Credit Policy

What are credit policies? – Definition

A firm could adopt a very conservative credit policy and extend credit only to customers with excellent credit ratings. Although this type of policy virtually eliminates bad debts or uncollectible accounts, the firm can lose sales and profits by not extending credit to individuals or firms with less-than-perfect credit histories that still might fully pay their accounts.

Explanation

In theory, a firm should extend credit to any particular class of credit customers from which the ultimate cash collected (through either partial or full payment on account) exceeds the total of the cost of goods sold to all customers in that class, plus other incremental selling and general and administrative expenses. If a firm follows such a credit policy, it can expect still to incur some bad debts or Uncollectible accounts. However, as long as these uncollectible accounts do not exceed the incremental profits from sales to other customers in this credit class, the firm will be better off.
For large firms, the cost of administering a credit department and the associated bad debts can be substantial. In an attempt to reduce the cost of their products, some firms have decided to eliminate retail credit sales. For example, Arco decided in 1982 to eliminate its retail gas credit cards in the hope of saving $73 million.