A company’s credit policy is vital in the management of cash flow, reduction of financial risks, and good customer relations. It establishes the terms upon which credit is offered to customers, such as payment terms, credit limits, and collection processes. A good credit policy balances increasing sales with the receipt of timely payments, thus affecting a company’s profitability and financial stability.
There are a number of factors that impact a firm’s credit policy, from economic conditions and industry standards to internal financial health and customer creditworthiness.
In this blog, we will discuss the factors determining the credit policy of firm and and how it impacts the financial position of the business.
Factors having an impact on credit policy
The credit policy is one of the essential factors determining both the quantity and quality of accounts receivables. Various factors determine the size of the investment a company makes in accounts receivables.
They are, for instance:
i. The effect of credit on the volume of sales;
ii. Credit terms;
iii. Cash discount;
iv. Policies and practices of the firm for selecting credit customers;
v. Paying practices and habits of the customers;
vi. The firm’s policy and practice of collection; and
vii. The degree of operating efficiency in the billing, record keeping and adjustment function, other costs such as interest, collection costs and bad debts etc., would also have an impact on the size of the investment in receivables. The rising trend in these costs would depress the size of investment in receivables.
A firm may follow an easy or strict credit policy. The firm following a liberal credit policy sells their goods or services to its customers easily on credit. On the contrary, firms with strict credit policies generally offer credit sales to selected customers only.
Following are some important factors that have significant impact on the credit policy of a firm.
Market conditions
Market conditions play a critical role in the credit policy of an organization. For instance, during a recession, when the economy slows down and unemployment rises, customers may face financial difficulties which may lead to delayed payments or default on their loans. This can have negative consequences for lenders who would need to adjust their credit policies by tightening lending criteria and reducing credit limits.
Customer creditworthiness
Every business company has to assess the creditworthiness of its clients. It helps businesses determine whether to offer credit or not to a specific client. When assessing a client’s creditworthiness, several factors are considered, such as their credit score, history of payments, and debt-to-income ratio. A higher credit score indicates that the borrower has been diligent about paying their debt on time and is therefore likely to repay the loan when due.
Industry competition
When there are several businesses operating in the same sector, they may compete with one another to win clients and grow their market share. Because of the competition, businesses may adopt aggressive pricing tactics, which might reduce their profit margins.
To be competitive in such a situation, businesses would need to change their credit rules. For instance, they could provide clients who are having trouble with cash flow with more accommodating payment terms or grant them credit lines. On the other side, aggressive financing terms offered by rivals that the industry as a whole cannot support might lead to a wave of defaults and bankruptcies.
Conclusion
A sound credit policy is critical in ensuring financial stability and promoting business development. Through the consideration of market conditions, customer reliability, and internal cash flow, companies can formulate a balanced strategy that reduces risks and increases sales potential. A strategic credit policy not only enhances cash management but also enhances customer relations and long-term profitability. Finally, companies that continuously examine and modify their credit policies are in a better position to weather economic changes and maintain a competitive advantage.
