This document discusses trade credit and receivables management. It begins by explaining that trade credit occurs when a firm sells products or services on credit, creating accounts receivable. It then outlines three key characteristics of a credit sale: risk, economic value exchange, and futurity of payment. The document goes on to discuss how a firm's investment in receivables depends on credit sales volume and collection period. It also explains how a firm can affect these factors through its credit policy, which involves credit standards, terms, and collection efforts. The goals and types of credit policies are defined, as well as the concept of an optimal policy that maximizes firm value by balancing incremental returns and costs.
2. Introduction
1
Trade credit happens when a firm sells its products or services on
credit and does not receive cash immediately. A firm grants trade
credit to protect its sales from the competitors and to attract the
potential customers to buy its products at favourable terms. Trade
credit creates accounts receivable or trade debtors that the firm is
expected to collect in future. The customers from whom
receivables or book debts have to be collected in the future are
called trade debtors or simply as debtors and represent the firm’s
claim or asset.
3. Introduction
2
A credit sale has three characteristics:
First, it involves an element of risk that should be carefully
analyzed.
Second, 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 value to be
received later on.
Third, it implies futurity. The buyer will make the cash payment
for goods or services received by him, in a future period.
4. 3
Credit Policy
A firm’s investment in accounts receivable depends on:
The volume of credit sales
The collection period
For example, if a firm’s credit sales are `30 lakh per day and customers,
on an average, take 45 days to make payment, then the firm’s average
investment in accounts receivable is:
Daily credit sales × Average collection period
Rs.30 lakh × 45 = Rs.1,350 lakh
5. 4
Credit Policy
The investment in receivables may be expressed in terms of costs of sales
instead of sales value. There is one way in which the financial manager can
affect the volume of credit sales and collection period and consequently,
investment in accounts receivable. That is through the changes in credit
policy. The term credit policy is used to refer to the combination of three
decision variables:
credit standards
credit terms
collection efforts
6. 5
Goals of Credit Policy
A firm’s credit policy aims at maximizing shareholders’ wealth
through increase in sales leading to net improvement in profitability.
A firm may follow a lenient or a stringent credit policy.
The firm, following a lenient credit policy, tends to sell on credit to
customers on very liberal terms and standards.
A firm following a stringent credit policy sells on credit on a highly
selective basis, only to those customers who have proven
creditworthiness and who are financially strong.
7. 6
Optimum Credit Policy
Optimum credit policy is one which maximizes the firm’s
value. The value of the firm is maximized when the
incremental or marginal rate of return of an investment
is equal to the incremental or marginal cost of funds
used to finance the investment. As the firm loosens its
credit policy, its investment in accounts receivable
becomes riskier because of increase in slow-paying and
defaulting accounts.
8. 7
Optimum Credit Policy
To achieve the goal of Optimum Credit Policy, the evaluation of
investment in accounts receivable should involve the following four
steps:
Estimation of incremental operating profit
Estimation of incremental investment in accounts receivable
Estimation of the incremental rate of return of investment
Comparison of the incremental rate of return with the required
rate of return Consider an example.
