Kat has a Master of Science in Organizational Leadership and Management and teaches Business courses.
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.
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.
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.
Possible Negative Impact
It takes money to run a business. Employees want a paycheck, and utilities, rent, and insurance must be paid. If credit terms are loose or extended for too many days, there may not be enough cash flow. This means money may be taken from other areas of the operation to compensate for the credit that was issued. Also, can the company afford to write off bad debt? Let's face it, there will be a share of accounts that will not pay their debts.
To avoid any issues, Horse Oats, Inc. must calculate how much money it needs to operate before extending credit beyond that figure. They should begin by establishing a credit limit. This creates a base for how much credit the company is willing to extend to a customer. Each customer has different needs and the amount of credit should be based on a credit check and volume and frequency of orders.
Credit terms refers to the timeline in which payment is due. Generally, businesses extend a 10n, or a ten-day period for payment, and include a small discount for paying within the time frame. Some may extend 30 days without a discount. This is up to the company itself. By analyzing current cash flow, the company will have a better idea of how long they will be able to wait for payments. In some cases, interest is tacked on for late payments.
A credit check on their credit-paying customers reduces risk. The credit check will provide Horse Oats, Inc. with information about the customer's credit history, payment history, and even debt-to-income ratio. This information will help Horse Oats to create customized credit policies for their customers. Customers who have a clean credit report and little debt may be extended a higher credit limit. Those with lower credit scores may have a stricter policy.
Deciding on a credit policy is a challenge. But these days, most businesses extend credit to increase sales. But it is risky. Customers may not pay on time or even at all. This affects the cash flow, making it difficult for the credit-extending business to operate.
Once a company decides to establish a credit policy, a few things should be considered. Can they afford to extend credit? Will sales increase as a result? And, how much can they afford to lose to bad debt?
Many of these questions can be answered by creating a credit policy that is specific and customized for individual customers. Some criteria may include a credit limit, payment terms, and a credit check.
Once adopted, the credit policy should be frequently analyzed to determine whether the company is collecting on the debt in a timely way.
To unlock this lesson you must be a Study.com Member.
Create your account
Register to view this lesson
Unlock Your Education
See for yourself why 30 million people use Study.com
Become a Study.com member and start learning now.Become a Member
Already a member? Log InBack