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(^224) Financial Management
There are two costs that we can associate with extending credit as: i) credit costs and
ii) opportunity costs. Credit costs are the cash flows that must be incurred when credit
is granted. They are positively related to the amount of credit extended. Opportunity
costs are the lost sales from refusing credit. These costs go down when credit is granted.
This means that there is a point where the sum total of these two costs are minimum
for the company. This point depicts the optimum credit policy that the company must
follow.
Figure 9.1: The Costs of Granting Credit
(Rupees) No credit One month’s
credit
Two month’s
credit
Sales 120,000 160,000 240,000
Debtors 13,333 40,000
Stocks (less creditors (Say, 1/12 of sales value) 10,000 13,333 20,000
Total 10,000 26,666 60,000
Increase in working capital through granting
credit
16,666 50,000
Marginal contribution 30,000 40,000 60,000
Less: Cost of:
Credit control (6,000) (6,000)
Bad debts (1,600) (4,800)
Relevant comparable profits 30,000 32,400 49,000
Increase in profits 2,400 19,200
But the company requires a return of15% on
the increase in capital employed; i.e.
2,500 7,500
The net advantage (or disadvantage) of the
proposed changes in credit policy is therefore
(Rs.100) Rs.11,700
Cost in rupees
of holding cash
Size of cash
C* balance (C)
Optimal size of cash balance
Trading costs
Opportunity costs
Total costs of holding cash