Credit Policy

The credit policy of a firm provides the framework to determine:

• Whether or not to extend credit to a customer
• Volume or amount of credit that can be extended

The credit policy of a firm will be decided based on the credit worthiness of its customers, market conditions, number of competitors, volume of sales, fund availability etc. Setting up of credit policy involves two broad dimensions. They are CREDIT STANDARDS and CREDIT ANALYSIS.

Credit Standards

Credit Standards are basic criteria or the minimum requirement for extending credit to a customer. The trade-off between benefits and costs to firm will be considered. The trade-off with reference to credit standards covers:

1. The Collection Cost – the effects of relaxed or non-restrictive credit standards would be more credit and more sales, large credit department to maintain accounts receivables and increase in the collection costs. The effects of restrictive credit standards will be the reverse, the costs of which are likely to be semi-variable
2. Investment in Accounts Receivables or Average Collection Period – a non-restrictive credit standard will involve a huge investment in debtors and a high average collection period. A restrictive standard will involve less investment in debtors and a lower average collection period
3. Bad Debts Expenses – a non-restrictive credit standard has more chances of incurring comparatively higher bad debts expenses than a restrictive credit standard
4. Sales Volume – a non-restrictive credit standard will comparatively have a high sales volume than a firm following a restrictive credit standard

Credit Analysis

Credit analysis involves obtaining credit information and evaluation of credit applicants. The sources of obtaining credit information are:

1. Internal sources (records of firms, history etc.)
2. External sources
3. Financial statements of customers
4. References from banks
5. References from trade and business
6. Reports from the credit bureau

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