Components of Credit Policy: Terms of Sale

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  • 0:03 What Is a Credit Policy?
  • 1:02 Terms of Sale
  • 2:04 Credit Extension Factors
  • 3:45 Collection Policy
  • 4:26 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define credit policy. You'll learn the three components of building a credit policy: terms of sale, credit extension and collection policy. We'll also explore the 5 Cs of credit and other credit analysis alternatives.

What Is a Credit Policy?

Francisco started designing jewelry, clothing and accessories in high school. Ten years later, his designs are worn all over the world. What started as a little sewing and manufacturing shop in the guest room of his parent's home has turned into an international corporation, Franco Designs (FD).

Francisco decided early on that he was not interested in opening his own retail locations because operating retail is too hectic. Instead, FD's success has been achieved by supplying products to large retailers. Until now, retailers paid the company by cash, check or wire transfer; however, many have asked for credit terms. Credit allows the purchaser to take possession of the goods and pay the supplier (lender) at an agreed upon later date. Francisco's accountant, Eduardo, has outlined a credit policy beneficial to the company and presents the details to FD's executives for approval.

Terms of Sale

Companies typically offer two purchasing options: cash and/or credit. When companies extend credit, retailers usually take advantage of the credit option and pay later. To encourage cash payments, Eduardo proposes that FD offer a discount for cash payments. For example, upon receipt of the product, retailers receive a 10% discount if payment is received within 15 days.

Another term of sale consideration is the length of credit terms. The extension of credit creates accounts receivable. Accounts receivable are monies owed to a company from credit purchases. If FD encourages cash payments within 15 days, how long will it allow outstanding accounts receivable? Francisco asks Eduardo, 'What is the industry standard for paying extended credit?' Eduardo replies that most companies require payments within 30 days. Francisco confers with the other executives and they decide to follow the industry standard. Next, Eduardo discusses the criteria for extending credit.

Credit Extension Factors

Large corporations with credit departments analyze each retailer's credit application and determine their credit worthiness based on the 5 Cs of credit: character, collateral, capacity, capital and conditions. Eduardo explains each: Character refers to the retailer's reputation for paying its bills. The lender can ascertain the retailer's character via letters of reference from other suppliers. Collateral secures the product in the event of non-payment. Capacity measures the retailer's ability to make periodic payments or payment in full. An analysis of the retailer's capital represents a down payment to secure the repayment of credit, and conditions are an analysis of the market to determine interest rates. Interest rates are the fee the lender will charge to allow the buyer to make payments. Interest rates are determined by economic conditions and the other 4 Cs of credit.

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