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Mohammed S. Awadh 1
Defining Optimum Credit Policy
By
Mohammed Salem Awadh
Consultant
Mohammed S. Awadh 2
Defining Optimum Credit Policy
Defining the Problem:
One of the major issues in the company is the controlling of the collection period and
developing optimum credit policy that minimizing the company loses, i.e how to trade
off and balance between two costs, the first is carrying costs and the second is the
opportunity costs of a particular credit policy. In other wards to define the point where
the total credit cost is minimized. This point corresponds to the optimal amount of
credit should equivalently, the optimal investment in receivables. So if the firm
extends more credit than minimum cost policy, the additional net cash flow from the
new customer will not cover the carrying costs of the investment in the receivable.
If the level of receivables is below minimum amount, than the firm is forgoing
valuable profit opportunities. So what is the best credit policy and what is the right
collection period?
Mohammed S. Awadh 3
The Operating Cycle And the Cash Cycle :
The primary concern in short-term finance is the firm's short-run operating and
financing activities.
Operating Cycle :
the operating cycle is define as the sum of inventory period and account receivable
period, it describe how the product moves through the current asset account. The
product begins life as inventory, it is converted to a receivable when it is sold, and it
is finally converted to cash when we collect from sale.
Operating cycle = Inventory period + Account receivable period
The Cash Cycle:
The cash cycle is the number of days that pass before we collect the cash from sale,
measured from when we actually pay for the inventory, the cash cycle is the
difference between the operating cycle and the account payable period
Cash Cycle = Operating Cycle - Account payable period
The following figure depicts the short-term operating activities and cash flows for a
typical manufacturing firm by way of a cash time line. As shown, the cash flow time
line presents the operating cycle and the cash cycle in graphical form. In the figure,
the need for short-term financial management is suggest by the gap between the cash
inflows and the cash outflows. This is related to the lengths of the operating cycle and
the accounts payable period.
The gap between short-term inflow and outflows can be filled either by borrowing or
by holding a liquidity reserve in the form of cash or marketable securities.
Alternatively, the gap can be shortened by changing the inventory, receivable, and
payable periods.
Mohammed S. Awadh 4
Credit and Receivables:
When a firm sells and services, it can demand cash on or before the delivery date or it
can extend credit to customers and allow some delay in payment. So the idea to grant
credit to the firm's customer is making an investment in a customer, an investment
tied to the sale of a product or service and it is a way of stimulating sales. The costs
associated with granting credit are not trivial. First, there is the chance that the
customer will not pay. Second, the firm has to bear the costs of carrying the
receivables. The credit policy
decision thus involves a trade-off
between the benefits of increased
sales and the costs of granting
credit.
Components of Credit Policy:
The 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 sales will specify 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 expand trying to
distinguish between customers who will pay and customers who will not pay.
The Operating Cycle
Cash Paid for
inventory
Account payable period
Time
Account Receivable Period
Cash cycle
Operating Cycle
Inventory
purchased
Inventory Period
Inventory
Sold
Cash
received
CarryingCostOpportunity
Costs
Total Cost
No of Weeks
COSTINUS$
Mohammed S. Awadh 5
Firms use a number of devices and procedures to determine the probability that
the customer 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.
Cash Flows from Granting Credit:
The accounts receivable period is described 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 granted credit
Optimal Credit Policy:
The optimal amount of credit is determined by the point at which the incremental cash
flows from increased sales are exactly equal to the incremental costs of carrying the
increase in investment in accounts receivable.
The Total Credit Cost Curve:
The trade-off between granting credit and not granting credit isn't hard to identify, but
it is difficult to quantify precisely. So we can only describe an optimal credit policy.
i.e the carrying costs associated with granting credit come in three forms:
1- The required return on receivables.
2- The losses from bad debts.
3- The cost of managing credit and credit collections.
These three costs will all increase as credit policy is relaxed.
If a firm has a very restrictive credit policy, then all of the associated costs will be
low. In this case, the firm will have a "shortage" of credit, so there will be an
opportunity cost. This opportunity cost is the extra potential profit from credit sales
Time
The Cash Flows from Granting Credit
Credit Sale
is made
Customer mails
checks
Firm deposits
check in bank
Bank credits
firm's account
Cash collection
Credit Sale is made
Mohammed S. Awadh 6
that is lost because credit is refused. This forgone benefit comes form two sources, the
increase in quantity sold, Q' minus Q and, potentially, a higher price. The costs go
down as credit policy is relaxed.
The sum of the carrying costs and the opportunity costs of a particular credit policy is
called the total credit cost
curve. We have such a curve in
the figure. it is illustrates there is
a point where the total credit cost
is minimized. This point
corresponds to the optimal
amount of credit or equivalently,
the optimal investment in
receivables.
If the firm extends more credit than this minimum, the additional net cash flow from
the new customer will not cover the carrying costs of the investment in the receivable.
If the level of receivables is below this amount, than the firm is forgoing valuable
profit opportunities.
In general, the costs the costs and benefits from extending credit will depends on
characteristics of particular firm and industries
Case Study:
Consider Shihab Agencies, given for certain product (simulated case)
Credits Sales: = 3 Millions USD
Cost of goods of sold: = 1.3 Millions USD
Average Inventory: = 0.21 Millions USD
Average Account Receivable: = 0.25 Millions USD
Average payable: = 0.18 Millions USD
Collection period = 30 Days
Carrying Cost = 1000 USD per credit policy
Opportunity Cost = 10000 USD per losing opportunity
Assuming the probability that the customer cannot fulfill the credit policy follow
Poisson distribution.
CarryingCostOpportunity
Costs
Total Cost
Amount of credit extend $$
COSTINUS$
Mohammed S. Awadh 7
ANALYSIS :
51
13.7
365
turnoverPayable
365
PeriodPayable
times13.7
18.0
3.1
PayableAverage
soldofgoodsofCost
turnoverPayable
Days30
12
365
turnoversReceviable
365
PeriodsReceivable
times12
25.0
3
ReceivableAccountAverage
SalesCredit
turnoversReceviable
Days58
24.6
365
turnoverInventory
365
PeriodInventory
times24.6
21.0
3.1
InventoryAverage
soldofgoodsofCost
turnoverInventory






Operating Cycle = Inventory Period + Account Receivable Period
= 58 + 30
= 88 Days
Cash Cycle = Operating Period – Account payable period
= 88 – 51
= 37 Days
Mohammed S. Awadh 8
But is this collection, is the right policy !!!!!! Lets say:
Consider the maximum relax credit policy = 90 Days = 12 weeks,
Definitely this will lead the possibility that the customer will not pay on time, so as
we know the standard Shihab policy = 30 Days = 4 weeks, since the probability that
the customer cannot fulfill the credit policy follow Poisson distribution.
The estimation factor of Poisson distribution = 90/30 = 12/4= 3
By applying U curve techniques
The following calculation is setup
Assuming that the occurrence of the
probability is at =90/2 = 45 days
(for simplification ).
Using:
Carrying Cost = 1000 USD per credit policy
Opportunity Cost = 10000 USD per losing opportunity
Mohammed S. Awadh 9
So the OPPORTUNITY COST at a certain credit policy =
= 
0
12
I
(Period ( I ) in weeks minus proposed credit policy at period ( I ) in weeks) *
(probability of failing to meet the commitment at that period) * Total time /2 *
opportunity cost per event (period )
CARRYING COST:
= Carrying cost per credit policy * Total time /2 * credit policy ( I )
While
TOTAL COST = OPPORTUNITY COST + CARRYING COST:
So the final and optimum policy = 4 Weeks = 30 Days
Mohammed S. Awadh 10
As shown in Figure :
Results:
The Optimum Collection Policy = 4 weeks
Summary:
The problem of defining optimum credit policy is setup and solved by using U curve
technique, even we use some assumption as Poisson distribution to reflect the
probability of failure of the customer to meet the commitments that made it for the
company but the results shows that the company can develop it own figures to reflect
the reality, the ratio of carrying cost to the cost of losing opportunity is constant for
optimum policy ( for this case ) so the company can evaluate these costs by knowing
one of them to develop the right credit policy.
     

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Defining optimum credit policy1

  • 1. Mohammed S. Awadh 1 Defining Optimum Credit Policy By Mohammed Salem Awadh Consultant
  • 2. Mohammed S. Awadh 2 Defining Optimum Credit Policy Defining the Problem: One of the major issues in the company is the controlling of the collection period and developing optimum credit policy that minimizing the company loses, i.e how to trade off and balance between two costs, the first is carrying costs and the second is the opportunity costs of a particular credit policy. In other wards to define the point where the total credit cost is minimized. This point corresponds to the optimal amount of credit should equivalently, the optimal investment in receivables. So if the firm extends more credit than minimum cost policy, the additional net cash flow from the new customer will not cover the carrying costs of the investment in the receivable. If the level of receivables is below minimum amount, than the firm is forgoing valuable profit opportunities. So what is the best credit policy and what is the right collection period?
  • 3. Mohammed S. Awadh 3 The Operating Cycle And the Cash Cycle : The primary concern in short-term finance is the firm's short-run operating and financing activities. Operating Cycle : the operating cycle is define as the sum of inventory period and account receivable period, it describe how the product moves through the current asset account. The product begins life as inventory, it is converted to a receivable when it is sold, and it is finally converted to cash when we collect from sale. Operating cycle = Inventory period + Account receivable period The Cash Cycle: The cash cycle is the number of days that pass before we collect the cash from sale, measured from when we actually pay for the inventory, the cash cycle is the difference between the operating cycle and the account payable period Cash Cycle = Operating Cycle - Account payable period The following figure depicts the short-term operating activities and cash flows for a typical manufacturing firm by way of a cash time line. As shown, the cash flow time line presents the operating cycle and the cash cycle in graphical form. In the figure, the need for short-term financial management is suggest by the gap between the cash inflows and the cash outflows. This is related to the lengths of the operating cycle and the accounts payable period. The gap between short-term inflow and outflows can be filled either by borrowing or by holding a liquidity reserve in the form of cash or marketable securities. Alternatively, the gap can be shortened by changing the inventory, receivable, and payable periods.
  • 4. Mohammed S. Awadh 4 Credit and Receivables: When a firm sells and services, it can demand cash on or before the delivery date or it can extend credit to customers and allow some delay in payment. So the idea to grant credit to the firm's customer is making an investment in a customer, an investment tied to the sale of a product or service and it is a way of stimulating sales. The costs associated with granting credit are not trivial. First, there is the chance that the customer will not pay. Second, the firm has to bear the costs of carrying the receivables. The credit policy decision thus involves a trade-off between the benefits of increased sales and the costs of granting credit. Components of Credit Policy: The 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 sales will specify 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 expand trying to distinguish between customers who will pay and customers who will not pay. The Operating Cycle Cash Paid for inventory Account payable period Time Account Receivable Period Cash cycle Operating Cycle Inventory purchased Inventory Period Inventory Sold Cash received CarryingCostOpportunity Costs Total Cost No of Weeks COSTINUS$
  • 5. Mohammed S. Awadh 5 Firms use a number of devices and procedures to determine the probability that the customer 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. Cash Flows from Granting Credit: The accounts receivable period is described 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 granted credit Optimal Credit Policy: The optimal amount of credit is determined by the point at which the incremental cash flows from increased sales are exactly equal to the incremental costs of carrying the increase in investment in accounts receivable. The Total Credit Cost Curve: The trade-off between granting credit and not granting credit isn't hard to identify, but it is difficult to quantify precisely. So we can only describe an optimal credit policy. i.e the carrying costs associated with granting credit come in three forms: 1- The required return on receivables. 2- The losses from bad debts. 3- The cost of managing credit and credit collections. These three costs will all increase as credit policy is relaxed. If a firm has a very restrictive credit policy, then all of the associated costs will be low. In this case, the firm will have a "shortage" of credit, so there will be an opportunity cost. This opportunity cost is the extra potential profit from credit sales Time The Cash Flows from Granting Credit Credit Sale is made Customer mails checks Firm deposits check in bank Bank credits firm's account Cash collection Credit Sale is made
  • 6. Mohammed S. Awadh 6 that is lost because credit is refused. This forgone benefit comes form two sources, the increase in quantity sold, Q' minus Q and, potentially, a higher price. The costs go down as credit policy is relaxed. The sum of the carrying costs and the opportunity costs of a particular credit policy is called the total credit cost curve. We have such a curve in the figure. it is illustrates there is a point where the total credit cost is minimized. This point corresponds to the optimal amount of credit or equivalently, the optimal investment in receivables. If the firm extends more credit than this minimum, the additional net cash flow from the new customer will not cover the carrying costs of the investment in the receivable. If the level of receivables is below this amount, than the firm is forgoing valuable profit opportunities. In general, the costs the costs and benefits from extending credit will depends on characteristics of particular firm and industries Case Study: Consider Shihab Agencies, given for certain product (simulated case) Credits Sales: = 3 Millions USD Cost of goods of sold: = 1.3 Millions USD Average Inventory: = 0.21 Millions USD Average Account Receivable: = 0.25 Millions USD Average payable: = 0.18 Millions USD Collection period = 30 Days Carrying Cost = 1000 USD per credit policy Opportunity Cost = 10000 USD per losing opportunity Assuming the probability that the customer cannot fulfill the credit policy follow Poisson distribution. CarryingCostOpportunity Costs Total Cost Amount of credit extend $$ COSTINUS$
  • 7. Mohammed S. Awadh 7 ANALYSIS : 51 13.7 365 turnoverPayable 365 PeriodPayable times13.7 18.0 3.1 PayableAverage soldofgoodsofCost turnoverPayable Days30 12 365 turnoversReceviable 365 PeriodsReceivable times12 25.0 3 ReceivableAccountAverage SalesCredit turnoversReceviable Days58 24.6 365 turnoverInventory 365 PeriodInventory times24.6 21.0 3.1 InventoryAverage soldofgoodsofCost turnoverInventory       Operating Cycle = Inventory Period + Account Receivable Period = 58 + 30 = 88 Days Cash Cycle = Operating Period – Account payable period = 88 – 51 = 37 Days
  • 8. Mohammed S. Awadh 8 But is this collection, is the right policy !!!!!! Lets say: Consider the maximum relax credit policy = 90 Days = 12 weeks, Definitely this will lead the possibility that the customer will not pay on time, so as we know the standard Shihab policy = 30 Days = 4 weeks, since the probability that the customer cannot fulfill the credit policy follow Poisson distribution. The estimation factor of Poisson distribution = 90/30 = 12/4= 3 By applying U curve techniques The following calculation is setup Assuming that the occurrence of the probability is at =90/2 = 45 days (for simplification ). Using: Carrying Cost = 1000 USD per credit policy Opportunity Cost = 10000 USD per losing opportunity
  • 9. Mohammed S. Awadh 9 So the OPPORTUNITY COST at a certain credit policy = =  0 12 I (Period ( I ) in weeks minus proposed credit policy at period ( I ) in weeks) * (probability of failing to meet the commitment at that period) * Total time /2 * opportunity cost per event (period ) CARRYING COST: = Carrying cost per credit policy * Total time /2 * credit policy ( I ) While TOTAL COST = OPPORTUNITY COST + CARRYING COST: So the final and optimum policy = 4 Weeks = 30 Days
  • 10. Mohammed S. Awadh 10 As shown in Figure : Results: The Optimum Collection Policy = 4 weeks Summary: The problem of defining optimum credit policy is setup and solved by using U curve technique, even we use some assumption as Poisson distribution to reflect the probability of failure of the customer to meet the commitments that made it for the company but the results shows that the company can develop it own figures to reflect the reality, the ratio of carrying cost to the cost of losing opportunity is constant for optimum policy ( for this case ) so the company can evaluate these costs by knowing one of them to develop the right credit policy.      