A firm may follow a lenient or a stringent credit policy. The firm following a lenient credit policy tends to sell on credit to customers on a very liberal terms and credit is granted for a longer period.

A firm following a stringent credit policy on the other hand, sell on credit on a highly selective basis only to those customers who have proven credit worthiness and who are financially strong.

 A lenient credit policy will result in increased sales and therefore increased contribution margin. However, these will also result in increased costs such as:

  1. Increased bad debt losses

  2. Opportunity cost of tied up capital in receivables

  3. Increased cost of carrying out credit analysis

  4. Increased collection cost

  5. Increased discount costs to encourage early payments

The goal of the firm’s credit policy is to maximise the value of the firm. To achieve this goal, the evaluation of investment in receivables should involve the following steps:

  1. Estimation of incremental operating profits from increased sales

  2. Estimation of incremental investment in account receivable

  3. Estimation of incremental costs

  4. Comparison of incremental profits with incremental costs