What is the credit policy and its element?

Credit Policy – Definition:

A credit policy is a legal policy prepared by the organization tailored to the better management of credits issued to customers. A complete set of guidelines that forms a structure of the credited amount provided to the customers is a credit policy.

It also contains the terms and conditions on which the company allows its customers to receive the credit. 

Management of the companies must establish a fair credit policy for their organization.

For accounts receivable, the company’s credit policy will be influenced by several factors, and they are:

● Demand for products

● Competitors terms

● Risk of irrecoverable debts

● Financing costs

● Costs of credit control

Why have a Credit Policy?

A lenient credit strategy might drive in extra clients, however, at an unbalanced expansion in cost.

A firm should build up an arrangement for credit terms given to its clients. In a perfect world, the firm would need to acquire cash with each request conveyed. It must be recognized that credit terms of the firm’s marketing policy. On the off chance that the exchange or industry has embraced a typical practice, it is presumably astute to keep in sync with it.

Elements of a Credit Policy:

A credit policy has four key elements or aspects:

(1) Assess creditworthiness.

(2) Credit limits.

(3) Invoice promptly and collect overdue debts. 

(4) Monitor the credit system.

Assessing creditworthiness

A firm should assess the creditworthiness of:

● all new customers immediately.

● existing customers periodically.

Information for assessing creditworthiness may come from: 

● bank references

● trade references

● competitors

● credit scoring

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● published information

● credit reference agencies company sales records

To minimize the risk of irrecoverable debts occurring, a company should investigate the creditworthiness of all new customers (credit risk) and review existing customers’ creditworthiness from time to time, mainly if they demand that their credit limit be raised.

Organizations can collect information about a customer’s credit rating from a diverse range of sources. 

These include:

Bank references – A client’s authorization should be looked for. These tend to be pretty standardized in the UK and are not perhaps as helpful as they could be. 

Trade references – Suppliers giving credit to the client can provide valuable data regarding how great the client is at taking care of bills on schedule. There is a dangerous threat, and it’s that the client might name those providers that are being paid on schedule.

Competitors – In certain businesses like insurance, contenders share data on clients, including financial health and worth.

Credit scoring – Indicators such as family circumstances, homeownership, occupation, and age can be used to predict likely creditworthiness. This is valuable when stretching out credit to the public where minimal other data is accessible. A diversified software package is at hand, which can help with credit scoring. 

Published information – The client’s yearly records and reports will help understand the organization’s overall financial stability and liquidity.

Credit reference agencies – Agencies such as Dun & Bradstreet publish general financial details of many companies, together with a credit rating. If the company requests a special report, they will then provide it for a nominal fee.  

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Company’s own sales records – For a current client, the business records will show how prompt the payer the organization is, even though they can’t show the capacity of the client to pay.

Credit limits

Credit limits points ought to reflect both: 

  1. credit amount available.
  2. time duration given before the payment is due. 

The company’s ledger account should be monitored to take charge of orders in the pipeline and invoiced sales before further credit is given to ensure limits are not breached.

A credit period starts once a receipt is gotten, so quick invoicing is fundamental. If debts go overdue, the risk of default increases, the follow-up procedures are required.

Invoicing and collecting overdue debts 

The more extended a debt is permitted to run, the higher the likelihood of possible default. An arrangement of follow-up methodology is required, remembering the danger of offending an esteemed client so much that their business is lost.

To chase overdue debts, the following techniques can be used:

Reminder letters: These are frequently viewed as a moderately poor method of acquiring payment, as numerous clients disregard them. Sending reminders via email is more effective than using the post. 

Telephone calls: Such calls are more expensive and valuable than reminder letters (which can be automatically generated by most accounting systems), but where large sums are involved, they can be an efficient way of speeding up payment.

Withholding supplies: Putting clients on the ‘stop list’ for additional orders or extra parts can empower fast repayment of debts.

Debt collection agencies and trade associations: They offer debt lection services on a fixed fee basis or ‘no collection no large’ terms. The provision of service differs impressively, and care ought to be taken in choosing a specialist.

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Legal action: A solicitor’s letter – Prompts payment, and many cases do not go to court. Court activity is generally not practical, yet it can deter different clients from paying late.

Monitoring the system 

The receivables position should be routinely evaluated as an aspect of the entire working capital, and remedial move is made when required.

The methods usually incorporate:

  1. Age analysis 
  2. Statistical data
  3. Ratios 

To monitor the system, management will require regular information to take corrective action and measure the impact of giving credit on working capital investment. The management reports will include the points as follows below:

● Age analysis of outstanding debts. 

● Statistical data is used to identify causes of default and the incidence of irrecoverable debts. This could be among different classes of customers and types of trade.

● Ratios, contrasted with the past period, to show the latest trends in credit levels and the occurrence of delinquent and irrecoverable debts.

Conclusion:

Credit policies are one of the most critical policies an organization could have. These policies comprise the legal terms and conditions that are set while providing credits to the customers. 

It is an excellent source of proof of credits issued to customers. Credit policies have four main aspects. These aspects frame up the entire policy and build trust in the customers.