Each company must establish its own credit policy based on the ground condition and the environment wherein it is operating. The major goal of the credit policy is to stimulate sales and also control expenses and bad debts linked with granting credit. The subsequent are the major components of a credit policy.
1) Credit period to be permitted to general customers
2) Credit period to be permitted to special customers and the criteria for defining special customer to be predefined
3) Credit rating system
4) Cash discount policy or discount policy for pre-payment through debtors
5) Collection policy
6) Accounting system and management information system i.e. MIS for scrutiny and efficient management of debtors
7) Policy for dealing along with bad and doubtful debts
8) Credit insurance cover
9) Exact documentation of credit sales.
If we regroup the above elements they can be classified in the four dimensions of a firm's credit policy that are given as:
a) Credit standards
b) Credit period
c) Cash discount
d) Collection effort.
Deciding on the credit policy involves a tradeoff among sales and expenses or losses. Decreasing credit standards would raise sales but at similar time would lead to rise in bad debt losses. Similar is true for another variable of credit policy also. Here let us examine the consequence of each of these variables on the total profit on the firm.