What are the Three Components of Credit Policy?

Credit Policy: Definition

Credit policy is mainly dependent on the volume of credit sales and the collection period. The volume of credit policy is a function of a company’s gross sales and the percentage of credit sales to total sales. Total sales of a company depend on many factors, such as market size, market share, quality of products, competition, etc.

Companies may sell their products in credit for various reasons, such as gaining more market share and being competitive in the industry. Credit sales create trade debtors or accounts receivables where the seller needs to wait for a certain period for the buyer to pay for the goods and services. The clients from whom the seller expects the payment in the future are known as trade debtors.

Characteristics of Credit Sales

There are three notable characteristics of credit sales.

The first is the element of risk that must be analyzed stringent. In fact, if a company does not judge the risks associated with sales to particular clients, it may end up in bad debt where it cannot recover the money in credit. That is why companies check the payment history and business standards of a client while offering it goods or services in credit.

The second characteristic is based on economic value. In fact, when a credit sale takes place, an economic value is transferred from the seller to the buyer. The value is obtained by the buyer immediately whereas the seller has to wait to get the value in the future. Therefore, credit sale is like a warranty where the buyer assures the seller to pay for the goods and services in the future.

The third characteristic associated with credit sales is futurity. As the payments have to be made in the future by the buyer, the element of futurity is inherent in credit sales. It is, therefore, important for the seller to consider an appropriate tenure of future for the buyer to pay for the goods or services offered on credit.

Therefore, we may define credit policy as the policy made by the seller to the buyer that makes the buyer eligible to pay for the goods or services offered by the seller in the future and in given terms set while the sale is made.

Nature of Credit Policy

To offer products on credit, a company needs to make investments in accounts receivable. The accounts receivable is dependent on two factors, namely −

• The volume of credit sale

• The collection period.

In fact, the investment in receivables can be measured in terms of costs of sales in lieu of sales value.

The first factor, i.e. the volume of credit sales depends on the company’s total sales and the company's ratio of credit sales to total sales.

The ratio of credit sales to the total sale is dependent on the nature of the business and the industry norms. While one manufacturer may sell its products without any credit, companies of another industry may offer credits that may stretch for months.

For example, the automobile industry in India offers cars for cash whirl the textile industry offers long periods to its customers to pay for the goods.

Components of Credit Policy

The term credit policy is usually used to represent three decision variable factors. They are as follows −

Credit standards − This variable determines the nature of buyers to whom the credit will be offered by the seller. If credit is given to slow-paying customers, the credit period will be elongated which is not desirable.

Credit Terms − This shows the duration of credit and terms of payment. Investment in accounts receivables increases if the customers take a longer time to pay.

Collection efforts − This variable determines the practical collection period. If the collection period is small, the investment in accounts receivable will be lower and vice versa.

Conclusion

A credit policy must manage the above-mentioned three components effectively to be efficient in managing the investment in accounts receivables. A too lenient credit policy is detrimental for the company while a too-tight policy may lead to lower sales and revenue losses.