What is Credit Policy? and its components.

Credit Policy

From an accounting perspective when credit is granted an account receivable is created. Such receivables include credit to other firms called trade credit and credit granted consumers called consumer credit

Components of credit policy

1. Terms of sale
2. Credit analysis
3. Collection policy

1. Terms of Sale

The conditions under which a firm sells its goods and services for cash or credit
-The period for which credit is granted
-The cash discount and the discount period
-The type of credit instrument

Factors that Influence credit period

There are a number of other factors that influence the credit period. Many of those also influence our customer operating cycle.

i. Periciability

It has relatively rapid turnover and relatively low collateral value credit periods are shorter.

ii. Consumer Demand

Seller may choose much longer credit periods for off season sales.

iii. Cost, profitability and standardization

Standard product have short credit period

iv. Credit risk

The greater the credit risks of the buyer the shorter the credit period.

v. Size of the account

If the account is small the credit period may be shorter as small accounts are more costly to manage.

vi. Completion

Longer credit period are offered in completion

Credit Function

i. Firms have expenses of running a credit department.
ii. Firms chose to contract all or part of credit to a factor.
iii. Firms that manage internal credit operations are self insured against default.
iv. Firms buy credit insurance through an insurance company

2. Credit analysis

Refers to the process of deciding whether or not to external credit to particular customer. It usually involves two steps.

a. Relevant information

-financial statements
-credit agency
-market good will

b. Credit Worthiness

i. Character

The customer’s willingness to meet credit obligations

ii. Capacity

The customer’s ability to meet credit obligations out of operating cash flows

iii. Capital

The customer’s financial reserves

iv. Collateral

An asset pledged in the case of default

Credit scoring

The process of quantifying the probability of default when granting consumer credit

3. Collection Policy

Collection policy is the final element in credit policy. Collection policy involves monitory
receivables to spot trouble and obtaining payment on past due accounts

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