A liberal credit policy: advantages and disadvantages

Meaning. A liberal (lenient) credit policy relaxes the terms of credit: credit is extended to more customers, including less creditworthy ones, for longer periods, and perhaps with more generous discounts and less pressing collection. A tight (stringent) policy does the opposite.

Advantages

1. Higher sales: longer credit attracts new customers and raises sales to existing ones.
2. Meeting competition: a firm may have to match the credit terms of competitors or lose customers.
3. Higher profit: the contribution from extra sales raises profit, so long as it exceeds the extra costs.

Disadvantages

1. Larger investment in receivables: more capital is tied up in debtors, for longer, with a financing cost.
2. More bad debts: credit reaches less worthy customers, some of whom do not pay.
3. Higher collection and administrative costs: more accounts, more credit investigation and more follow-up.
4. Lower liquidity: cash comes in later, and slow payers tie up still more funds.

Analysis. A liberal policy raises profitability but lowers liquidity and adds cost and risk; a tight policy does the reverse. The finance manager should liberalise credit only up to the point where the incremental revenue matches the additional costs, the optimum lying at the trade-off between cost, profitability and liquidity.