The important dimensions of a firm’s Credit policy are:
1. Credit standards
2. Credit period
3. Cash discount
4. Collection program
These variables are related and have a bearing on the level of stale, bad debt loss, discount taken by customers, and collection expenses. For purposes of expository convenience, however we examine each of these variables independently.
Credit Standards: A pivotal question in the credit policy of the firm is: What standard should be applied in accepting or rejecting an account for credit granting? A firm has a wide range of choices in this respect. At one end of the spectrum it may decide not to grant credit to any customer, however strong his credit rating may be. At the other end, it may decide to grant credit to all customers, irrespective of their credit rating. Between these two extreme positions lie several possibilities which are often the more practical ones.
In general, liberal credit standards tend to push sales up by attracting more customers. This is, however, accompanied by a higher incidence of bad debt loss, a larger investment in receivables, and a higher cost of collection. Stiff credit standards have the opposite effects. They tend to depress sales, reduce the incidence of bad debt loss, decrease the investment in receivables, and lower the collection cost.
Credit Period: The credit period refers to the length of time allowed to customers to pay for their purchases. It generally varies from 15 days to 60 days. When a firm does not extend any credit, the credit period would obviously be Zero. If a firm allows say 30 days of credit with no discount to induce early payment, its credit terms are stated as ‘net 30’
Lengthening of the credit period pushes sales up by inducing existing customers to purchase more and attracting additional customers. This is, however, accompanied by a larger investment in receivables and a higher incidence of bad debt loss. A shortening of the credit period would have the opposite effects it will tend to lower sales, decrease investment in receivables and reduce the incidence of bad debt loss.
Cash Discount: Firms generally offer cash discount to induce prompt payment The percentage of discount and the period for which it is available are reflected in the credit terms. For example, credit terms of 2/10, net 30 mean that a discount of 2 per cent is offered if the payment is made by the 10th day; otherwise the full payment is due by the 30th day.
Liberalizing the cash discount policy can result in the discount percentage being increased and/or the discount period being lengthened. Such an action tends to enhance sale (because the discount is regarded as price reduction), reduce the average collection period (as customers pay promptly) and increase the cost of discount.
Collection Program: Aimed at timely collection of receivables the collection program of the firm consists of the following:
1. Monitoring the state of receivables
2. Dispatch of letters to customers whose due date is approaching
3. Telegraphic, telephonic or electronic advice to customers around the due date.
4. Threat of legal action to overdue accounts
5. Legal action against overdue accounts
A rigorous collection program tends to decrease sales, shorten the average collection period, reduce bad debts percentage and increase the collection expense. A tax collection program, on the other hand, would push sales up, lengthen the average collection period, increase the bad debt percentage, and perhaps reduce the collection expenses.
Before granting credit the firm must ask the questions: How creditworthy is the customer? In judging the credit worthiness of a customer, the basic factors are the three C’s – character, capacity, and collateral. Character refers to the willingness of the customers to honor his obligation. It reflects integrity a normal attribute considered very important by credit managers. Capacity refers to the ability of the customer to pay on time. It depends on the financial situation particularly the working capital position and profitability and the general business conditions affecting the performance of the customers. Collateral represents the security offered by the firm in the form of mortgages.