The term credit policy refers to those decision variables which influence the amount of trade credit, i.e., the investment in receivables. A firm’s investment in receivables is largely affected by general economic conditions, the pace of technological change, the extent of the competition, industry norms, and the financial structure of the company itself. Though a firm has no control on these external factors, it can influence trade credit through its credit policies within externally imposed constraints.
A fundamental prerequisite for designing an optimal credit policy involves the estimation of its diverse aspects. The various decision variables which are required to be considered in this regard include:
- Credit standards;
- Credit terms; and
- Collection period.
The credit standards adopted by a firm have a significant bearing on sales and receivables. A firm with a loose or relaxed credit standard enjoys higher sales and receivables, whereas one with a tight credit standard finds that there is a dampening effect on its sales and receivables. The credit standards of a firm are largely monitored by:
- Willingness of customers to pay;
- Capacity of customers to pay; and
- General economic milieu.
Credit is among a host of factors that affect the firm’s sales. The extent to which credit can stimulate demand is contingent upon the severity of other factors. It is desirable for a firm to lower its credit standards to the point where increased sales exceed the associated costs. However, a relaxation in credit standards would result in a lengthening of the collection period, and that may tempt new customers not to pay their bills in time.
In deciding upon a relaxation of credit restrictions, the management should know to what extent it will be able to increase the sales and how much expenditure it will have to incur to achieve this increase.
The conditions or specifications under which firms sell goods to customers are referred to as credit terms. The important components of credit terms include:
- Credit period;
- The cash discount terms.
The credit period refers to the time duration for which credit is extended to customers. It is expressed in terms of time. For example, if a firm’s credit period is net 30 days, it is expected that the customer will make the payment within 30 days of sale.
Cash discount is another important aspect of credit terms. Most business undertakings offer this discount to speed up collections. The cash discount policy indicates the rate of discount payable and the period for which it has been offered. The management, in deciding about the quantum and period of cash discount, should assess whether the discount offered will be really helpful in procuring business for it. If not, a cash discount policy would be burdensome for the business.
The cash discount and the credit period are two ingredients of credit terms. These relate to the amount of discount payable, the discount period and the credit tenure. For example, if the credit terms are expressed as “3/15 net 45,” it means that 3% discount is allowed if payment is made after 15 days and that if this offer is not availed of, then payment has to be made within 45 days.
Favorable credit terms are largely offered to increase a firm’s sale. Though the management is at liberty to design its own credit policies, adequate consideration should be given to the strategy of the competitors, failing which it may sustain undue losses.
To make the credit policy function effectively, a sound collection policy is indispensable. Most businessmen know that all the customers do not pay in time. Some are slow payers, while others are non-payers. A collection policy helps to accelerate collections from slow payers and tends to reduce bad debts. In order to collect payment from slow payers, a firm should follow a definite policy. For example, if a customer has been granted 30 days credit, and if no payment is received after the expiry of this period, he should be asked to make payment. If the letter asking for payment remains unattended, another letter may be sent; and this may be followed by a registered letter, a telegram, and even a visit by the company’s sales personnel. If there is no response, legal proceedings maybe initiated. However, before resorting to legal action, the firm’s financial position must be studied. If it happens to be financially weak, it is better to compromise for a reduced payment. If the firm does not do so, but adopts a strict collection policy, its permanent customers, who happen to be slow payers for one reason or other, shift their business to those firms which offer liberal credit terms. But if a lenient collection policy, is followed, the profitability of the company will suffer. Firms, therefore, have to be very cautious in implementing their collection policy.
Factors Influencing Credit Policy
The credit policy of a firm is largely determined by general economic conditions, the rate is technological change, the extent of competition, and industry norms. But within the limits of the external environment, it is free to design its credit policy. A sound credit policy should be based on two factors: one, the cost of extending credit which includes interest on money, probable losses due to uncontrollable accounts, the expenditure incurred on handling the account, and, two, the net profit that may be earned on sales generated by the credit policy.