What are the Types of Credit Policy Variables?

What are Credit Policy Variables?

Credit policy variables are an essential feature of every credit policy. These variables impact the credit policy directly or indirectly. Since the variables have the power to make or break a credit policy they are considered indispensable while forming and executing the credit policy. Management of credit policies requires efficient handling of credit policy variables.

The four types of credit policy variables are as follows −

Credit Standards

Standards of Credit Policy refer to the offering of credit to particular customers and it is purely institutional in character. A company may decide to grant credit to a company willingly while it can hold the offer even when the customer is very credit-diligent.

When the standard of a credit policy is liberal the company offers credit to many customers without considering their credit rating. As is obvious, this increases the sales and may also increase profitability but it is very risky in nature. As the liberal policies extend credit to doubtful customers, the chances of bad debt increase, and it may hamper the long-term profitability of a company.

When the credit policy of a company is tight or more coherent, the company loses some potential customers. So, a tight credit policy faces a loss of opportunity. However, since the company is very selective while offering credit, the chances of losing money as bad debt gets very limited. Therefore, a tight credit standard makes the credit policy considerably less risky.

Credit Period

Another credit policy variable that impacts the policy directly is the duration of time that the company offers to the customer to pay for the goods and services availed on credit. It is also called the credit period. The credit period may depend on the industry and nature of customers. However, a good company that knows its customers should be able to offer a credit period that is optimum yet restrictive in nature.

In a liberal credit policy, the duration to pay back the accounts receivables is longer. So, the companies offering a longer credit period enjoy more sales as the customers buy more from the company because they get extended time to pay back. However, a long credit tenure may increase the chances of defaults by the customers too.

Cash Discounts

Cash discounts are offered to customers who pay back the accounts receivable prior to the last date of the credit period. It enhances the collection of the accounts receivable and hence also increases the chances of sales and profitability. Discounts in credit policy depend on the nature of the business and the industry. While some industries, such as textiles and real estate offer large discounts on early payment, the discounts in automobiles and FMCG may be less in quantity.

Customers usually love to avail discounts on purchased goods and services. So, offering discounts may reduce the period a company takes to pay for the goods and services. This allows the company to enjoy more flexibility and profit in the longer term.

Collection Efforts

A company that sells products or services in credit must have a credit policy that includes a particular form of collection efforts. Without any effort to collect the credits, the companies may face more bad debts and losses. So, in order to gain more profit, the companies must employ a strict collection effort for recovering the credits granted to their customers.

Some companies take legal help in recovering the credits when they are due and they inform the customers about their rules and regulations during the time of sale. A good collection effort along with legal help can go a long way in making a company profitable and free from excessive bad debts.

Conclusion

Longer credit tenures require the companies to invest more in accounts receivables and although the chances of profits are higher, the lengthening of credit periods also increases the chances of bad debts. So a company has to be careful in this regard.