According to Sangster (2000) and Pelkowitz (1986), a debtor is defined as an accounting term referring to a person or organization that owes a consideration to a business for goods supplied or services rendered. Both authors agree that a debtor is someone who owes money to another party for products supplied, especially when a business sells on credit to its clients. They further assert that credit sales not only increase total sales but also boost total income.
Despite the fact that credit sales can boost overall income, Atrill and McLaney (2004) point out that selling on credit leads to additional expenses for a business, including credit administration costs, bad debts, and missed opportunities to use funds for more profitable purposes. They further assert that these costs need to be compared with the benefits of increased sales from allowing customers to delay payment. Van Horne (1978) shares this perspective and argues that for any credit extended to a client, the benefits must outweigh the costs. Since there are costs associated with offering credit, it is crucial for firms to have a well-defined credit policy to guide debt issuance and management.
According to Flynn (et-al) (2004), a credit policy is a firm’s overall approach to granting credit, including decisions on the amount of credit and cash discounts offered. The Cronje and Du-Toit definition further clarifies that a credit policy provides directions on whether to grant credit to a client, as well as the specific amount and duration. Both definitions emphasize that a credit policy serves as a guide for extending and managing credit.
A credit policy should aim to achieve an optimal credit policy, which maximizes profits considering the associated risks of issuing credit. According to Ross (2000), it is only logical to grant credit when the firm’s net present value (NPV) is positive. When evaluating a credit policy and determining whether extending credit will lead to a positive NPV and increase the business’s net worth, there are five key factors to consider:
– Revenue effects: If credit is granted, a higher price may be charged, potentially increasing the quantity sold and total revenue.
The firm will experience a positive net present value (NPV) as a result of this.
- Costs effects – Although the firm may experience delayed revenues, it still incurs the costs of sales immediately.
- The cost of debt – When the firm grants credit, it must arrange to finance the resulting receivables. As a result, the firm’s cost of short-term borrowing is a factor in the decision to grant credit.
- The probability of non-payment – A certain percentage of the credit buyers will not pay.
- The cash discount – Some of the customers may choose to pay earlier to take advantage of the discount. This creates a positive NPV.
If the credit policy terms and standards lead to a higher net present value (NPV) for the company, then the company should offer credit to customers and establish criteria for selecting potential customers in accordance with the credit policy.
According to Cronje (et-al) (1998), a credit policy is the assessment of the credit worthiness of debtors using realistic credit standards. Lawrence Gitman, who defines credit policy selection as the process of choosing which customer should receive credit, agrees with this perspective.
According to Van Horne (1995), the process evaluates the credit worthiness of customers and compares it to the firm’s credit standards. Credit standards, as defined by Van Horne (1995), are the minimum requirements for extending credit. Schall (2002) agrees with Van Horne’s definition and states that credit standards are the criterion used by the organization to screen credit applicants. Schall emphasizes that applicants must meet the firm’s standards in order to qualify for credit. Atril and McLaney (2004) also highlight these definitions.
The authors emphasize that a credit policy establishes the credit criteria used by the company. They also list the other components of a credit policy, which include: choosing eligible customers for credit, determining the duration of offering credit, deciding whether to provide discounts for prompt payment, and establishing collection policies.
According to Gitman (2000) and Atril and McLaney (2004), there are several techniques available for selecting customers who can be offered credit. One of these techniques is the 5Cs model, which evaluates customers based on their ability to pay. This model involves gathering information about the applicant, analyzing it to assess their creditworthiness, and deciding whether to extend credit or not.
