Management of Receivables^223
If we are getting trade credit to fund our needs, we also have to extend trade credit to
our customers. A company grants trade credit to protect its sales from the competitors
and to attract the potential customers to buy its products at favourable terms.
Extending trade credit creates receivables or book debts which the company expects
to collect in the near future. The book debts or receivables arising out of trade credit
has three characteristics:
- It involves an element of risk: This should be carefully analysed. Cash sales
are riskless, but not the credit sales as the cash is yet to be received. - It is based on economic value: To the buyer, the economic value in goods or
services passes immediately at the time of sale, while the seller expects an
equivalent amount of value to be received later on. - It implies futurity: The cash payment for the goods or services received by the
buyer will be made by him in a future period. The customers from whom receivables
or book debts are due are called ìdebtorsî and represent the companyís claim or
asset.
Let us take up an example to illustrate the benefit of providing trade credit.
Example
A company is planning to extend credit to its customers. The choice is between one
month and two monthís credit. The first yearís results under the three alternatives, of
providing no credit and one & two months credit, are tabulated below.
Note that we have not shown an ëinterestí charge on the increased working capital
because in due course the increase in stocks and debtors will in effect be financed
out of the improved profits, and no specific borrowing may be needed. However,
regardless of how the working capital is financed it must still produce the required rate
of return.
The example makes the fairly obvious points that giving credit involves cost, including
the opportunity cost of additional capital employed. In some cases these costs will
cancel out or outweigh any gains from increased business like in the second alternative
above. In some cases the granting of credit may not increase the sales of the business
but may be justified because it will prevent a loss of sales to a competitor.
Chapter-9
Management of Receivables