1. Forming of credit policy.
2. Executing the credit policy.
3. Formulating and executing collection policy.
1. Forming of Credit Policy
For efficient management of receivables, a concern must adopt a credit policy. A credit policy is related to decisions such as credit standards, length of credit period, cash discount and discount period, etc.
(a) Quality of Trade Accounts or credit standards:- The volume of sales will be influenced by the credit policy of a concern. By liberalizing credit policy the volume of sales can be increased resulting into increased profits. The increased volume of sales is associated with certain risk too. It will result in enhanced cost and risks of bad debts and delayed receipts. The increases in number of customers will increase the clerical work of maintaining the additional accounts and collecting of information about the credit-worthiness of customers. There may be more bad debt losses due to extension of credit to less worthy customers. These customers may also take more time than normally allowed in making the payments resulting into tying up of additional capital in receivables. On the other hand, extending credit to only credit worthy customers will save costs like bad debt losses, collection costs, investigation costs, etc. The restriction of credit such customers only will certainly reduce sales volume, thus resulting in reduced profits.
A finance manager has to match the increased revenue with additional costs. The credit should be liberalized only to the level where incremental revenue matches the additional costs. The quality of trade accounts should be decided so that credit facilities are extended only up to that level. The optimum level of investment in receivables also adversely affects the liquidity of a firm. On the other hand, a tight credit policy increases the liquidity of the firm. Thus, optimum level of investment in receivables is achieved at a point where there is a tradeoff between cost, profitability and liquidity as depicted.
(b) Length of Credit Period: - Credit terms or length of credit period means the period allowed to the customers for making the payment. The customers paying well in time may also be allowed certain cash discount. There is no binging on fixing the terms of credit. A concern fixes its own terms of credit depending upon its customers and the volume of sales. The customers of industry act as constraints on credit terms of individual concerns. The competitive pressure from other firms compels to follow similar credit terms, otherwise customers may feel inclined to purchase from a firm which allows more for paying credit purchases. Sometimes more credit time is allowed to increase sales to existing customers and also to attract new customers.
The length of credit period and quantum of discount allowed determine the magnitude of investment in receivables.
A firm may allow liberal credit terms to increase the volume of sales. The lengthening of this period will mean blocking of more money in receivable which could have been invested somewhere else to earn income. There may be an increase in debt collection costs and bad debt losses too. If the earnings from additional sales by lengthening credit period are more than the additional costs then the credit terms should be liberalized. A finance manager should determine the period where additional revenue equates the additional costs and should not extend credit beyond this period as the increase in cost will be more than the increase in revenue.
(c) Cash Discount: - Cash discount is allowed to expedite the collection of receivables. The funds tied up in receivables are released. The concern will be able to use the additional funds received from expedited collections due to cash discount. The discount allowed involves cost. The financial manager should compare the earnings resulting from released funds and the cost of discount. The discount should be allowed only if its cost is less than the earnings from additional funds. If the funds cannot be profitably employed then discount should not be allowed.
(d) Discount Period :- The collection of receivables is influenced by the period allowed for availing the discount. The additional period allowed for this facility may prompt some more customers to avail discount and make payments. This will mean additional funds released from receivables which may be alternatively used. At the same time the extending of discount period will result in late collection of funds because those who were getting discount and making payments as per earlier schedule will also delay their payments. For examples, if the firm allowing cash discount for payments within seven days now extends it to payments within fifteen days. There may be more customers availing discount and paying early but there will be those also who were paying earlier within seven days will now pay in fifteen days. It will increase the collection period of the concern. Hence, this decision involves matching of the effect on collection period with the increased cost associated with additional customers availing the discount.
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