Credit Policy

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.

• A credit policy documents rules and guidelines about a customer's credit terms and period. Companies, financial institutions, or governments issue it.
• The two types of credit policies are lenient and restrictive. The former has fewer restrictions, and the latter has tight control over the terms.
• The elements of this policy include credit terms, creditworthiness, cash discounts, credit limits, collection period, and customer information.
• A good policy can promote sales margins, and the reverse can decrease them.

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:

#1 - Liberal Or Lenient Credit Policy

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.

#2 - Restrictive Or Tight Policy

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:

#1 - Credit Terms

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).

#2 - Credit Worthiness Of The Customer

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.

#3 - Cash Discounts

Credit policies include cash discounts as a vital component. A higher discount attracts more customers and reduces DSO. 

#4 - Credit Limits 

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.

#5 - Collection Policy 

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.

#6 - Customer Information

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:

Example #1

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.

Example #2

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:

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 -

• Contractionary Monetary Policy
• Credit Creation
• Tight Monetary Policy