Analysing the trade credit policy decisions

A firm grants trade credit to a customer to protect its sale from the competitors or to attract the potential
customers from the competitors to buy its product at favourable terms. This decision results in
investments of firms funds in accounts receivables (or trade debtors) for the period of credit and has to
be financed from working capital either by getting funds from banks or other sources.

Credit granting decision involves an element of risk as the buyer of goods or services may not make
full payment when it becomes due. The firm has to incur expenses in collecting these amounts
(collection expenses) and may have to incur some bad debt expense on account of partial or non-
recovery of the amount due (bad debt expense). Occasionally the firm grants cash discount to expedite
the collection of receivables thereby incurring cash discount expense. Hence, managing the accounts
receivables is an investment function that deals with setting credit standards, deciding the credit period
to be allowed, the terms of cash discount and level of effort to be placed in collecting the dues from
customers in time (collection effort).

The value of a firm is maximized when the incremental or marginal rate of return on investment is
greater than the incremental or marginal cost of funds used to finance this investment in accounts
receivables. As the four credit policy variables are related and have a bearing on the level of sales,
managers use incremental cost-benefit approach to analyse the impact of these decisions on the residual
income that captures both the elements of profitability and risk involved. The procedure of evaluating
the investment in accounts receivable involves the following steps:
1. Estimation of incremental net operating profit after tax (incremental NOPAT)
2. Estimation of incremental investments in accounts receivable (incremental receivables)
3. Estimation of opportunity cost of this incremental investment.
4. Estimation of net benefit

The residual income is the excess of incremental operating profit over the incremental cost of funds
raised to fund these investments. If the residual income is expected to be positively impacted by the
proposed change in credit policy variables, then the said policy could be adopted. For purposes of
convenience, impact of each of these variables will be estimated independently.

I. Impact of tightening or loosening the credit standards

Credit standards are criteria to decide the type of customers to whom goods could be sold on credit. The
decision choices before the firm in this respect ranges from not extending credit to any customer,
however strong his credit worthiness may be, to the other extreme of granting credit to all customers
irrespective of their credit worthiness. Suppose the firm choses the alternative of tightening the credit
standards viz. the firm may sell mostly on cash and may extend credit only to the most reliable and
financially strong customers. The benefit of this credit policy alternative would be the reduction in the
investments made in accounts receivables and the lesser cost of credit administration alongwith no bad
debt losses. However, this credit policy alternative also results in depressed sales that leads to reduced
operating profit. In general, liberal credit standards tend to push sales up by attracting more customers.
This is, however, accompanied by the firm have more slow-paying customer that lead to larger
investment in receivables, a higher incident of bad debt loss, and a higher collection expense. Thus the
choice of credit standards, that is deciding what standard should be applied in accepting or rejecting an
account for credit gaining, influences the quality of firms customers and involves a trade off between
incremental return and incremental costs of administering it.

The time taken by the customer to repay the obligations, viz. the Average Collection Period (ACP) and
the proportion of uncollected receivables (default rate) are the two measures used to assess the credit
quality of customers. Default risk is the likelihood that a customer will fail to repay the obligation. To
estimate the default risk and to classify the customers into various credit risk categories, the managers
use variety of quantitative and qualitative techniques that are supplemented with reasonable judgement
based on past practice and experience.
The firm may classify the customers into at least three credit categories:
1. Good accounts viz. financially strong customers with high credit worthiness
2. Bad accounts viz. financially very weak customers with very high risk.
3. Marginal accounts viz. customers with moderate credit worthiness and risk.

The marginal customers help in expanding the firms sales but the bad debt losses and credit
administration expenses will also increase. Hence, the managers would relax credit standards up to the
point where the incremental gains equal the incremental costs to enhance the firms sales & profitability.
The effect of relaxing the credit standards on residual income (income left after providing for the
opportunity cost of the capital locked in the incremental investment) may be estimated as follows:

RI = [S (1 V) S bn] (1 t) - k I (1)

where RI is the change in residual income

S is increase in sales
V is ratio of cost of goods sold and variable expenses to sales
bn is bad debt loss ratio on new sales
t is corporate tax rate
k is post-tax opportunity cost of capital
I is the incremental investment in accounts receivables

In this case,

I = S/360 x ACP x V (2)

where S/360 = average daily change (increase) in sales. The divisor here can with equal
justification be 365, rather than 360
ACP = average collection period
V is ratio of cost of goods sold and variable expenses to sales

The benefit of relaxing the credit standards and the consequent cost are captured in equation
(1). S (1-V) measures the increase in gross profit (defined here as Sales minus cost of goods sold and
variable portion of administrative costs, selling costs and collection costs) on account of incremental
sales while S.bn reflects the expected bad debt loss on this incremental sales. Hence the [S (1-V) -
S bn] (1-t) represents the incremental net operating profit after tax (NOPAT) arising from increase in
sales after considering expected bad debt losses. kI measures the after-tax opportunity cost of
additional funds locked in the accounts receivables.

Illustration
Industrial Oxygen Ltd (IOL) had recorded 800 million sales for the financial year 2015-2016. The
firms profitability is declining for the past three years and the management felt that it might be due to
extending unlimited trade credit to the marginal customers. The firm considers the customers financial
position and probability of default in classifying them into four different risk categories, 1 through 4
(customers in risk category 1 have the highest credit rating while the customers in risk category 4 have
the lowest credit rating).

During the year 2015-2016, the firm didnt have any cash sales and the goods were sold on net 30 basis.
The current credit policy of IOL is to extend unlimited credit to customers in categories 1 and 2, limited
credit to customers in category 3 and not to extend any trade credit to customers in last category. The
average collection periods on 31 March was 40 days. The firms gross profit margin and operating profit
margin were 25% and 10% respectively.
As a result of the current credit policy, IOL is foregoing sales to the extent of 100 million to customers
in category 3 and 140 million to customers in category 4. The firm is considering the adoption of a
more liberal credit policy under which the customers in category 3 would be extended unlimited credit
and the customers in category 4 would be extended limited credit. Such relaxation would increase sales
by 240 million on which bad debt losses would be 15%. The fixed operating expenses were 43 million.
The expected average collection period for this incremental sales is 45 days. Contribution margin for
the firm is 20% and the marginal corporate tax rate is 30%. Given the risks in sales to marginal
customers, the relevant opportunity cost of capital is 12%.

We may assume that the fixed operating expenses are to be borne by customers in categories 1 and 2.
Relaxing the credit policy would improve the gross profit by 48 million while the expected bad debt
loss on it would be 36 million.

Incremental NOPAT = [240 * 20% - 240 * 15%] * (1 0.30) = 8.40 million

Investments in accounts receivables = 240 * 45/360 = 30 million

Changes in residual income = 8.40 million - 30 million * 12% = 4.80 million

One can infer that marginal customers contribute to 23% of overall sales and would increase the after-
tax profit by 8.40 million. Since the after-tax profit exceeds the minimum profit to be earned on this
investment, it is desirable to adopt the liberal credit policy towards this marginal customers.

Credit Period
The credit period refers to the length of time customers are allowed to pay for their liabilities on account
of credit purchases. In general, it varies from 15 days to 60 days in wholesale trade and a longer period
in retail trade. The firms credit period may be governed by the industry norms. If it offers the goods or
services on sale with payment to be made in 30 days from invoice date, then its credit terms are stated
as net 30.

A firm lengthens the credit period to expand sales by inducing existing customers to purchase more and
attracting additional customers that increases its operating profit. This is, however, accompanied by a
larger investment in accounts receivables and a higher incidence of bad debt loss. On the other hand, it
may tighten the credit period if customers are defaulting too frequently and bad debt losses are building
up. The NOPAT will increase only when the cost of extended credit period is less than the incremental
operating profit. The investments in accounts receivables will increase on account of existing customers
taking up more time to repay the amounts as well as new customers availing trade credit for an extended
period.

Since the effects of lengthening the credit period are similar to that of relaxing the credit standards, we
may estimate the effect on residual income of change in credit period by using the same formula:

RI = [S (1 V) S bn] (1 t) k I

I = (ACPn - ACPo) [So / 360] + V (ACPn) S / 360 (3)

where I = increase in receivables investment

ACPn = Average collection period after lengthening the credit period
ACPo = Average collection period before change in credit period
S = increase in sales on account of lengthening the credit period
V = ratio of variable costs to sales
It may be noted that the incremental investment in receivables arising from existing sales is based on
the value of sales, whereas the investment in receivables arising from new sales is based on the variable
costs associated with new sales. The difference exits because the firm would have collected the full
sales price on the old, receivables earlier in the absence of credit policy change, whereas it invests only
the variable costs associated with new receivables.

Illustration
Paramount India Ltd currently provides 45 days of credit to its customers. The current sales is 500
million. The firm is considering the alternative of extending its credit period to 60 days. Such an
extension is likely to push sales up by 100 million. The bad debt proportion on additional sales would
be 10 percent. The ratio of variable costs to sales is 0.80. The marginal tax rate is 30 percent and the
opportunity cost of funds is 12 percent.

Incremental sales = 100 million

Incremental contribution = (1 0.80) * 100 = 20 million
Incremental bad-debt and collection costs = 10%*100 = 10 million
Incremental NOPAT = (20 10) * (1 0.3) = 7 million
Incremental investment in receivables = (60 45)*500/360 + 0.80*60*100/360 = 34.17 mil
Impact on residual income = 7.00 34.17*0.12 = 2.90 mil

Alternatively, the after-tax return on investment in accounts receivables were 20.49% and is greater
than the opportunity cost of funds invested in the accounts receivable. Since the impact of lengthening
credit period was positive on the residual income, the firm may relax the credit period.

Cash Discount
A cash discount is a reduction in payment offered to the customer to induce him to make prompt
payment earlier than the agreed credit period. The percentage discount and the period during which it
is available are reflected in the credit terms. For example, credit terms of 2/10, net 30 means that a
discount of 2 percent is offered if the payment is made by the tenth day, otherwise the full payment is
due by the thirtieth day.

A firm uses the cash discount as a tool to increase sales, as the discount is regarded as price reduction,
and accelerate collections from customers. Liberalising the cash discount policy may mean that the
discount percentage is increased and/or the discount period is lengthened. Such an action tends to reduce
the average collection period, as customers pay promptly, and increase the cash discount expenses. The
effect of such an action on residual income may be estimated by the following formula:

RI = [S (1V) DIS] (1 t) + k I (4)

I = So/360 (ACPo ACPn) V S/360 ACPn (5)
DIS = pn (So + S) dn poSodo (6)

where So = sales before liberalizing the discount terms

S = increase in sales as a result of liberalising the discount terms
V = proportion of variable costs to sales
k = opportunity cost of capital
I = savings in receivables investment
DIS = increase in discount cost
ACPo = average collection period before liberalising the discount terms
ACPn = average collection period after liberalising the discount terms
pn = proportion of discount sales after liberalising the discount terms
dn = new cash discount percentage
po = proportion on discount sales before liberalising the discount terms
do = old cash discount percentage
On the right hand side of Equation (4), [S*(1V) DIS] measures the increase in operating profit on
account of incremental sales. DIS reflects the increase in cash discount expenses on account of
extending the cash discount period or changing the cash discount rate. Hence, [S (1V) DIS]*(1t)
represents the increase in NOPAT and the kI measures the after-tax opportunity cost of additional
funds locked in receivables. The decision criterion is to adopt the proposed policy if it can result in
increasing the residual income.

Illustration
The present credit terms of Alankrit Decors Ltd are 1/10, net 30. Its sales are 300 million, its average
collection period is 20 days and its variable costs to sales ratio is 0.90. The proportion of sales on which
customers currently take discount, po, is 0.6. The firm is considering relaxing its discount terms to
1.5/10, net 30. Such a relaxation is expected to increase sales by 50 million, reduce the ACP to 14
days, and increase the proportion of discount sales to 0.9. The marginal corporate tax rate is 30 percent
and its opportunity cost of capital is 12 percent.

Increase in cash discount expenses = 0.90*(300+50)*0.015 0.60*300*0.01

= 2.925 million
Increase in NOPAT = [S (1V) DIS](1t)
= [50*(10.90) 2.925]*(10.3)
= 1.4525 million
Reduction in investments in receivables = So/360 (ACPo ACPn) V S/360 ACPn
= (300*(20 14) 0.90*50*14)/360
= 3.2500 million
Impact on residual income = [S (1V) DIS] (1 t) + k I
= 1.4525 + 0.12*3.25
= 1.8425

Since the impact of change in discount policy on residual income is positive, it is desirable to change
the discount from 1/10, net to 1.5/10 net 30.

Collection Effort
A collection policy is to be set by the firm as some customers are slow-prayers while some are non-
payers. The aim of the collection program is to accelerate collections from slow-payers, thereby
ensuring fast turnover of working capital while keeping the bad debt losses and collection expenses
within limits. The collection program of the firm may consists of monitoring the state of trade
receivables, despatch of letters to customers whose due date is approaching, electronic and telephonic
advice to customers around the due date, threat of legal action when the accounts become overdue, and
initiating a legal action against overdue accounts.

A rigorous collection program aligns the collection efficiency at the intended levels stated in the credit
policy. However, it tends to decrease sales, shorten the average collection period, reduce bad debt
losses, and increase the collection expense. A lax collection program, on the other hand, would push
sales up, lengthen the average collection period, increase the bad debt losses, and perhaps reduce the
collection expense. The effect of decreasing the rigour of collection program on residual income may
be estimated as follows:

RI = [S (1 V) BD] (1 t) k I (7)
BD = bn (So + S) boSo (8)
I = So/360 (ACPn ACPo) + S/360 ACPn V (9)

where RI = change in residual income S = increase in sales

V = variable costs to sales ratio BD =increase in bad debt cost
I = increase in investment in receivables5 k = opportunity cost of capital
On the right hand side of Equation (7), [S*(1V) BD] measures the increase in NOPAT after bad debt
losses and collection expenses. One can incorporate the effect of offering cash discount into this part of
the equation while measures the amount of investments freed up due to faster collection of receivables.

Illustration
Indorama Electronics Limited is considering relaxing its collection effort. Its sales are 800 million,
its average collection period is 30 days and its bad debt ratio is 0.05. The relaxation in collection effort
is expected to push sales up by 125 million, increase the average collection period to 40 days, and
raise the bad debt ratio to 0.08. Its variable costs to sales ratio, V is 0.85 and the opportunity cost of
capital is 10 percent. The marginal corporate tax ratio is 30 percent.

Increase in bad debt expenses =0.08*(800+125) 0.05*800 = 34 million

Increase in NOPAT= [125*(1 0.85) 34]*(1 0.3) = 2.625 million
Increase in investment in receivables = (800*(40 30) + 125*40*0.85)/360 = 34.028 mil
Change in residual income = 2.625 0.10*34.028 = 0.7778 million

Since the effect of relaxing the collection efforts on residual income is negative, it is not worthwhile to
relax the collection effort.

Summary
Extending credit is an important corporate finance decision as it can enhance sales and profitability.
The important variables in this decision are credit standards, collection efforts, credit period and cash
discounts. Any changes made in these policy variables can impact the level of investment in receivables,
bad debt losses, cash discount expenses and collection expenses. The combined effect is captured by
measuring the change in residual income. A firm can adopt a policy decision if it expected to enhance
the residual income. One shall also note that these decisions result in changes in level of investment in
inventory and the level of operating current liabilities. It is prudent to incorporate the changes in them
as well while analysing these credit policy decisions.