In many business firms, credit has been found to be an influential selling tool and a basic foundation upon which trading relationships are built. Credit facilities have been found to benefit both the business firm and its customers. Despite the fact that credit is quite important for the growth of business, it usually carries risks and costs which are borne by the seller or the business firm (Bullivant. n.d.). As such, it is important for business firms to come up with guidelines which check the type of customers who the business can extend credit to, the exact terms of payment, limits on outstanding balances and how to deal with defaulting customers. These guidelines are what make up the credit policy of a company and are vital for the productivity of the business firm. A credit policy is a document which establishes the basic structure for extension of credit to customers. This paper will explore the important aspects of credit policies and decisions, the critical role played by ethical considerations in credit decision making and the financial impact of these aspects and considerations to the business.
A credit policy is important for business since it helps manage one of the firms major assets: debtors. Managing debtors or accounts receivable involves minimizing of bad debts and improving cash flow. Credit policy spell out all possible credit situations and circumstances, and provide an appropriate response to all credit scenarios (Kaplan, 2016). Credit policy also ensures consistency on how to approach customers and how to handle different challenges that may arise such as delayed payments or defaults (Miller, 1999). The credit policies usually have spelled out procedures and actions to be followed whenever a client cannot meet the terms of credit extended (Dunn, 2009). As such immediate recourse action is usually established to help the clients or customers pay their credit and also protect the business. Though credit policies usually depend on the strategy and structure of business, there are certain elements which they usually have. Elements of credit policy include credit limit, credit terms, deposits, customer information, credit cards and personal checks (Small business encyclopedia, 2016). Credit policy provides a means of reconciling differences between sales and finances. It also provides the terms of trade for the company and procedures which can be followed when unusual circumstances arise. The policy also provides the procedures to follow when reviewing the level of trade with some clients plus their payment history. Credit limits, a period of payment and the process for opening new accounts for the customer are established by the document (Briggs, 2011).
Credit policy helps in increasing the levels of sale, promotes a stronger relationship with the customer and protects ones investment in accounts receivables. Apart from the conditions stipulated by the credit policy of business, there are other factors which are usually considered before making a credit decision. These factors include factors such as clients terms of application, for example, the amount which they want to borrow and for what purpose. Another factor to consider is the status of the client when they are borrowing i.e. details about their employment, what they earn and their current credit commitments (Barclays, 2016).
Credit policy assist in managing debtors and ensuring the investment made on accounts receivable is protected. The policy achieves this by determining how credit is evaluated, how the collection is handled and the terms and conditions of sale. Credit evaluation is done by establishing the limits of all active customers. This limit is usually established using D&B or TRW ratings, credit references, financial statements, security, or other information obtained directly from the customer (ABC-Amega, 2015). All these help to identify credit worthiness of customers or companies quickly. We are going to look at how D&B ratings are used to establish credit worthiness of clients. Dun &Bradstreet rating (D&B rating) is a manual that helps business understand the risks they are likely to come across in the course doing business with certain companies. It has two parts, the risk indicator, and the financial strength indicator. The financial strength indicator is usually calculated using the companys assets. The risk indicator is calculated by looking into key areas within the companys financial statement or business information which can be used to forecast probability of a business failure (Serviss, 2016). An example of financial strength indicator and risk indicator is shown below. Once a company applies for credit or wants goods or services on credt, the credit department will investigate the company and rank them using the companys financial strength indicator and the risk indicator. A company could be ranked as 5A-4. This shows that the company is quite strong financially though they are at a higher risk of making a loss. Once this rating has been established, credit limit will automatically be established by using an already matrix which had been formed by the company.
Financial indicator based on net worth (Serviss, 2016).
5A Financial strength of 60+ million
4A Financial strength of 45-60 million
3A Financial strength of 30-45 million
2A Financial strength of 15-30 million
1A Financial strength of 2.5-15 million
A Financial strength of 500,000-2.5 million
B Financial strength of 100,000-500,000
5A Financial strength of 60+ million
Risk indicator (Serviss, 2016).
Risk Indicator Probability of failure Guide to Interpretation
1 Minimal risk Proceed with transaction - offer terms required
2 Low risk Proceed with transaction
3 Greater than average risk Proceed with transaction but monitor closely
4 Significant level of risk Take suitable assurances before extending credit
Credit matrix (Serviss, 2016).
5A-1 100% of credit applied
5A-2 80% of credit applied
5A-3 50% of credit applied
5A-4 20% of credit applied
According to Serviss (2016), at 5A-4, the company which applied for credit will be allowed only 20% of what they had applied for. This will protect the crediting company from exposing itself to huge risk and the client will also receive some good, service or funds. Evaluation of creditworthiness of new clients and continuing client will have a positive impact on profitability and liquidity. It will limit the risk of exposure to bad debts and slow paying debtors.
Terms and conditions of sale is another element of credit policy which protects the rights of a seller. They are usually included in the sales contracts, orders, and invoices, even emails related to the sale. These terms usually spell the terms of sale and credit limit (Smith, 2016). This contract usually set procedures to be taken when a debtor refuses to pay up. As such terms and conditions of sale serve to protect the creditor hence protects the profitability of a company (Rics, 2015). Another important thing to consider during formulation of credit policy is how to collect a debt. Having a plan how to handle accounts receivable quickly and actively will have an impact on liquidity and profitability of the company. Proper handling of debtors and efficient debt collection will reduce the cost of doing business and increase the likelihood of collecting past due amounts especially on large accounts (Experian, 2016).
Ethical consideration also plays a crucial role in credit decision making. Credit decisions made are supposed to be procedural and involve best practices. One cannot properly handle debtors without good ethics. Documenting a code of ethics helps businesses to guide their decision makers to the preeminent ethical decisions (Malgaco, 2004). When proper practices of debt collection or credit terms extended to customers are not ethical, or up to standard, such decisions could negatively impact business. The business may lose customers or have a bad reputation hence have difficulty in retaining and attracting new customers (Quast, 2011). Practicing good ethics during formulation of credit decisions and policies will ensure that the business is approachable and the type of service extended to customers will be good. These favorable business ethics will have several positive effects such as customer loyalty and good communication between the business and clients (Nexum, n.d). The overall effect will be good cash flow and minimal bad debt. Good ethics equally applies to customers who are also required to employ good ethics during their dealing with businesses. Their otherwise bad business ethics could lead them to being listed under credit boards and their credibility destroyed (Jones & Middleton, 2007). The customer should aim to improve on their credit rating something which will influence their future access to credit facilities.
In conclusion, credit policy plays a very important role in the growth and development of business. It provides the guidelines to control debtors, an asset, which if not checked can have a negative impact on the liquidity and profitability of business. During formulation of credit policies and decisions, ethical considerations should also be followed since good ethics is what will determine the nature of the relationship between the business and the customers. A good credit policy protects and benefits both the business and its customers.
List of References
ABC-Amega, 2014. Basic Outline for Developing a Credit Policy [Online] (Updated Nov 2015) available at :< http://www.abc-amega.com/articles/credit-management/developing-a-credit-policy>[Accessed 11 May. 2016]
Barclays. 2016. What factors do lenders consider when making credit decisions? [Online] available at: <https://www.help.barclays.co.uk/faq/credit-rating/lender-decision.html> [Accessed 11 May. 2016]
Briggs, K. 2011. Elements of a credit policy [Online] available at :< http://kevin-briggs.co.uk/elements%20of%20a%20credit%20policy.htm> [Accessed 11 May. 2016]
Bullivant G. n.d. Crediit policy [Online] available at: <http://www.fecma.eu/media/text/ECMG-Credit%20Policy.pdf> [Accessed 11 May. 2016]
Dunn, M. 2009. Why you need a credit policy [Online] available at: <https://www.entrepreneur.com/article/202922> [Accessed 11 May. 2016]
Experian, 2016.Optimize your debt recovery strategies [Online] available at :< http://www.experian.com/business-services/debt-recovery.html> [Accessed 11 May. 2016]
Jones, J & Middleton, K. 200. Ethical Decision-Making by Consumers: The Roles of Product Harm and Consumer Vulnerability. [Online] available at :< http://link.springer.com/article/10.1007%2Fs10551-006-9109-2> [Accessed 11 May. 2016]
Kaplan, D. 2016. How Credit Policies Affect Operations and Debt Collections[Online] available at: < http://www.kaplancollectionagency.com/resource-center/advice-for-in-house-debt-collection/how-credit-policies-affect-operations-and-debt-collections/> [Accessed 11 May. 2016]
Malgaco, D. 2004. The Impact of Ethics on Decision Making [Online] available at :< https://blogs.msdn.microsoft.com/deomel/2004/12/13/the-impact-of-ethics-on-decision-making-2/> [Accessed 11 May. 2016]
Miller, C. 1999. Credit Policy [Online] available at :< https://www.crfonline.org/orc/ca/ca-1.html> [Accessed 11 May. 2016]
Nexum n.d. Importance of excellent credit policy [Online] available at: <http://www.bwaresolutions.com/credit%20policy.pdf> [Accessed 11 May. 2016]
Quast, L. 2011. How to prevent poor ethical decision making. [Online] available at: <http://www.forbes.com/sites/lisaquast/2011/12/19/how-to-prevent-poor-ethical-decision-making/#3f1522a7544a> [Accessed 11 May. 2016]
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