Credit Policy Variables and Credit Evaluation

Understand Credit Policy Variables and Credit Evaluation

Key rules to remember

Credit terms notation

a/b, net c means a% discount if paid within b days, otherwise full amount by day c

Example: 2/10, net 45 means 2% discount within 10 days, full payment by day 45.

Average receivables

Average receivables = Credit sales per day × Average collection period

Use credit sales, not total sales, unless told all sales are on credit. Use 360 or 365 days as the question states.

Cost of carrying receivables

Carrying cost = Investment in receivables × Required rate of return

Investment in receivables is usually taken at cost (variable cost, or total cost as the question directs), not at sales value.

Incremental analysis of a policy change

Net benefit = Incremental contribution − Incremental bad debts − Incremental carrying cost − Incremental collection cost − Discount cost

Accept the change only if net benefit is positive. Add or drop terms as the question gives them.

Cost of giving up a cash discount (approximate)

Cost = [Discount % ÷ (100 − Discount %)] × [360 ÷ (Credit period − Discount period)]

Used to judge whether a discount is worth offering or taking.

How to solve Credit Policy Variables and Credit Evaluation questions

1. 1Read the question and identify which variable changes: standards, period, discount or collection effort. Note what else is given, such as the required return.
2. 2For theory, define the variable, state the effect of loosening and tightening on sales, receivables, bad debts and cost, and give a conclusion.
3. 3For numbers, list the current and proposed positions side by side: sales, contribution, average collection period, bad debts.
4. 4Compute the incremental contribution from extra sales using the contribution margin or variable cost ratio given.
5. 5Compute average receivables under each policy, convert to investment at cost if the question says so, and find the extra carrying cost at the required return.
6. 6Add the incremental bad debts, collection cost and discount cost. Discount cost is discount % × sales taking the discount.
7. 7Find net benefit as incremental contribution minus all incremental costs.
8. 8State the decision clearly: adopt if net benefit is positive, reject if negative. For credit evaluation questions, name the 5 Cs or the information source and tie each to the customer in the case.

Quickest way: Incremental profit in one pass

Common mistakes in Credit Policy Variables and Credit Evaluation

• Valuing the investment in receivables at sales value

  Students multiply average collection period by sales and stop there.

  Fix: Convert to cost (variable cost or total cost, as directed) before applying the required return, because only the cost is actually blocked.

• Charging bad debts or carrying cost on the whole sales, not the incremental part

  Students forget that the existing policy already has these costs.

  Fix: Take the difference between proposed and present for every cost line.

• Mixing up credit standards and credit period

  Both are described as loosening credit.

  Fix: Standards decide who gets credit. Period decides how long they get. Write this one-line distinction in your answer.

• Treating the cash discount as pure gain

  Faster collection looks attractive.

  Fix: Deduct the discount cost on the sales that take it and compare it with the saving in carrying cost and bad debts.

• Listing the 5 Cs without explaining them

  Students memorise names only.

  Fix: Give one line for each C and, if a case is given, apply it to the customer facts.

• Using the wrong day count

  Students default to 365 or 360 without reading.

  Fix: Use the number of days stated in the question. If none is stated, state your assumption in the answer.

Worked examples