Credit policy Variables10/06/2020
The important dimensions of a firm’s credit policy are credit standards, credit period, cash discount and collection effort. These variables are related and have a bearing on the level of sales, bad debt loss, discounts taken by customers, and collection expenses.
i) Credit standards:
A firm has a wide range of choice in this respect. At one and of the spectrum, it may decide not to extend credit to any customer, however strong his credit rating may be. At the other end, it may decide to grand credit to all customers irrespective of their credit rating. Between these two extreme positions lie several positions, 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 opposite effects. They tend to depress sales, reduce the incidence of bad debt loss, decrease the investment in receivables, and lower the collection cost.
ii) Credit period:
The credit period refers to the length of time customers are allowed 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 30 days, say, of credit, with no discount to induce early payments, 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. Shortening of the credit period would have opposite influences: It tends to lower sales, decrease investment in receivables, and reduce the incidence of bad debt loss.
iii) Cash discount:
Firms generally offer cash discounts to induce customers to made prompt payments. The percentage discount and the period during 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 tenth day; otherwise the full payment is due by the thirtieth day.
Liberalizing the cash discount policy may mean that the discount percentage is increased and/or the discount period are lengthened. Such an action tends to enhance sales (because the discount is regarded as price reduction), reduce the average collection period (as customers pay promptly), and increase the cost of discount.
iv) Collection Effort:
The collection programmed of the firm, aimed at timely collection of receivables consisting of monitoring the state of receivables, dispatch of letters to customers whose due date is approaching, telegraphic and telephonic advice to customers around the due date, threat of legal action to overdue accounts and legal action against overdue accounts.