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Credit Policy

Definition of Credit Policy

  • A credit policy is a set of rules and standards that govern how companies grant credit to customers and handle collections.
  • It outlines credit terms, creditworthiness assessments, cash discounts, credit limits, collection procedures, and customer information management.

Types of Credit Policy

  1. Liberal or Lenient Credit Policy:
  2. Imposes fewer restrictions on credit terms, attracting more customers and increasing sales.

  3. Can lead to higher bad debts and liquidity issues.

  4. Restrictive or Tight Policy:

  5. Has strict terms for extending credit to customers.
  6. Selective in granting credit, which may result in a loss of customers but ensures consistent cash flow.

Elements of Credit Policy (6Cs):

  1. Credit Terms:
  2. Define payment duration for customers.
  3. Example: "Net 30" rule for new customers, extended terms for loyal customers.

  4. Strict credit terms may reduce sales but lower bad debt expenses and Days Sales Outstanding (DSO).

  5. Creditworthiness of the Customer:

  6. Evaluate the creditworthiness of customers to assess their likelihood of default.

  7. Existing customers may have a positive credit history, while new ones pose higher default risks.

  8. Cash Discounts:

  9. Include discounts to attract customers and reduce DSO.

  10. Credit Limits:

  11. Determine the extended credit period based on creditworthiness.

  12. Lower credit scores result in shorter credit limits.

  13. Collection Policy:

  14. Specify collection terms, late fees, and interest payable.

  15. Tight collection policies may affect customer relationships and reduce investments in accounts receivables.

  16. Customer Information:

  17. Maintain essential documents and information related to transactions.
  18. Helps in assessing and reviewing clients' data.

Examples

  • Example #1: A wholesale business sets different credit policies for clients based on their tenure. Longer credit periods are given to older clients, leading to faster repayments and higher sales.
  • Example #2: Governments, like the Indian and U.S. Federal governments, can announce changes in credit policies, affecting various economic sectors.

Overall, your description provides valuable insights into credit policy, its types, and the critical elements that businesses consider when managing credit risk and customer relationships.

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