What are the elements of credit policy

ABCAdda | Updated Jan 10, 2023

What are the elements of credit policy? Every financial institution takes a lot of effort to make their customers happy by granting credits and timely answering their customer's questions. However, with the growing usage of credit card customers, businesses often face significant credit risks if they don't create a firm credit management policy.

In this blog, I'm going to explain the five elements that help lenders to craft a sound credit policy and mitigate credit risk are:

  1. By evaluating the risk tolerance of a company.
  2. By setting up clear terms and conditions.
  3. By assessing the creditworthiness of borrowers.
  4. By designing a practical credit application.
  5. By strengthening the payment system.

Define credit:

Credit is the amount of money, goods, or services that an individual/entity borrows from the lender with an understanding that the principal will be paid within the due date along with the interest rate. 

What is a credit application?

A credit application is a form filled out by the borrower to get loan approval from lenders. Customers can fill out the credit application manually or electronically.

Before knowing in detail about "what are the elements of credit," let us look at the definition of credit policy.

What is a credit policy?

  • A credit policy is a set of guidelines created and implemented by a company, like setting up credit limits, payment terms and conditions for the borrower, and drawing clear courses of action for unpaid borrowers.
  • Credit policy should define your company's credit limits, terms, and conditions associated with the credits given and late payments, and debt collection terms.

What are the elements of credit policy?

Here are the five elements of an effective credit policy that help an organization to mitigate credit risks that include:

1. By evaluating the risk tolerance of a company:

The best way to mitigate credit risk is by evaluating the creditworthiness of your customers. Another precaution to reduce credit risk is calculating your company's credit risk tolerance. DSO and receivable turnover ratio formulas can assess the lender's risk tolerance.

2. By setting up precise terms and conditions:

By setting up clear terms and conditions for your company, like the riskiness involved in granting a loan to customers, what kind of legal action does your company take in case of late payments? Credit checking process, disclaimers, among other terms and conditions.

3. By assessing the creditworthiness of borrowers:

Credit rating and credit score assess the creditworthiness of borrowers. Credit agencies give the borrower's past debt history, late payments, email id, signature, and contact details. You can decide whether to approve or reject the loan application with this information.

4. By designing a practical credit application:

The credit application must capture crucial information like the borrower's full name, business tie-ups, business registration number, contact address, phone numbers, and email id.

5. By strengthening the payment system:

After granting a loan to the customer, ensure proper monitoring of customer payments and adopt an easy payment system. If there is, credit risk takes steps to overcome the risk.

Conclusion:

We hope our article on "what are the elements of credit" has given the answer you are searching for. This article clearly explained how a company must evaluate a customer's creditworthiness to avoid credit risk. So, here is the end of our article.