The credit policy of a firm provides the framework to determine Loans quotes (a) whether or not to extend credit to a customer, and (b) how much credit to extend. The credit policy decision of firm has two broad dimensions: (1) Credit Standards and (2) Credit Analysis. A firm has to establish and use standards in making credit decisions, develop appropriate sources of credit information and methods of credit analysis.
The term ?credit standards? represents the basic criteria for the extension of credit to customers. The quantitative basis of establishing credit standards is factors such as credit ratings, credit references, average payments period and certain financial ratios. The overall standards can be divided into two categories: (a) tight or restrictive, or (b) liberal or non-restrictive. That is to say, our aim is to show what happens to the trade-off when standards are relaxed or, alternatively, tightened. The trade-off with reference to credit standards covers (a) the collection cost, (b) the average collection period, (c) level of bad debt losses, and (d) level of sales. These factors should be considered while deciding whether to relax credit standards or not. If standards are relaxed, it means more credit will be extended while if standards are tightened, less credit will be extended. The implications of loans quotes of the four factors are elaborated below:
The implications of relaxed credit standards are (a) more credit, (b) a large credit department to service accounts receivable and related matters, (c) increase in collection costs. The effect of tightening of credit standards will be exactly the opposite. These cost are likely to be semi-variable. This is because upto a certain point the existing staff will be able to carry on the increased workload, but beyond that, additional staff would be required. These should be included in the variable cost per unit and need not be separately identified.
Investments in Receivables or the Average Collection Period
The investment in accounts receivable involves a capital cost, as funds have to be arranged by the firm to finance them till customers make payments. Moreover, the higher the average accounts receivable, the higher is the capital or carrying cost. A change in the credit standards ? relaxation or tightening ? leads to a change in the level of accounts receivable either (a) through a change in sales, or (b) through a change in collections.
A relaxation in credit standards implies an increase in sales, which, in turn, would lead to higher average accounts receivable. Further, relaxed standards would mean that credit is extended liberally so that it is available to even less creditworthy customers who will take a longer period to pay overdues. The extension of trade credit to slow-paying customers would result in a higher level of accounts receivable.
In contrast, a tightening of credit standards would signify (a) a decrease in sales and lower average accounts receivable, and (b) an extension of credit limited to more creditworthy customers who can promptly pay their bills and thus, a lower average level of accounts receivable.
Thus, a change in sales and change in collection period together with a relaxation in standards would produce higher carrying costs, while changes in sales and collection period results in loans quotes lower costs when credit standards are tightened. These basic reactions also occur when changes in credit terms or collection procedures are made.
Bad Debt Expenses
Another factor, which is expected to be affected by changes in the credit standards, is bad debt expenses. They can be expected to increase with relaxation in credit standards and decrease if credit standards become more restrictive.
Changing credit standards can also be expected to change the volume of sales. As standards are relaxed, sales are expected to increase. Conversely, a tightening is expected to cause a decline in sales.
Besides establishing credit standards, a firm should develop procedures for evaluating credit applicants. The second aspect of credit policies of a firm is credit analysis and investigation. Two basic steps are involved in the credit investigation process: (a) obtaining credit information, and (b) analysis of credit information. It is on the basis of credit analysis that the decisions to grant credit to a customer as well as the quantum of credit would be taken.
Obtaining Credit Information
The first step in credit analysis is obtaining credit information on which to base the evaluation of a customer. The sources of information are (1) internal, and (2) external.
Usually, firms require their customers to fill various forms and documents giving details about financial operations. They are also required to furnish trade references with which the firms can have contacts to judge the suitability of the customer for credit. This type of information is obtained from internal sources of credit information. Another internal source of credit information is derived from the records of the firms contemplating an extension of credit. It is likely that a particular customer may have enjoyed credit facility in the past. In that case, the firm would have information on the behavior of the applicant in terms of the historical payment pattern. This type of information may not be adequate and may have to be supplemented by information from other sources.
The availability of information from external sources to assess the creditworthiness of customers depends upon the development of institutional facilities and industry practices. In India, the external sources of credit information are nor as developed as in the industrially developed countries of the world. Depending upon the availability, the external sources such as financial statements, bank references, trade references, credit bureau reports, and so on can be employed to collect information.
Analysis of Credit Information
Once the credit information has been collected from different sources, it should be analyzed to determine the creditworthiness of the applicant. Although there are no established procedures to analyze the information, the firm should devise one to suit its needs. The analysis should cover both loans quotes qualitative and quantitative aspects.
The second decision-area in accounts receivable management is the credit terms. After the credit standards have been established and the creditworthiness of the customers has been assessed, the management of a firm must determine the terms and conditions on which trade credit will be made available. The stipulations under which goods are sold on credit are referred to as credit terms. These relate to the repayment of the amount under the credit sale. Thus, credit terms specify the repayment terms of receivables.
Credit terms have three components: (a) credit period, in terms of the duration of time for which trade credit is extended during this period the overdue amount must be paid by the customer; (b) cash discount, which the customer can take advantage of, that is, the overdue amount will be reduced by this amount; and (c) cash discount period, which refers to the duration during which the discount can be availed of. These terms are usually written in abbreviations.
The credit terms affect the profitability as well as the cost of a firm. A firm should determine the credit terms on the basis of cost-benefit trade-off.