Management of Receivables^227
Credit Terms
As discussed previously, credit policy has a direct influence on sales, investment levels,
bad-debt losses, and collection costs. From a managerial view-point and looking strictly
at the relationship between credit policy and sales, one could conclude that a very
liberal credit policy is highly desirable. However, the relationship between credit policy
and investment levels, bad-debt losses, and collection costs implies that a very conservative
credit policy is desirable. An appropriate credit policy balances profits from increased
sales due to more liberal credit terms with increased costs due to increased investments,
bad-debt losses, and collection costs. The ideal credit policy allows for the liberalisation
of credit terms to the point where the marginal revenues from a new category of credit
accounts is exactly equal to the marginal costs of selling and servicing accounts.
In practice it is not feasible to establish the ideal credit policy. However, firms do
consider alternative credit terms to see what influence they have on profits. Our focus
here will be to look at certain specific credit terms and see how they might affect
profits and what guidelines a firm could use to enhance its profitability. The three specific
components of credit terms are credit period, credit discount, and discount period.
Credit Period: The credit terms are specified on the invoices sent out by firms. A
typical credit term may state: 2/10, net 30. The first number "2" is the credit discount
and indicates that a 2 per cent discount may be taken if the invoice is paid within the
number of days specified by the second term, or 10 days. The second term "10" is the
discount period and indicates the number of days during which the credit discount can
be taken. The last number "30" indicates the credit period. The credit period specifies
the number of days that a firm can take to pay the invoice without being considered to
be delinquent. With terms of 2/10, net 30 the credit period is 30 days and the full amount
of the invoice is due within 30 days.
One way to liberalise credit terms is to increase the credit period. Conversely, credit
terms can be tightened by shortening the credit period. Mitsui Corporation is currently
selling on credit terms of 2/10, net 30. Its annual gross sales are at the Rs 36 crore level
currently. All sales are for credit. Fifty per cent of its clients take the 2 per cent discount
and pay on the tenth day. The other 50 per cent, who do not take the discount, on the
average pay after 30 days. The sales volume between discount takers and non-discount
takers is evenly divided. The company's management is considering two alternative
credit plans: plan A would change the credit terms 2/10, net 45; plan B would extend
the credit period even further, making the terms 2/10, net 60. plan A is expected to
increase sales by 5 per cent from current levels, whereas plan B would increase sales
by 7 per cent. Mitsui's margins on sales before credit-related costs and taxes are 20 per
cent. Investments in accounts receivable carry a 12 per cent before tax cost.
In trying to decide whether to keep the present credit plan or switch to either of plans
A or B, management recognises that an occasional result of extending the credit period