Business firms often sell goods on credit to facilitate sales. It is valuable to customers as it augments their resources, and it is particularly appealing to customers who cannot borrow from other sources or find it very expensive or cumbersome to do so.
The credit period extended by business firms usually ranges from 15 days to 45 days. When goods are sold on credit, finished goods get converted (from the point of view of the selling firm) into receivables (book debts). Receivables, when realized, generate cash.
The important dimensions of a firm’s credit policy are credit standards, credit period, cash discount and collection effort. These variables are related and have a bearing on the level of sales, bad debt loss, discounts taken by customers, and collection expenses.
A pivotal question in the credit policy of a firm is: What standard should be applied in accepting or rejecting an account for credit granting? A firm has a wide range of choice in this respect. At one end of the spectrum, it may decide not to extend credit to any customer, however strong his credit rating may be. At the other end, it may decide to grant credit to all customers irrespective of their credit rating.
In general, liberal credit standards tend to push sales up by attracting more customers. This is, however, accompanied by a higher incidence of bad debt loss, a larger investment in receivables and a higher cost of collection. Stiff credit standards have opposite effects. They tend to depress sales, reduce the incidence of bad debt loss, decrease the investment in receivables and lower the collection cost. Firms generally offer cash discounts to induce customers to make prompt payments. The percentage discount and the period during which it is available are reflected in the credit terms.