490 Part 6 Working Capital Management, Forecasting, and Multinational Financial Management
15-8 ACCOUNTS RECEIVABLE
Although some sales are made for cash, today the vast majority of sales are on
credit. Thus, in the typical situation, goods are shipped, inventories are reduced,
and an account receivable is created.^12 Eventually, the customer pays, the! rm
receives cash, and its receivables decline. The! rm’s credit policy is the primary
determinant of accounts receivable, and it is under the administrative control of
the CFO. Moreover, credit policy is a key determinant of sales, so sales and mar-
keting executives are concerned with this policy. Therefore, we begin our discus-
sion of accounts receivable by discussing credit policy.15-8a Credit Policy
Credit policy consists of these four variables:- Credit period is the length of time buyers are given to pay for their purchases.
For example, the credit period might be 30 days. Customers prefer longer
credit periods, so lengthening the period will stimulate sales. However, a lon-
ger credit period lengthens the cash conversion cycle; hence, it ties up more
capital in receivables, which is costly. Also, the longer a receivable is outstand-
ing, the higher the probability that the customer will default and that the
account will end up as a bad debt. - Discounts are price reductions given for early payment. The discount speci-
! es what the percentage reduction is and how rapidly payment must be made
to be eligible for the discount. For example, a 2% discount is often given if the
customer pays within 10 days. Offering discounts has two bene! ts. First, the
discount amounts to a price reduction, which stimulates sales. Second, dis-
counts encourage customers to pay earlier than they otherwise would, which
shortens the cash conversion cycle. However, discounts mean lower prices—
and lower revenues unless the quantity sold increases by enough to offset the
price reduction. The bene! ts and costs of discounts must be balanced when
credit policy is being established. - Credit standards refer to the required! nancial strength of acceptable credit cus-
tomers. With regard to credit standards, factors considered for business custom-
ers include ratios such as the customer’s debt and interest coverage ratios, the
customer’s credit history (has the customer paid on time in the past or tended to
be delinquent), and the like. For individual customers, their credit score as
developed by credit rating agencies is the key item. In both cases, the key ques-
tion is this: Is the customer likely to be willing and able to make the required
payment on schedule? Note that when standards are set too low, bad debt losses
will be too high; on the other hand, when standards are set too high, the! rm
will lose too many sales and thus pro! ts. So a balance must be struck between
the costs and bene! ts of tighter credit standards. - Collection policy refers to the procedures used to collect past due accounts,
including the toughness or laxity used in the process. At one extreme, the! rm
might write a series of polite letters after a fairly long delay; at the other
extreme, delinquent accounts may be turned over to a collection agency rela-
tively quickly. Firms should be somewhat! rm, but excessive pressure can
Account Receivable
Funds due from a
customer.Account Receivable
Funds due from a
customer.Credit Policy
A set of rules that includes
the firm’s credit period,
discounts, credit
standards, and collection
procedures offered.Credit Policy
A set of rules that includes
the firm’s credit period,
discounts, credit
standards, and collection
procedures offered.
Credit Period
The length of time
customers have to pay for
purchases.Credit Period
The length of time
customers have to pay for
purchases.
Discounts
Price reductions given for
early payment.Discounts
Price reductions given for
early payment.Credit Standards
The financial strength
customers must exhibit to
qualify for credit.Credit Standards
The financial strength
customers must exhibit to
qualify for credit.Collection Policy
Degree of toughness in
enforcing the credit terms.Collection Policy
Degree of toughness in
enforcing the credit terms.(^12) Whenever goods are sold on credit, two accounts are created—an asset item entitled account receivable
appears on the books of the selling! rm, and a liability item called an account payable appears on the books of
the purchaser. At this point, we are analyzing the transaction from the viewpoint of the seller; so we are focusing
on the variables under the seller’s control—in this case, receivables. In Section 15-9, we will examine the
transaction from the viewpoint of the purchaser when we discuss accounts payable as a source of funds and
consider their cost relative to the cost of funds obtained from other sources.