A credit policy is a set of rules and standards that directs how companies can grant credit to customers and the collection method. It also describes who in the company is in charge of allotting credit. The main objective of this policy is to set certain guidelines that help handle credit risk.
Credit policy variables help in understanding the outstanding credit balance of customers. Businesses can easily set up credit terms and limit certain customers. Also, businesses can use it to shield against unknown credit risks. It also helps in keeping a consistent approach toward customers. However, a tight policy can lead to inventory issues.
Credit policy is a document containing guidelines and regulations issued by the company for the credit granted to the customers. It gives a clear overview of the outstanding credit accounts and amounts. The issuer of this policy can be companies, governments, and banks.
This policy is a vital element of business strategies and financial management. Therefore, there is a separate credit department allotted to administer the policy. They are responsible for curating the right policy variables to manage uncertain risks. Once developed, the senior management can approve it. The main objectives of this policy are to reduce bad debts and manage risk control factors. Besides, they also consider other factors like business size, cash flow, industry type, customer base, and others.
Thus, if a company issues a good credit policy, it leads to a fast recovery of bad debts. Otherwise, it can lead to huge losses. It is vital to have such a policy based on current terms rather than historical data. Therefore, firms must review the policy consistently to have good results. However, it can differ from one firm to another.
Besides, there is a credit policy for banks and governments also. It protects against the extreme risk arising in financial institutions like banks. As they provide a prime credit facility to customers, it becomes necessary to install a credit policy for banks. Likewise, even governments act as a lender to other countries. Thus, proper evaluation of the credit policy's terms, components, and objectives becomes important.
There are two types of credit policy prevailing in credit management. Let us look at them:
According to this, businesses and companies try to be liberal or put very few restrictions on credit terms. As a result, there is an increase in sales, and it attracts new customers. However, a lenient credit policy can lead to bad debts and liquidity issues.
Here, the terms are very strict for any client or customer. As a result, firms are very selective in extending credit terms and duration. However, it can lead to a loss of customers and consistent cash flow for the firm.
Let us look at the elements, components, or 6Cs of the credit policy as they are called for a better understanding:
Every business has certain terms and conditions regarding credit policy. It also includes the payment duration for every customer. For example, some industries might keep a standard "Net 30" rule for new customers, allowing them to repay within 30 days. Likewise, old or loyal customers receive extended terms (60 to 90 days) because of their credit history. Besides, if the credit terms are strict, sales get reduced. However, it can lower bad debt expenses and DSO (Days Sales Outstanding).
It is a crucial element of the policy. Old customers often have a positive credit score or history. However, there are high chances of default by the new ones. In addition, it can increase the DSO and bad debt expense. Therefore, businesses must assess and evaluate the creditworthiness of customers.
Credit policies include cash discounts as a vital component. A higher discount attracts more customers and reduces DSO.
Credit limits are the extended period given to customers based on the credit policy. So, old or customers having good credit scores have an extension. However, a low credit score attracts less duration. Therefore, policies with a shorter limit can reduce DSO and average sales.
Credit policies have a different collection term for every customer. Companies must provide them with all information on collection policies like late fees, interest payable, and others. So, if firms try to frame a tight policy, it can hamper their customer relationship. Also, the investments in accounts receivables will reduce.
It is necessary from the lender's side to have all information and documents regarding the deal. Some include sales documents, bill invoices, contracts, and others. Also, it benefits in assessing and reviewing clients' data.
Let us look at the examples of credit policy to get a better idea:
Suppose Enid has a firm that operates a wholesale business. Her business deals with various clients and commodities. As it involves more revolving cash, sometimes it takes work for her to manage them. Therefore, a separate credit department oversees the credit operations. They frame different policies for each client. For example, clients that are five years old receive a credit period of 60 days, whereas new ones get restricted to a month. As a result, it became easy to monitor and assess each customer. Thus, an appropriate policy led to fast repayment and higher sales.
In August 2022, the Indian government announced amendments or changes in the credit policy for the sixth time. In contrast, the U.S Federal government changed it seven times in the same year. And the major change in this policy included a hike in the interest points by 50 points to combat the effect of the economic cycles.
Although credit and monetary policy have similar characteristics, they differ slightly. So, let us look at the difference between them:
| Basis | Credit Policy | Monetary Policy |
|---|---|---|
| Meaning | It refers to the rules the company sets for managing the credit period and terms of the customers. Monetary policies are the regulations for controlling the country's interest rates. Purpose Manage, handle, and control the credit risk arising from unknown circumstances. | To set and determine the interest rates for banks in the country. |
| Types | Lenient and restrictive policy. | Contractionary and expansionary monetary policy. |
| The issuer of the policy | Companies, financial institutions, and governments. | The central bank of the country. For example, RBI (Reserve Bank of India) and Federal Reserve. |
| Exception | Some nations might refer to credit and monetary policy as the same. | None |
Credit policies have a strong impact on the working capital of the firm. A liberal policy can lead to a reduction in profits. However, a longer credit limit can lead to less dependency on working capital. Also, businesses have to rely less on banks and other financial institutions for funds.
What is the optimum credit policy?It refers to the maximum credit efforts made by the company to increase the returns from the policy. In addition, they use it as a marketing tool to trade off costs and profits.
What is the credit policy manual?It is a manual that states the terms and conditions of this policy. It also includes collection periods and practices performed by the seller and buyer.
How do you evaluate credit policy?There are certain elements of the policy that need to be evaluated consistently. They are:
● Credit sales
● DSO (Days Sales Outstanding)
● Credit Period, etc.
This article has been a guide to what is Credit Policy. We explain the topic in detail, including its examples, types, elements, and differences with monetary policy. You may also find some useful articles here -
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