Big Picture in Focus: ULOc. Discuss the importance of trading off
liquidity and profitability in establishing credit and collection policies.
Metalanguage
For you to demonstrate ULOa, you will need to have an operational understanding of
the following terms below.
1. Credit Policy. A set of guidelines for extending credit to customers.
2. Credit Standards. Refers to the minimum financial strength of acceptable
credit customer and the amount available to different customer.
3. Credit Terms. It is the length of period buyers are given to pay for their
purchases.
4. Collection Policy. Refers to procedures the firm follows to collect past –due
accounts.
Essential Knowledge
To perform the aforesaid big picture (unit learning outcomes) for the weeks 4-5 of the
course, you need to fully understand the following essential knowledge laid down in
the succeeding pages. Please note that you are not limited to exclusively refer to
these resources. Thus, you are expected to utilize other books, research articles and
other resources that are available in the university’s library e.g. ebrary,
search.proquest.com etc., and even online tutorial websites.
1. Accounts Receivable Management
The goal of accounts receivable management is to ensure that the firm’s investment
in accounts receivable is appropriate and contributes to shareholder’s wealth
maximization.
2. Credit Policy
It is a set of guidelines for extending credit to customers.
1.
Credit Standards. Refers to the minimum financial strength of acceptable
credit customer and the amount available to different customer. It has
significant influence over sales. If the credit policy is relaxed, while sales may
increase, the quality of accounts receivable may suffer.
Areas to be evaluated to measure credit quality:
a. Character
b. Capacity
c. Capital
d. Collateral
e. Conditions
2.
3.
4.
Credit Terms. It is the length of period buyers are given to pay for their
purchases.
Collection Policy. Refers to procedures the firm follows to collect past –due
accounts.
Delinquency and Defaults.
3. Summary of Trade-offs in Credit and Collection Policies
Trade-Offs
Benefits
1. Relaxation of credit
a. Increase in sales
standards.
and
total
contribution margin
Cost
a. Increase in credit
processing cost.
b. Increase collection
costs.
c. Higher
Default
costs.
d. Higher opportunity
costs.
2. Lengthening of credit
period.
a. Increase in sales
and
total
contribution margin
a. Higher opportunity
costs
higher
investment
in
receivables.
3. Granting cash discount.
a. Increase in sales
and
total
contribution
margin.
b. Opportunity income
on
lower
investment
in
receivable.
a. Lesser profit.
Intensified
efforts
a. Lower
default
costs.
b. Lower opportunity
costs.
a. Higher
collection
expense.
b. Lower sales with
good
quality
receivables.
collection
When the management decides change the credit policy, they must determine first if
the changes will give them an incremental profit, if there is, then pursue the changes.
Illustration: (Relaxation of credit policy)
ABC Corporation’s products sells for P10 a unit of which P7 represents variable cost
before taxes including credit department cost. Current annual credit sales are P2.4M.
The firm is considering a more liberal extension of credit, which will result in a slowing
in the average collection period from one month to two months.
The relaxation in credit standards is expected to produce a 25% increase in Sales.
Assume that the firm’s required rate of return on investment is 20% before taxes. Bad
debts losses will be 5% of incremental sales and collection expenses will increase by
P20,000.
Required:
Should the firm liberalize its credit policy?
Solution:
Incremental Contribution margin from additional units
(60,000 x 3)
Less: Bad Debts (600,000 x 5%)
Collection expense
Incremental Profit
P180,000
30,000
20,000
P130,000
Required return on additional investment:
Present level of receivables (2.4M / 12 mos)
Level of receivable after change in credit policy (3M / 6 mos)
Additional Receivables
Additional Investment in receivable (P300,000 x 70%)
Multiply : Required return
Required return on additional investments
P200,000
500,000
P300,000
210,000
20%
P 42,000
Conclusion:
In as much as the profit on additional sales of P130,000 exceeds the required rate of
return on the additional investments of P42,000, the firm would be well- advised to
relax its credit standards.
Illustration: (Change in credit terms)
The Rhoman Shades Company has 12% opportunity cost of capital and currently sells
on term n/20. It has current annual sales of P10M, 80% of which are on credit. Current
average collection period is 60 days. It is now considering to offer terms 2/10, n/30 in
order to reduce the collection period. It expects 60% of customers to take advantage
of the discount and the collection period to be reduced to 40 days.
Required:
Should the company change its term from n/20 to 2/10, n/30?
Solution:
Present
Opportunity Cost
ROI x Ave. Receivables
Present (12% x P1.333M)
Proposed (12% x P0.888M)
Sales Discount
( 8m X 60% X 2%)
Total
Proposed
160,000
106,667
P160,000
96,000
P202,667
Conclusion:
The company would be better off by maintaining the present credit terms and policy of
not granting cash discount because of the lesser costs involved as shown above.
Self-Help: You can also refer to the sources below to help you
further
*Cabrera, E. B. (2016). Financial management: Principles and application (Vol. 1).
Manila: GIC Enterprises & Co., Inc.
*Brigham, E., & Houston, J.(2013). Fundamentals of financial management (13th
ed.). Singapore: Cengage Learning Asia Pte Ltd.
*Agamata, F. T. (2012). Reviewer in management advisory services (2013 Ed.).
Manila: GIC Enterprises & Co., Inc.
Let’s Check
Questions:
1. In what form of credit most commonly offered?
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2. What are the three quantitative measures that can be applied to the collection policy
of the firm?
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3. What are some of the factors that determine the length of the credit period? Why is
the length of the buyer’s operating cycle often considered an upper bound on the
length of the credit period?
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4. What are the five Cs of credit? Explain why each is important?
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Let’s Analyze
Questions:
1. The one item listed below that would warrant the least amount of consideration
in credit and collection policy decisions is the
A.
Cash discount given.
B.
Quantity discount given.
C.
Quality of accounts accepted.
D.
Level of collection expenditures.
2. When a company analyzes credit applicants and increases the quality of the
accounts rejected, the company is attempting to
A.
Maximize sales.
B.
Maximize profits.
C.
Increase bad-debt losses.
D.
Increase the average collection period.
3. Accounts receivable turnover will normally decrease as a result of
A.
An increase in cash sales in proportion to credit sales.
B.
A change in credit policy to lengthen the period for cash discounts.
C.
A significant sales volume decrease near the end of the accounting
period.
D.
The write-off of an uncollectible account (assume the use of the
allowance for doubtful accounts method).
4. Numero 1 Co.’s budgeted sales for the coming year are P96 million, of which 80%
are expected to be credit sales at terms of n/30. The company estimates that a
proposed relaxation of credit standards would increase credit sales by 30% and
increase the average collection period form 30 days to 45 days. Based on a 360day year, the proposed relaxation of credit standards would result to an increase in
accounts receivable balance of
A. P1,920,000
C. P6,080,000
B. P2,880,000
D. P6,880,000
In a Nutshell
Based on the concepts on financial forecasting presented, write the three remarkable
lessons you learned.
1. _________________________________________________________
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2. _________________________________________________________
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3. __________________________________________________________
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Q&A List
Do you have any question for clarification? Write them here.
Questions/Issues
1.
2.
3.
4.
5.
Keyword Index
Accounts Receivable Management
Credit policy
Credit terms
Credit standards
Answers