What is a Credit Policy?


The credit policy is an important tool to improve the selling efforts of a company. However, before discussing about credit policy, it is important to first understand about trade credit and its characteristics.

What is Trade Credit?

Trade credit is an important feature of a business policy of a firm. Companies need to sell their products or services the value of which will be paid in the future to make their offers to sellers more competitive. Trade credit is also a way manufacturers adopt to make the product offer more attractive to the point of sale sellers.

Trade credit creates trade debtors or accounts receivable. The customers of manufacturers from whom the book debts or receivables have to be collected are known as book debtors. They represent the company’s claim or assets.

Characteristics of Trade Credit

Trade credit has three distinct characteristics. They are as follows −

Risk Associated with Credit Sale

The first is the element of risk associated with the credit sale. A credit sale does not recover the price of the product immediately as in the case of a cash sale. Therefore, the risks associated with the sale must be carefully analyzed before selling the product in credits.

Economic Value of the Product

The second characteristic is the economic value of the product that gets transferred to the seller from the manufacturer, the value of the product or service is immediately transferred while the price of the product is yet to be realized. So, the economic value of the product is due in the future in contrast to cash sales where the value is realized instantly.

Futurity of the Process

The third characteristic is the futurity of the process. The debtor is liable to pay the price of the products or services in the future, not in the present. So, the value of the product is realized in the future which is an important feature because the credit policy must also take care of this issue.

Debtors form a substantial portion of total business value in India. They are the major sources of current assets after the inventories. Debtors create one-third of current assets in India so a policy that governs the deals with debtors is important and unavoidable in the business sense.

Nature of Credit Policy

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 firm’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. These factors cannot be controlled completely by managers.

The percentage of credit sales to total sales is related to the nature of the business and the norms of the industry.

For example, the automobile industry requires immediate payment while the textiles offer enough credit to the sellers.

Financial managers can impact the volume of sales and the collection period by changing the norms of credit sales which is known as a credit policy.

The main components of a credit policy, also known as Decisions Variables, include the following −

Credit Standards − This defines the types of customers depending on the average collection periods. If the credit standards are loose, the sellers will consume more time to pay which may lead to more investment in accounts receivables and also to default risk.

Credit Terms − It specifies the duration of credit and the way the customers may pay for the products or the services offered by the company. The accounts receivable investments will grow if the credit terms are too long.

Collection Efforts − Collection efforts determine the practical collection period. It is directly proportional to accounts receivable. That means, the lower the collection period, the lower will be the investment in accounts receivable.

Conclusion

A well-measured credit policy goes a long way in providing great sales for the companies. However, a proper balance must be maintained while constructing the credit policy and its components must be given due focus to remain competitive in the market and grow with passing time.

Updated on: 30-Jun-2022

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