Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VII. Short−Term Financial

Planning and Management

21. Credit and Inventory
    Management

© The McGraw−Hill^735

Companies, 2002

Components of Credit Policy

If a firm decides to grant credit to its customers, then it must establish procedures for ex-

tending credit and collecting. In particular, the firm will have to deal with the following

components of credit policy:

1.Terms of sale. The terms of sale establish how the firm proposes to sell its goods

and services. A basic decision is whether the firm will require cash or will extend

credit. If the firm does grant credit to a customer, the terms of sale will specify

(perhaps implicitly) the credit period, the cash discount and discount period, and

the type of credit instrument.

2.Credit analysis. In granting credit, a firm determines how much effort to expend

trying to distinguish between customers who will pay and customers who will not

pay. Firms use a number of devices and procedures to determine the probability that

customers will not pay, and, put together, these are called credit analysis.

3.Collection policy. After credit has been granted, the firm has the potential problem

of collecting the cash, for which it must establish a collection policy.

In the next several sections, we will discuss these components of credit policy that

collectively make up the decision to grant credit.

The Cash Flows from Granting Credit

In a previous chapter, we described the accounts receivable period as the time it takes to

collect on a sale. There are several events that occur during this period. These events are

the cash flows associated with granting credit, and they can be illustrated with a cash

flow diagram:

As our time line indicates, the typical sequence of events when a firm grants credit is as

follows: (1) the credit sale is made, (2) the customer sends a check to the firm, (3) the firm

deposits the check, and (4) the firm’s account is credited for the amount of the check.

Based on our discussion in the previous chapter, it is apparent that one of the factors

influencing the receivables period is float. Thus, one way to reduce the receivables pe-

riod is to speed up the check mailing, processing, and clearing. Because we cover this

subject elsewhere, we will ignore float in the subsequent discussion and focus on what

is likely to be the major determinant of the receivables period, credit policy.

The Investment in Receivables

The investment in accounts receivable for any firm depends on the amount of credit

sales and the average collection period. For example, if a firm’s average collection

period, ACP, is 30 days, then at any given time, there will be 30 days’ worth of sales

708 PART SEVEN Short-Term Financial Planning and Management

terms of sale
The conditions under
which a firm sells its
goods and services for
cash or credit.

credit analysis
The process of
determining the
probability that
customers will not pay.

collection policy
The procedures followed
by a firm in collecting
accounts receivable.

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The Cash Flows of Granting Credit

Credit Customer Firm deposits Bank credits

sale is mails check in firm’s

made check bank account

Time

Cash collection

Accounts receivable