Credit policy Variables
Credit criteria, credit periods, cash discounts, and collection efforts are four crucial aspects of a company’s credit policy that should not be overlooked. These factors are connected and have an effect on the total amount of sales, the amount of bad debt loss, the amount of discounts that consumers take advantage of, and the amount of money spent on collection fees.
1. Credit standards: With regard to these criteria, a company has a great deal of leeway to choose from. At one end of the spectrum, the company may determine that it will not provide credit to any of its customers, regardless of how high that customer’s credit rating may be. On the other hand, it is possible that it will choose to provide credit to all of its customers regardless of the consumers’ credit ratings. In the middle of these two polar opposites are a variety of perspectives, the majority of which are more realistic.
In most cases, lax credit requirements contribute to an increase in sales by drawing in a greater number of buyers. This, however, is accompanied with a greater incidence of bad debt loss, a bigger investment in receivables, and a higher cost of collection. All of these things are a result of the higher cost of collection. The consequences of having strict credit criteria are the reverse. They have a tendency to bring about a decline in sales, a reduction in the incidence of bad debt loss, a reduction in the investment in receivables, and a reduction in the cost of collection.
2. Credit period: The term “credit period” refers to the amount of time that a consumer is given to pay for the items that they have purchased. In most cases, it might range anywhere from 15 to 60 days. When a company does not provide any customers credit, the credit duration is, as one would expect, equal to zero. If a company extends credit for, say, 30 days but does not provide a discount to customers who pay early, then the company is said to have “net 30” credit terms.
The extension of the credit term drives higher sales by encouraging the company’s already-existing consumers to make more purchases as well as drawing in new clients. However, this is accompanied with a bigger investment in receivables and a higher incidence of bad debt loss. Both of these are unavoidable consequences. A reduction in the length of the credit term would have the opposite effect of what was intended: it would likely result in fewer sales, a smaller investment in receivables, and a lower frequency of bad debt losses.
3. Cash discounts: In most cases, businesses will provide cash discounts to clients in an effort to encourage early payments. The credit conditions take into account both the percentage discount that is offered and the time period in which it may be redeemed. For instance, credit terms of 2/10, net 30 signify that a discount of 2% is granted if the payment is made by the tenth day; otherwise, the full payment is required by the thirty-first day. If the payment is not made by the tenth day, the whole payment is due by the thirty-first day.
When the policy of cash discounts is liberalised, it is possible that the percentage of the discount will be raised, and/or the discount term will be extended. A move like this has the potential to improve sales (because to the fact that the discount is seen as a price drop), decrease the average collection time (due to the fact that consumers pay soon), and raise the cost of the discount.
4. Collection Effort: The collection programme of the company, which is aimed at timely collection of receivables and consists of monitoring the state of receivables, sending letters to customers whose due date is approaching, sending telegraphic and telephonic advice to customers around the due date, threatening legal action to overdue accounts, and taking legal action against overdue accounts.