## Factors Determining Credit Policy

Credit policy governs how a firm extends credit to customers. It directly affects sales, receivables, bad debts and financing costs.

### Factors Affecting Credit Policy

Factor	Effect
Effect on Sales Volume	Lenient credit terms may increase sales; strict terms may reduce them.
Credit Terms	Credit period, interest rates and repayment schedules influence receivables.
Cash Discounts	Discounts for early payment encourage faster inflows and reduce outstanding receivables.
Customer Selection Policies	Criteria for approving credit customers balance risk against sales growth.
Customer Payment Habits	Customers' paying practices affect the likelihood of delays/defaults.
Collection Policies	Strict collection ensures timely payment; a lenient policy may increase bad debts.
Operational Efficiency	Efficient billing/record-keeping minimises errors and costs.
Other Costs	Interest, collection expenses and bad debts affect investment in receivables.

### Lenient vs. Stringent Credit Policy

	Lenient (Liberal) Policy	Stringent (Strict) Policy
Sales	Increase	May reduce (if competitors offer better terms)
Receivables	Higher	Lower
Bad debt risk	Higher	Lower
Financing needs	Higher	Lower
Credit approval	Liberal	Selective

### Factors Under the Control of the Finance Manager

Supervising credit administration — efficient handling of approvals and collections.
Deciding credit policies — balancing risk and sales growth.
Setting credit selection criteria — eligibility conditions for credit customers.
Speeding up cash collections — aggressive collection to convert receivables to cash faster.
Balancing costs & profits — optimal trade-off between investment in receivables and profitability from higher sales.

The central theme is a trade-off: more liberal credit boosts sales but raises receivables investment, bad debts and financing cost — the finance manager seeks the policy that maximises net benefit.

Worked example

### Example 1

Trade-off illustration: A firm considers relaxing its credit policy. Expected extra annual sales = ₹5,00,000 at a contribution (P/V) ratio of 30%, giving extra contribution of ₹1,50,000. The relaxation raises average receivables, adding an opportunity/financing cost of ₹40,000 and extra bad debts of ₹25,000.

Net benefit = ₹1,50,000 − ₹40,000 − ₹25,000 = ₹85,000. Since net benefit is positive, the more lenient policy is worthwhile.

⚠️ Common exam mistakes

Assuming a lenient credit policy is always better because it raises sales — it also raises bad debts, receivables investment and financing cost, which must be netted off.
Treating customer payment habits and collection policy as the same thing — one is customer behaviour, the other is the firm's own enforcement approach.
Ignoring that only some factors (administration, policy, selection criteria, collection speed, cost-profit balance) are within the finance manager's control.

Reference:

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