Credit Control and Collection Policy

Credit and Collection Policies

Economic conditions, product pricing, product quality, and the firm’s credit policies are the chief influences on the level of a firm’s accounts receivable. All but the last of these influences are largely beyond the control of the financial manager. As with other current assets, however, the manager can vary the level of receivables in keeping with the trade-off between profitability and risk. Lowering credit standards may stimulate demand, which, in turn, should lead to higher sales and profits. But there is a cost to carrying the additional receivables, as well as a greater risk of bad-debt losses. It is this trade-off that we wish to examine. The policy variables we consider include the quality of the trade accounts accepted, the length of the credit period, the cash discount (if any) for early payment, and the collection program of the firm. Together, these elements largely determine the average collection period and the proportion of credit sales that result in bad-debt losses. We analyze each element in turn, holding constant certain of the others as well as all external variables that affect the average collection period and the ratio of bad debts to credit sales. In addition, we assume that the evaluation of risk is sufficiently standardized so that degrees of risk for different accounts can be compared objectively.

Credit Standards

Credit policy can have a significant influence on sales. If our competitors extend credit liberally and we do not, our policy may have a dampening effect on our firm’s marketing effort. Credit is one of the many factors that influence the demand for a firm’s product. Consequently, the degree to which credit can promote demand depends on what other factors are being employed. In theory, the firm should lower its quality standard for accounts accepted as long as the profitability of sales generated exceeds the added costs of the receivables. What are the costs of relaxing credit standards? Some arise from an enlarged credit department, the clerical work involved in checking additional accounts, and servicing the added volume of receivables. We assume that these costs are deducted from the profitability of additional sales to give a net profitability figure for computational purposes. Another cost comes from the increased probability of bad-debt losses. We postpone consideration of this cost to a subsequent section and assume, for now, that there are no bad-debt losses. Finally, there is the opportunity cost of committing funds to the investment in additional receivables instead of to some other investment. The additional receivables result from (1) increased sales and (2) a longer average collection period. If new customers are attracted by the relaxed credit standards, collecting from these less-creditworthy customers is likely to be slower than collecting from existing customers. In addition, a more liberal extension of credit may cause certain existing customers to be less conscientious about paying their bills on time. An Example of the Trade-off. To assess the profitability of a more liberal extension of credit, we must know the profitability of additional sales, the added demand for products arising from the relaxed credit standards, the increased length of the average collection period, and the required return on investment. Suppose that a firm’s product sells for $10 a unit, of which $8 represents variable costs before taxes, including credit department costs. The firm is operating at less than full capacity, and an increase in sales can be accommodated without any increase in fixed costs. Therefore the contribution margin per unit for each additional unit sold is the selling price less variable costs involved in producing an additional unit, or $10 − $8 = $2. Currently, annual credit sales are running at a level of $2.4 million, and there is no underlying growth trend in such credit sales. The firm may liberalize credit, which will result in an average collection period of two months for new customers. Existing customers are not expected to alter their payment habits. The relaxation in credit standards is expected to produce a 25 percent increase in sales, to $3 million annually. The $600,000 increase represents 60,000 additional units if we assume that the price per unit stays the same. Finally, assume that the firm’s opportunity cost of carrying the additional receivables is 20 percent before taxes. This information reduces our evaluation to a trade-off between the added expected profitability on the additional sales and the opportunity cost of the increased investment in receivables. The increased investment arises solely from new, slower-paying customers. We have assumed that existing customers continue to pay in 1 month. With additional sales of $600,000 and a receivable turnover of six times a year for new customers (12 months divided by the average collection period of 2 months), the additional receivables are $600,000/6 = $100,000. For these additional receivables, the firm invests the variable costs tied up in them. For our example, $0.80 of every $1 in sales represents variable costs. Therefore the added investment in receivables is 0.80 × $100,000 = $80,000. With these inputs, we are able to make the calculations shown in Table 10.1. Inasmuch as the profitability on additional sales, $2 × 60,000 = $120,000, far exceeds the required return on the additional investment in receivables, 0.20 × $80,000 = $16,000, the firm would be well advised to relax its credit standards. An optimal policy would involve extending credit more liberally until the marginal