Financial Management

Factors determining the credit policy of a firm

The credit policy of a firm is concerned with how much to sell on credit and the time within which the debt must be settled or the amount must be recovered.

For example, some firms have a net 30 credit policy, which means that debtors must clear the payments for the goods purchased or service availed within 30 days of availing of the service of buying the goods. The credit policy of a firm is an important determinant in the success or failure of its business.

A firm’s credit policy is usually based on the firm’s view of the risk it may face, which is usually termed credit risk. A firm will normally want to know the risks associated with extending credit before deciding the terms and conditions of credit. This is because an increase in credit costs would lead to the cost of financing becoming higher and consequently to the firm’s profitability being reduced. This leads us to the question, “Is the firm willing to be more risky by extending credit?”

A firm which is reluctant to accept credit risks will normally want to know the potential risks involved and the terms and conditions to be put in place before deciding to extend credit.

A business with stringent credit policies will only sell on credit to customers who have established creditworthiness and sound financial standing. On the other hand, some firms will try to sell as much as possible on credit to build their customer base in a hope to recover the credit sooner or later; however, this approach may involve some risks of bad debts etc.

credit policy

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 their customers easily on credit. On the contrary, firms with strict credit policies generally offer credit sales to selected customers only.

A firm’s credit policy has to be based on three principles:

(i) the risk of being unable to pay the debts should be borne by the firm;

(ii) the firm should not be penalised by extending credit to its clients;

(iii) the firm should be able to protect its interests.

These principles apply whether the credit arrangement is short term or long term. In the case of a long-term loan, a firm may want to take out credit insurance to cover the risk. There are two ways in which the above principles may be expressed:

  • A firm’s credit policy may be in writing or in the firm’s code of conduct. The credit policy in the code of conduct may differ from the policy in writing. The code may be revised from time to time as circumstances change.
  • The firm’s credit policy may be based on general principles, which do not depend on any written or oral statement. In this case, any statement made by an authorised representative is taken to be an interpretation of the policy.
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