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How to Analyze a Credit Policy

Lesson Transcript
Instructor: Kat Kadian-Baumeyer

Kat has a Master of Science in Organizational Leadership and Management and teaches Business courses.

In business-to-business sales, customers often use credit to pay for products or services. The seller extends the credit to the buyer under certain terms and conditions. In this lesson, we will learn how to create and analyze a new credit policy.

What Is a Credit Policy?

Farmer Clark is new to the area and wants to create a relationship with Horse Oats, Inc., a seller of hay and oats for his new horse farm. He would like to deal with a vendor that accepts orders and allows customers to pay at a later date. Clark knows that he will have to adhere to certain terms and conditions.

What Farmer Clark is requesting is that Horse Oats, Inc. extends him credit. For the hay and oat vendor to allow Clark to pay at a later date, a credit policy must be created. Think of this as the rules that must be agreed to before credit is extended.

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  • 0:00 What is a Credit Policy?
  • 0:38 Considerations
  • 2:30 Sales
  • 2:52 Possible Negative Impact
  • 3:19 Avoiding Issues
  • 4:35 Lesson Summary
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Considerations

Extending credit is unavoidable for most businesses. Horse Oats, Inc. is no different. But before a company ships off valuable products without proper payment, it is best to analyze the credit policy to be sure the business will not experience negative financial effects. Once the credit policy is in place, it should be analyzed over a period to determine if there need to be changes made.

Extending credit can have an effect on a business' short-term accounts receivables. Horse Oats, Inc. will research how others in the same business extend credit. They should investigate how other related companies deal with credit and repayments. It may give them insight into the development of their credit policy.

Horse Oats, Inc. should also consider how much credit they can extend. This will have much to do with cash flow requirements for the business. Cash flow is the amount of cash that flows through the company in the form of sales and accounts receivable during a period of time. If Horse Oats is cash-strapped, extending credit for long periods of time may affect the bottom line in the short run. After all, they may need money to pay employees or purchase raw materials.

Risk is another factor. Horse Oats, Inc. takes a risk any time they deliver products without payment. The purchaser can take off running with the goods and make a late payment. The customer may go out of business before he can repay the trusting creditor. Or worse yet, the customer just refuses to pay. That is why it is important to establish a clear policy for credit.

There is no one set way to create a credit policy. Keep in mind, the more loosely worded, the more likely there will be excessive outstanding customer balances. However, an overly strict policy may scare potential customers off. The company should ask themselves a few questions to analyze whether extending credit is a good idea.

Sales

For some customers, having the option to pay on credit is a deal maker that encourages them to buy. The Small Business Administration contends that extending credit may boost sales because customers will focus less on price and more on quality products. But that does not come without risk. Extending credit also means that temporarily, there is less money flowing into the business.

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