Credit Policies
For most companies, accounts receivable and inventories are very important investments, often dominating fixed asset investments. With the concern for return on assets expressed by many companies in recent years, there has come ever increasing focus on the funds committed to receivables and inventories. Whether these current assets are managed efficiently influences very strongly the amount of funds invested. In this chapter, we explore the key variables involved in efficiently managing receivables and inventories. In both situations, the optimal investment is determined by comparing benefits to be derived from a particular level of investment with the costs of maintaining that level. We consider first the credit and collection policies of the firm as a whole and then discuss procedures for the individual account. The last part of the chapter investigates techniques for efficiently managing inventories.
Economic conditions and the firm's credit policies are the chief influences on the level of a firm's accounts receivables. Economic conditions, of course, are largely beyond the control of the financial manager. As with other current assets, however, the manager can vary the level of receivables in keeping with the trade off between profitability and risk. Lowering quality standards may stimulate demand,
which, in turn, should lead to higher profits. But there is a cost to carrying the additional receivables, as well as a greater risk of bad debt losses. It is this trade off that we wish to examine.
We must emphasize that the credit and collection policies of one firm are not independent of those of other firms. If product and capital markets are reasonably competitive, the credit and collection practices of one company will be influenced by what other firms are doing. If we charge $20 for our product and demand payment within 15 days of shipment, while our competitors sell the identical product for $20 but have 60 day terms, we will have difficulty in selling. In the reverse situation, we will be flooded with orders. Eventually, production will bump capacity, and further production will be very inefficient. Our competitors undoubtedly will respond and change their credit terms. The point is that credit and collection policies are interrelated with the pricing of a product or service and must be viewed as part of the overall competitive process. Our examination of certain policy variables implies that the competitive process is accounted for in the specification of the demand function as well as the opportunity cost associated with taking on additional receivables.
The policy variables we consider include the quality of the trade accounts accepted, the length of the credit period, the cash discount, any special terms such as seasonal datings and the collection program of the firm. Together, these elements largely determine the average collection period and the proportion of bad debt losses. We analyze each element in turn, holding constant certain of the others, as well as any exogenous variables that affect the average collection period and the percentage of bad debt losses. In addition, we assume that the evaluation of risk is sufficiently standardized so that degrees of risk for different accounts can be compared objectively.
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