CREDIT TERMS - Working Capital Management

Credit terms in Receivable Management

The other important dimension of accounts receivable management is to decide the terms of credit in advance. The decision about the credit terms would involve the decision about the following variables:

  1. Credit period
  2. Credit limit
  3. Cash discount
  4. Discount rate and discount period.

Credit period is the time for which the company is willing to allow their customers not to pay their bills. By the end of the credit period, the company expects that the customers would pay their bills. At any point of time there may be interested customer in a longer credit period. If the company liberalizes its credit period, the company may be able to attract such customers. But at the same time the extension of credit period means more investment in accounts – an example of ADE LIMITED to illustrate this point.

Suppose ADE LIMITED is interested in increasing their credit period from 30 days to 45 days. The company is expecting a 5 percent increase in sales as a result of relaxing credit period. The bad debt will be 2.5 percent of increased sales. The company would also be required to incur additional amount of N20,000 for collections.

The relaxation in credit period would thus have the following effects:

Unit N N Increase in sales 4000 x 100 400,000 Increase in variable costs (4000 x 60) 240,000 Increase in gross profit 160,000 Less Bad debts 10,000 Collection charges 20,000 Commission 40,000 70,000 Profit before tax 160,000 – 70,000 [ 90,000 ] Profit after tax 50% [ 45,000 ]

The relaxation of credit period would involve additional investment in accounts receivable. The increase in accounts receivable investment can be obtained in the same way as done under 3.1 – the increase in account receivable investment would be N433,333. On this additional investment, we are getting a return of N45,000 in terms of percentage. This return is 10.38 percent which is less than 15 percent, hence ADE LIMITED would not relax the credit period.

Similarly, the liberalization of credit limit has positive impact on the sales of the company whereas at the same time the investment in accounts receivable will increase. One can use the same approach in analyzing the financial effects of relaxing the credit limit.

CONCLUSION

In this Unit, we have given the importance of accounts receivable in a day-to-day operation of a business enterprises and we have also discussed two dimensions of receivable management that is the credit standard and credit terms.


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