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.

Credit policy is one of the most important aspects of a firm’s financial management. It lays down the guidelines for extending credit to customers, managing accounts receivable, and ensuring timely payment from debtors. A sound credit policy can help a business improve cash flow, reduce bad debts, and maintain healthy relationships with customers.

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 the hope to recover the credit sooner or later; however, this approach may involve some risks of bad debts etc.

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

Any firm must evaluate the creditworthiness of its customers. It aids businesses in deciding whether or not to extend credit to a certain client. When evaluating a customer’s creditworthiness, a number of criteria are taken into account, including their credit score, payment history, and debt-to-income ratio. A better credit score shows that the borrower has been responsible for making on-time debt payments and is thus more 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.

Show More