Concept of Credit Policy
The discharge of the credit function in a company embraces a number of activities for which the policies have to be clearly laid down. Such a step will ensure consistency in credit decisions and actions. A credit policy thus, establishes guidelines that govern grant or reject credit to a customer, what should be the level of credit granted to a customer etc. A credit policy can be said to have a direct effect on the volume of investment a company desires to make in receivables.
A company falls prey of many factors pertaining to its credit policy. In addition to specific industrial attributes like the trend of industry, pattern of demand, pace of technology changes, factors like financial strength of a company, marketing organization, growth of its product etc. also influence the credit policy of an enterprise. Certain considerations demand greater attention while formulating the credit policy like a product of lower price should be sold to customer bearing greater credit risk. Credit of smaller amounts results, in greater turnover of credit collection. New customers should be least favored for large credit sales. The profit margin of a company has direct relationship with the degree or risk. They are said to be inter-woven. Since, every increase in profit margin would be counterbalanced by increase in the element of risk.
Credit policy of every company is at large influenced by two conflicting objectives irrespective of the native and type of company. They are liquidity and profitability. Liquidity can be directly linked to book debts. Liquidity position of a firm can be easily improved without affecting profitability by reducing the duration of the period for which the credit is granted and further by collecting the realized value of receivables as soon as they fails due. To improve profitability one can resort to lenient credit policy as a booster of sales, but the implications are:
- Changes of extending credit to those with week credit rating.
- Unduly long credit terms.
- Tendency to expand credit to suit customer’s needs; and
- Lack of attention to over dues accounts.
Setting a Credit Policy
To establish a credit policy, a company must establish credit terms, credit standards and a collection policy.
1. Credit Terms
Credit terms refer to the stipulations recognized by the firms for making credit sale of the goods to its buyers. In other words, credit terms literally mean the terms of payments of the receivables. A firm is required to consider various aspects of credit customers, approval of credit period, acceptance of sales discounts, provisions regarding the instruments of security for credit to be accepted are a few considerations which need due care and attention like the selection of credit customers can be made on the basis of firms, capacity to absorb the bad debt losses during a given period of time. However, a firm may opt for determining the credit terms in accordance with the established practices in the light of its needs. The amount of funds tied up in the receivables is directly related to the limits of credit granted to customers. These limits should never be ascertained on the basis of the subjects own requirements, they should be based upon the debt paying power of customers and his ledger record of the orders and payments. There are two important components of credit terms which are detailed below:
- Credit period: The credit period lays its multi-faced effect on many aspects the volume of investment in receivables; its indirect influence can be seen on the net worth of the company. A long period credit term may boost sales but it‘s also increase investment in receivables and lowers the quality of trade credit. While determining a credit period a company is bound to take into consideration various factors like buyer’s rate of stock turnover, competitors approach, the nature of commodity, margin of profit and availability of funds etc. The period of credit diners form industry to industry. In practice, the firms of same industry grant varied credit period to different individuals. as most of such firms decide upon the period of credit to be allowed to a customer on the basis of his financial position in addition to the nature of commodity, quality involved in transaction, the difference in the economic status of customer that may considerably influence the credit period. The general way of expressing credit period of a firm is to coin it in terms of net date that is, if a firm’s credit terms are “Net 30”, it means that the customer is expected to repay his credit obligation within 30 days. Generally, a free credit period granted, to pay for the goods purchased on accounts tends to be tailored in relation to the period required for the business and in turn, to resale the goods and to collect payments for them. A firm may tighten its credit period if it confronts fault cases too often and fears occurrence of bad debt losses. On the other side, it may lengthen the credit period for enhancing operating profit through sales expansion. Anyhow, the net operating profit would increase only if the cost of extending credit period will be less than the incremental operating profit. But the increase in sales alone with extended credit period would increase the investment in receivables too because of the following two reasons: (i) Incremental sales result into incremental receivables, and (ii) The average collection period will get extended, as the customers will be granted more time to repay credit obligation.
- Cash Discount Terms: The cash discount is granted by the firm to its debtors, in order to induce them to make the payment earlier than the expiry of credit period allowed to them. Granting discount means reduction in prices entitled to the debtors so as to encourage them for early payment before the time stipulated to the i.e. the credit period. Grant of cash discount beneficial to the debtor is profitable to the creditor as well. A customer of the firm i.e. debtor would be realized from his obligation to pay Soon that too at discounted prices. On the other hand, it increases the turnover rate of working capital and enables the creditor firm to operate a greater volume of working capital. It also prevents debtors from using trade credit as a source of working capital. Cash discount is expressed is a percentage of sales. A cash discount term is accompanied by (a) the rate of cash discount, (b) the cash discount period, and (c) the net credit period. For instance, a credit term may be given as “1/10 Net 30” that mean a debtor is granted 1 percent discount if settles his accounts with the creditor before the tenth day starting from a day after the date of invoice. But in case the debtor does not opt for discount he is bound to terminate his obligation within the credit period of thirty days. Change in cash discount can either have positive or negative implication and at times both. Any increase in cash discount would directly increase the volume of credits sale. As the cash discount reduces the price of commodity for sale. So, the demand for the product ultimately increase leading to more sales. On the other hand, cash discount lures the debtors for prompt payment so that they can relish the discount facility available to them. This in turn reduces the average collection period and bad debt expenses thereby, bringing about a decline in the level of investment in receivables. Ultimately the profits would increase. Increase in discount rate can negatively affect the profit margin per unit of sale due to reduction of prices. A situation exactly reverse of the one stated above will occur in case of decline in cash discount. Yet, the management of business enterprises should always take note of the point that cash discount, as a percentage of invoice prices, must not be high as to have an uneconomic bearing on the financial position of the concern. It should be seen in this connection that terms of sales include net credit period so that cash discount may continue to retain its significance and might be prevented from being treated by the buyers just like quantity discount. To make cash discount an effective tool of credit control, a business enterprise should also see that is allowed to only those customers who make payments at due date. And finally, the credit terms of an enterprise on the receipt of securities while granting credit to its customers. Credit sales may be got secured by being furnished with instruments such as trade acceptance, promissory notes or bank guarantees.
2. Credit Standards
Credit standards refers to the minimum criteria adopted by a firm for the purpose of short listing its customers for extension of credit during a period of time. The nature of credit standard followed by a firm can be directly linked to changes in sales and receivables. A liberal credit standard always tends to push up the sales by luring customers into dealings. The firm, as a consequence would have to expand receivables investment along with sustaining costs of administering credit and bad-debt losses. As a more liberal extension of credit may cause certain customers to the less conscientious in paying their bills on time. Contrary, to these strict credit standards would mean extending credit to financially sound customers only. This saves the firm from bad debt losses and the firm has to spend lesser by a way of administrative credit cost. But, this reduces investment in receivables besides depressing sales. In this way profit sacrificed by the firm on account of losing sales amounts more than the cost saved by the firm. Prudently, a firm should opt for lowering its credit standard only up to that level where profitability arising through expansion in sales exceeds the various costs associated with it. That way, optimum credit standards can be determined and maintained by inducing trade-off between incremental returns and incremental costs.
3. Collection Policy
Collection policy refers to the procedures adopted by a firm (creditor) collect the amount of from its debtors when such amount becomes due after the expiry of credit period. The requirements of collection policy arises on account of the defaulters i.e. the customers not making the payments of receivables in time. As a few turnouts to be slow payers and some other non-payers. A collection policy shall be formulated with a whole and sole aim of accelerating collection from bad-debt losses by ensuring prompt and regular collections. Regular collection on one hand indicates collection efficiency through control of bad debts and collection costs as well as by inducing velocity to working capital turnover. On the other hand it keeps debtors alert in respect of prompt payments of their dues. A credit policy is needed to be framed in context of various considerations like short-term operations, determinations of level of authority, control procedures etc. Credit policy of an enterprise shall be reviewed and evaluated periodically and if necessary amendments shall be made to suit the changing requirements of the business. It should be designed in such a way that it co-ordinates activities of concerns departments to achieve the overall objective of the business enterprises. Finally, poor implementation of good credit policy will not produce optimal results.
To conclude, the credit policy of a company should be developed in accord with the strategic, marketing, financial and organisational context of the business and be designed to contribute to the achievement of corporate objectives. The corporate strategy can include trade credit management not just in terms of its contribution to collection and cash flow but as a means of generating sales and profits, and of investing in customers by building relationships. The management of trade credit can help build stable and long term relationships with customers, generate information about the customer and their requirements and facilitate different customer strategies in terms of credit granting, credit terms and customer service. The objective is to generate growing but profitable sales.