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Credit Policy

Credit Policy Assignment / Homework Help
The credit policy of a firm provides the framework to determine:
  • Whether or not to extend credit to a customer
  • Volume or amount of credit that can be extended
The credit policy of a firm will be decided based on the credit worthiness of its customers, market conditions, number of competitors, volume of sales, fund availability etc. Setting up of credit policy involves two broad dimensions. They are CREDIT STANDARDS and CREDIT ANALYSIS.

i) Credit Standards

Credit Standards are basic criteria or the minimum requirement for extending credit to a customer. The trade-off between benefits and costs to firm will be considered. The trade-off with reference to credit standards covers:
  • The Collection Cost the effects of relaxed or non-restrictive credit standards would be more credit and more sales, large credit department to maintain accounts receivables and increase in the collection costs. The effects of restrictive credit standards will be the reverse, the costs of which are likely to be semi-variable
  • Investment in Accounts Receivables or Average Collection Period a non-restrictive credit standard will involve a huge investment in debtors and a high average collection period. A restrictive standard will involve less investment in debtors and a lower average collection period
  • Bad Debts Expenses a non-restrictive credit standard has more chances of incurring comparatively higher bad debts expenses than a restrictive credit standard
  • Sales Volume a non-restrictive credit standard will comparatively have a high sales volume than a firm following a restrictive credit standard
Example:

Present Credit Policy and scenario:

Sale Price per unit= $60; Variable cost per unit = $40;
Fixed cost per unit = $15; Annual credit sales = $600,000;
Collection period = 1 month; Minimum return = 16%

If the existing credit policy is liberalized, the projections are:

=> Sales will increase by 40%
=> Collection period will increase to 2 months
=> Bad debts on increased sales will be 5%.

Solution:
Present unit sales ($600,000/$60) = 10,000
Additional units (10,000+40%) = 4,000

Calculation of Additional profits: (Advantage of change in policy)

Incremental sales in units x Contribution margin per unit
=> 4,000 units x ($60 - $40) => $80,000

Disadvantages of change in policy

(Incremental bad debts + opportunity cost of funds tied up in incremental A/R)
Incremental bad debts = 4000 units x $60 x 5% => $12,000

Steps for calculating opportunity cost of investment tied up in A/R:
  • Turnover of accounts receivables:

    Proposed plan = Number of days in the year/Average collection period = 360/60 = 6 times or(number of months in a year/average collection period in months 12/2) Present Plan = 360/30 = 12 times
  • Total cost of sales:

    Present plan = Number of units x cost per unit => 10,000 x $55 = $550,000
    Proposed plan => $550,000 + (4,000 units x $40) => $710,000.
    (please note that at idle capacity fixed cost remains constant and therefore incremental cost is the only variable cost of $40 per unit)
  • Average investment in accounts receivables = Total cost of sales/A/R turnover

    Present plan = $550,000/12 times =>$45,833
    Proposed plan = $710,000/6 times => $118,333
  • Marginal investment in A/R => $118,333 - $45,833 = $72,500
  • Minimum return = 16%. So opportunity cost of funds tied up = $72,500 x 16% => $11,600

Net Advantage of relaxation of credit standards:

Additional earnings $80,000
Less: Additional bad debts expenses $12,000
Less: Opportunity cost of funds tied up $11,600
Net Savings $56,400

Since there is a net savings of $56,400 the company may choose to relax the credit standards.


ii) Credit Analysis

Credit analysis involves obtaining credit information and evaluation of credit applicants. The sources of obtaining credit information are:
  • Internal sources (records of firms, history etc.)
  • External sources
  • Financial statements of customers
  • References from banks
  • References from trade and business
  • Reports from the credit bureau
Evaluation of credit should consider both quantitative and qualitative aspects, before granting credit.

Quantitative Aspect:
The assessment of the quantitative aspects is based on the factual information available from the financial statements, the past records of the firm etc. Preparation of aging schedule, ratio analysis from financial statements of customer and trend analysis will reveal the financial strength of the customer.

Qualitative Aspect:
References from other suppliers, bank references and specialist bureau reports would give an idea about the credit worthiness of the customer.

In the ultimate analysis, the decision whether to extend credit to the applicant and what amount to extend will depend upon both quantitative and qualitative aspects.

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