A firm could adopt a very conservative credit policy and extend credit only to customers with excellent credit ratings.
Although this type of policy virtually eliminates bad debts or uncollectible accounts, the firm can lose sales and profits by not extending credit to individuals or firms with less-than-perfect credit histories that still might fully pay their accounts.
In theory, a firm should extend credit to any particular class of credit customers from which the ultimate cash collected (through either partial or full payment on account) exceeds the total of the cost of goods sold to all customers in that class.
If a firm follows such a credit policy, it can expect still to incur some bad debts or Uncollectible accounts.
However, as long as these uncollectible accounts do not exceed the incremental profits from sales to other customers in this credit class, the firm will be better off.
For large firms, the cost of administering a credit department and the associated bad debts can be substantial.
In an attempt to reduce the cost of their products, some firms have decided to eliminate retail credit sales.
For example, Arco decided in 1982 to eliminate its retail gas credit cards in the hope of saving $73 million.
Credit policy is a set of guidelines defining the terms under which customers can purchase goods or services on credit, such as the maximum credit period, payment terms, and accepted forms of payment.
A well-defined credit policy helps to protect a business from nonpayment by controlling how much credit it provides and how it collects payments from its customers. It also allows businesses to offer their products or services to more customers who may be unable to pay in cash at the time of purchase.
Elements of a business' credit policy typically include an outline for customer application and approval process, credit limits, payment terms and conditions, invoicing, and late payment penalties.
Having a clearly defined Credit Policy helps businesses to reduce risk from bad debts, to be more organized in managing customer accounts, and to have greater control over cash flow. A good policy also assists customers by giving them clear expectations for how they should pay their bills.
To ensure that your business has an effective Credit Policy, it is important to set realistic payment terms that are agreeable to both you and your customers. Additionally, review customer creditworthiness before granting credit extensions and monitor existing customers’ accounts closely. Furthermore, it is important to enforce late payment penalties and review your Credit Policy regularly.
About the Author
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.
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