CREDIT STANDARDS - Working Capital Management

Defining the credit standards is an important component of credit policy of the company. The credit standards do have an important bearing on the sales of the company.

Credit Standards in Financial Management

The credit standards of a company lay down minimum requirement for the evaluation of credit to its customers. The company may define these requirements in the very conservative or a strict manner and this restrain the marginal customers are those whose financial position is doubtful may not really be bad. Such a policy would be appropriate for the companies which do not want to take high risk or alternatively, the company may follow a very liberal standard and be very aggressive in taking the risk.

The company uses some of the following quantitative indicators for establishing credit standards:

  1. Payment period
  2. Selecting financial rates
  3. Rating based on financial ratios.

The subjective assessment obtained through the market about the credit worthiness of the customers may also feature as one of the item in the credit standards. These quantitative and subjective indicators may provide the basis for establishing and enforcing the credit standards.

At any point of time, the company would be interested in examining the effect of change in credit standards. This is done by comparing the profitability generated by lowering down the credit standards and the added cost of accounts receivable. So long as the profitability is more than the added cost, the company can lower down the credit standards. It is important to determine the costs of lowering down the credit standards and also to find out the impact on profitability of the company. Lowering down toe the credit standards would have the following effects:

  1. increase in average collection period.
  2. increase in sales.
  3. increase in accounts receivable investment.
  4. increase in bad debts losses, and
  5. increase in servicing cost of account receivable.

The effect of lowering down the credit standards on key variables such as sale and investment in accounts receivable “can be quantified by the costs versus benefits of such changes”. At the time of the cost such as increase in bad debt losses and increased cost of monitoring and servicing the accounts receivable should also be considered. It may be very difficult for the firm to make any distinction between the credit standards for new customers and existing customers. Relaxing the credit standards for the new customers would have certainly some impact on the payment behaviour of existing customers. The firm may experience collection period.

You may take the following approach in assessing the effects of lowering down the credit standard:

  • Determine, find out the profitability of additional sales.
  • Determine increase in bad debt losses, collection expenses and any other cost arising from relaxing the standards.
  • Determine increase slowness of the average collection period and additional amount of investment requirement in accounts receivable and multiply it by the required rate of return on investment in accounts receivable.

Let us take a case to illustrate this approach.

Example: ADE LIMITED is engaged in manufacturing water.

Each water pack is priced at N100. The sales of the company during the last accounting year were 80,000 units. The variable cost per unit is N60, the fixed costs of the company are N16. The company is contemplating to relax its credit standards and as a result, the company is expecting 10 percent increase in sales. But at the same time by relaxing the credit standards the average collection period of the company is likely to increase from 30 days to 45 days. The bad debt losses are expected to be 2% of increased sales. The collection expenses are likely to go up by N50,000. The company also pay commission of 10% on the sales and this cost is not included in the variable cost. If the after-tax required rate of return on investment of the company is 15 percent and the tax rate is 50% should the company relax its credit standards?

Unit N

Additional sales generated 8000 x 100 800,000 Variable cost 8000 x 60 480,000 Gross margin 320,000

Other costs:

Bad debt expenses 800,000 x 0.2 16,000 Commission 800,000 x 1 80,000 Collection expenses 50,000 146,000 Profit 174,000 After – tax profit50% 87,000

The effect of increase in sales on investment in accounts receivable will be calculated as follows:

Average Collection Accounts receivable= ----------------------- Period x sales per day

Accounts receivable before change in credit standards:

30 x (8,000,000/360) = N666,667

Accounts receivable after change in credit standards:

45 x (88,000,000/360) = N1,100,000

Additional investment in accounts receivable as a result of change in result standard is N433,333 required return on additional investment:

4,333,333 x 1.5 N65,000.

The above analysis shows that the profitability on additional sales as a result of change in credit far exceeds the required return on account receivable investment, thus, the change is profitable for ADE LIMITED.

It is important to understand that the above analysis is based on the following assumptions:
The company has the capacity to meet the additional demand and as a result of the increase in sales does not create any additional capacity costs. In case the company is operating already at full capacity then the analysis has to take into account the possible change in the costs structure of the company. The above analysis is thus based on the assumption that the price and the costs remain constant. Only the cost related to bad debts expenses and credit administration change.

To meet the higher requirement of demand, the company does not require additional inventory. If the level of inventory requirements changes as a result of change in sales volume, then the additional investment requirements for inventory purpose should be included in accounts receivable investment.

The required return should then be calculated by applying the opportunity cost to the total investment.

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