Credit policy is a set of guidelines and rules that a business follows to extend credit to its customers.
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A credit policy outlines the terms and conditions of credit sales, such as the credit period, credit limit, interest charges, payment terms, and collection procedures. The goal of a credit policy is to manage credit risk, maintain cash flow, and improve profitability.
The variables of a credit policy are as follows:
- Credit Period: It is the duration for which a customer can keep the goods or services on credit. The credit period can vary depending on the nature of the business and the creditworthiness of the customer.
- Credit Limit: It is the maximum amount of credit that a customer can avail from the business. The credit limit is determined based on the customer’s creditworthiness and past payment history.
- Credit Standards: It is the criteria that a business uses to evaluate the creditworthiness of a customer. The credit standards can include factors such as credit history, income, financial ratios, and other credit scores.
- Collection Policy: It is the process that a business uses to collect the payments from customers who have availed credit. The collection policy can include sending reminders, follow-ups, and other collection techniques.
- Payment Terms: It is the terms and conditions that a business sets for the payment of credit sales. The payment terms can include the due date, discounts for early payment, and penalties for late payment.
- Interest Charges: It is the interest rate that a business charges on the outstanding credit balance of a customer. The interest charges can vary depending on the creditworthiness of the customer and the prevailing market rates.
By managing these variables, a business can establish an effective credit policy that reduces credit risk, improves cash flow, and enhances profitability.