The components of a firm's credit policy are the terms of sale, the credit analysis, and the collection policy.
The terms of sale describe the amount and period of time for which credit is granted and the type of credit instrument.
The decision to grant credit is a straightforward NPV decision that can be improved by additional information about customer payment characteristics. Additional information about the customers' probability of defaulting is valuable, but this value must be traded off against the expense of acquiring the information.
The optimal amount of credit the firm offers is a function of the competitive conditions in which it finds itself. These conditions will determine the carrying costs associated with granting credit and the opportunity costs of the lost sales from refusing to offer credit. The optimal credit policy minimizes the sum of these two costs.
We have seen that knowledge of the probability that customers will default is valuable. To enhance its ability to assess customers' default probability, a firm can score credit. This relates the default probability to observable characteristics of customers.
The collection policy is the method of dealing with past-due accounts. The first step is to analyze the average collection period and to prepare an aging schedule that relates the age of accounts to the proportion of the accounts receivable they represent. The next step is to decide on the collection method and to evaluate the possibility of factoring—that is, selling the overdue accounts.
