customers upon their next credit review cycle.
• Scheduled Reviews: The credit policy must be reviewed at least annually, or more frequently if there are significant changes in the market or economy.

Anticipating Roadblocks: Common Pitfalls in the Indian Context

• Sales Team Resistance: The sales team might feel the policy restricts their ability to sell. Overcome this by involving them in the creation process and highlighting how it helps them focus on quality customers.
• Inconsistent Application: The biggest threat to a policy is making too many “special exceptions” based on relationships. Stick to the documented exception process.
• Ignoring Red Flags: Don’t ignore warning signs like frequent changes in company structure, bounced cheques, or delayed statutory filings (e.g., GST returns).
• Lack of Technology: Managing this process manually for a large customer base is prone to errors. Consider investing in AR automation software.

Fostering Collaboration: How a Clear Credit Policy Aligns Your Teams

A credit policy is a powerful tool for breaking down departmental silos and fostering a shared sense of responsibility for the company’s financial health.

• Sales Team: They are transformed from order-takers into business managers. With clear guidelines, they can confidently negotiate deals that are both profitable and financially sound. They spend less time chasing payments and more time selling.
• Finance & AR Team: Their role shifts from reactive “payment chasers” to proactive risk managers. The policy provides them with the authority and a clear framework for their actions, reducing disputes and improving efficiency.

– Senior Management/Leadership: Gains a clear, real-time view of credit risk across the entire customer portfolio. It enables better financial forecasting, strategic planning, and risk management.

• Customers: A transparent and consistently applied policy builds trust. Customers understand the process, appreciate the clarity, and see you as a professional and reliable business partner.

Measuring What Matters: Key Performance Indicators (KPIs) for Success

To gauge the effectiveness of your credit policy, track these critical metrics:

• Days Sales Outstanding (DSO): (Total Accounts Receivable / Total Credit Sales) x Number of Days. The single most important metric. Your goal is to consistently lower it.
• Collection Effectiveness Index (CEI): ((Beginning Receivables + Monthly Credit Sales – Ending Total Receivables) / (Beginning Receivables + Monthly Credit Sales – Ending Current Receivables)) x 100. This measures the effectiveness of your collection efforts.
• Bad Debt to Sales Ratio: (Amount of Bad Debt / Total Credit Sales). Tracks the percentage of sales that you have to write off.
• Percentage of Overdue Invoices: The proportion of your AR ledger that is past its due date. Track this for different aging buckets (1-30 days, 31-60 days, etc.).

The Policy in Action: Real-World Scenarios in the Indian Market

• Scenario 1: Onboarding a New MSME Customer from a Tier-2 City.

  The policy dictates a thorough check. The AR team pulls their GST filing history, checks their CIBIL Company Credit Information Report (CCIR), and asks for 3 trade references. The report shows a moderate risk score, so they are approved with a conservative initial credit limit of ₹2 Lakhs and 30-day terms, with a review scheduled after 6 months of consistent payment history.

• Scenario 2: A Large, Key Account Requests an Extended Credit Period for a Big Order.

  The customer, a well-known listed company, requests 90-day terms instead of their usual 60 for a large festive season order. The policy’s exception process kicks in. The Sales Head prepares a business case, the AR Manager analyzes the customer’s excellent payment history and low-risk profile, and the CFO provides the final approval, documenting it for the record.

Building a Stronger O2C Ecosystem: Practices that Enhance Your Credit Policy

A credit policy works best when supported by other best practices and technologies:

• AR Automation Software: Automates invoicing, payment reminders, and collections workflows, ensuring the policy is followed consistently and freeing up your team for high-value tasks.
• E-invoicing and Digital Payments: Leverage India’s digital infrastructure. E-invoicing under the GST regime ensures invoice accuracy and faster processing. Integrating payment gateways (UPI, Net Banking) makes it easier for customers to pay on time.
• Regular Customer Account Reviews: Don’t just assess risk at onboarding. Conduct annual or semi-annual credit reviews for all key customers to adjust credit limits and terms based on their performance.
• Strong Master Data Management: Ensure that customer information (billing address, contact details, GSTIN) is accurate and up-to-date to avoid invoice disputes and payment delays.