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What are the Features of Optimum Credit Policy?
Features of Optimum Credit Policy
The optimum credit policy of an organization represents the best credit efforts to maximize the returns from the use of the policy as a marketing tool. Usually, it depends upon the organization as to how much control over the credit policy must be exerted.
A too-tight credit policy will lead to loss of opportunities while a too lenient credit policy may lead to an extension of bad debts. Therefore, an optimum credit policy is required by companies to excel in business operations.
The main features of an optimum credit policy are as mentioned below −
Credit policy variables
Evaluation of credit
Decision of granting credit
Control of receivables
Credit Policy Variables
The credit policy variables that affect the policy in the long term are as follows −
Credit Standards − This variable represents the firm’s stand on whether to grant credit or not to a customer. The organization may decide not to grant credit to a customer even if the credit history of the customer is very good.
On the other hand, a firm may grant credit to firms even if their creditworthiness is doubtful.
Liberal credit policies tend to attract more customers and it may increase sales and profitability. However, there are more risks of bad debt associated with a liberal credit policy. A tight policy, on the other hand, losses the opportunity of earning more revenue as it rejects many potential customers.
Credit Period − It is the time a firm allows its customers to pay the credit amount. A liberal credit policy will allow more time for customers to pay back the money.
So, it will increase sales as customers will buy more from the firm, and hence profitability may go up too. This however will require more investment in receivables and a higher incidence of bad debt losses.
Shortening the period, on the other hand, will lower sales, decrease the investments in receivables and reduce the bad debts.
Cash Discount − This is offered by firms in order to make customers pay early. Usually, larger discounts are paid to customers who pay within a certain period. This helps reduce bad debts and increases the sales of the firm by the customers as more goods can be bought by spending the same amount.
Collection Efforts − Collection efforts increase the collection of revenue and a tight collection process may reduce bad debts and other costs associated with a credit sale. It is usually combined with a legal term to pay the credit within a given period.
Evaluation of Credit
The firm must evaluate the character, capacity, and collateral to evaluate the creditworthiness of the customers. Character refers to the customer’s intention to obey legal terms. Capacity refers to the ability to pay back the credit and collateral is the security offered by the customer as a form of a mortgage.
Credit Granting Decision
The decision of granting credit lies with the management. Before granting the credit, a firm may check the variables mentioned above. It may also look at factors that affect the creditworthiness of a customer and their willingness to pay back the money in time.
If a company is lenient, it will take the granting decision earlier and without much analysis. On the other hand, a company that is stringent will make a decision later after analyzing various factors.
Control of Receivables
Two methods are usually used for this. They are as follows −
Days of sales outstanding − It is a ratio of receivables outstanding to average daily sales at a particular time. According to DSO, the accounts receivables are considered to be in control if the DSO is equal to or less than a given norm.
Aging Schedule − This creates different age brackets to pay the credits or the accounts receivables. In this method, the actual AS is compared with a standard to check whether the receivables are in control.
The payment pattern (PP) approach is more practical and used in modern times. The PP approach overcomes the defect of aggregation of sales and receivables over a specific period of time. It focuses on the payment behavior which is key in calculating accounts receivables. It is expressed as proportions or in percentages.
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