Defining Optimum Credit Policy

By Mohammed Salem Awadh

Consultant

Mohammed S. Awadh 1

Defining Optimum Credit Policy

Defining the Problem:

One of the major issues in the company is the controlling of the collection period and

developing optimum credit policy that minimizing the company loses, i.e how to trade

off and balance between two costs, the first is carrying costs and the second is the

opportunity costs of a particular credit policy. In other wards to define the point where

the total credit cost is minimized. This point corresponds to the optimal amount of

credit should equivalently, the optimal investment in receivables. So if the firm

extends more credit than minimum cost policy, the additional net cash flow from the

new customer will not cover the carrying costs of the investment in the receivable.

If the level of receivables is below minimum amount, than the firm is forgoing

valuable profit opportunities. So what is the best credit policy and what is the right

collection period?

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The Operating Cycle And the Cash Cycle :

The primary concern in short-term finance is the firm's short-run operating and

financing activities.

Operating Cycle :

the operating cycle is define as the sum of inventory period and account receivable

period, it describe how the product moves through the current asset account. The

product begins life as inventory, it is converted to a receivable when it is sold, and it

is finally converted to cash when we collect from sale.

Operating cycle = Inventory period + Account receivable period

The Cash Cycle:

The cash cycle is the number of days that pass before we collect the cash from sale,

measured from when we actually pay for the inventory, the cash cycle is the

difference between the operating cycle and the account payable period

Cash Cycle = Operating Cycle - Account payable period

The following figure depicts the short-term operating activities and cash flows for a

typical manufacturing firm by way of a cash time line. As shown, the cash flow time

line presents the operating cycle and the cash cycle in graphical form. In the figure,

the need for short-term financial management is suggest by the gap between the cash

inflows and the cash outflows. This is related to the lengths of the operating cycle and

the accounts payable period.

The gap between short-term inflow and outflows can be filled either by borrowing or

by holding a liquidity reserve in the form of cash or marketable securities.

Alternatively, the gap can be shortened by changing the inventory, receivable, and

payable periods.

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Carrying CostOpportunity Costs

Total Cost

No of Weeks

CO

ST IN

US$

Credit and Receivables:

When a firm sells and services, it can demand cash on or before the delivery date or it

can extend credit to customers and allow some delay in payment. So the idea to grant

credit to the firm's customer is making an investment in a customer, an investment

tied to the sale of a product or service and it is a way of stimulating sales. The costs

associated with granting credit are not trivial. First, there is the chance that the

customer will not pay. Second, the firm has to bear the costs of carrying the

receivables. The credit policy decision thus involves a trade-off between the benefits

of increased sales and the costs

of granting credit.

Components of Credit Policy:

The components of credit policy:

1- Terms of sale.

The terms of sale establish

how the firm proposes to sell its goods and services. A basic decision is whether

the firm will require cash or will extend credit. If the firm does grant credit to a

customer, the terms of sales will specify the credit period, the cash discount and

discount period and the type of credit instrument.

2- Credit Analysis.

In granting credit, a firm determines how much effort to expand trying to

distinguish between customers who will pay and customers who will not pay.

Mohammed S. Awadh

The Operating Cycle

Cash Paid for inventory

Account payable period

Time

Account Receivable Period

Cash cycle

Operating Cycle

Inventory purchased

Inventory Period

Inventory Sold

Cash received

4

Time

The Cash Flows from Granting Credit

Credit Sale is made

Customer mails checks Firm deposits check in bank Bank credits firm's account

Cash collection

Credit Sale is made

Firms use a number of devices and procedures to determine the probability that

the customer will not pay, and put together, these are called credit analysis.

3- Collection policy:

After credit has been granted, the firm has the potential problem of collecting the

cash, for which it must establish a collection policy.

Cash Flows from Granting Credit:

The accounts receivable period is described as the time it takes to collect on a sale.

There are several events that occur during this period. These events are the cash

flows associated with granted credit

Optimal Credit Policy:

The optimal amount of credit is determined by the point at which the incremental cash

flows from increased sales are exactly equal to the incremental costs of carrying the

increase in investment in accounts receivable.

The Total Credit Cost Curve:

The trade-off between granting credit and not granting credit isn't hard to identify, but

it is difficult to quantify precisely. So we can only describe an optimal credit policy.

i.e the carrying costs associated with granting credit come in three forms:

1- The required return on receivables.

2- The losses from bad debts.

3- The cost of managing credit and credit collections.

These three costs will all increase as credit policy is relaxed.

If a firm has a very restrictive credit policy, then all of the associated costs will be

low. In this case, the firm will have a "shortage" of credit, so there will be an

opportunity cost. This opportunity cost is the extra potential profit from credit sales

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Carrying CostOpportunity Costs

Total Cost

Amount of credit extend $$C

OST

IN U

S$

that is lost because credit is refused. This forgone benefit comes form two sources, the

increase in quantity sold, Q' minus Q and, potentially, a higher price. The costs go

down as credit policy is relaxed.

The sum of the carrying costs and the opportunity costs of a particular credit policy is

called the total credit cost curve. We have such a curve in the figure. it is illustrates

there is a point where the total

credit cost is minimized. This

point corresponds to the optimal

amount of credit or equivalently,

the optimal investment in

receivables.

If the firm extends more credit

than this minimum, the additional net cash flow from the new customer will not cover

the carrying costs of the investment in the receivable.

If the level of receivables is below this amount, than the firm is forgoing valuable

profit opportunities.

In general, the costs the costs and benefits from extending credit will depends on

characteristics of particular firm and industries

Case Study:

Consider Shihab Agencies, given for certain product (simulated case)

Credits Sales: = 3 Millions USD

Cost of goods of sold: = 1.3 Millions USD

Average Inventory: = 0.21 Millions USD

Average Account Receivable:= 0.25 Millions USD

Average payable: = 0.18 Millions USD

Collection period = 30 Days

Carrying Cost = 1000 USD per credit policy

Opportunity Cost = 10000 USD per losing opportunity

Assuming the probability that the customer cannot fulfill the credit policy follow

Poisson distribution.

ANALYSIS :

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Inventory turnover =Cost of goods of soldAverage Inventory

=1 . 30. 21

=6 .24 times

Inventory Period = 365Inventory turnover

=3656 .24

= 58 Days

Receviables turnover =Credit Sales Average Account Receivable

=30 . 25

=12 times

Receivables Period = 365Receviables turnover

=36512

= 30 Days

Payable turnover =Cost of goods of soldAverage Payable

=1 .30 .18

=7 . 13 times

Payable Period = 365Payable turnover

=3657 . 13

= 51

Operating Cycle = Inventory Period + Account Receivable Period

= 58 + 30

= 88 Days

Cash Cycle = Operating Period – Account payable period

= 88 – 51

= 37 Days

But is this collection, is the right policy !!!!!! Lets say:

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Consider the maximum relax credit policy = 90 Days = 12 weeks,

Definitely this will lead the possibility that the customer will not pay on time, so as

we know the standard Shihab policy = 30 Days = 4 weeks, since the probability that

the customer cannot fulfill the credit policy follow Poisson distribution.

The estimation factor of Poisson distribution = 90/30 = 12/4= 3

By applying U curve techniques

The following calculation is setup

Assuming that the occurrence of the

probability is at =90/2 = 45 days

(for simplification ).

Using:

Carrying Cost = 1000 USD per credit policy

Opportunity Cost = 10000 USD per losing opportunity

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So the OPPORTUNITY COST at a certain credit policy =

= ∑12

I=0

(Period ( I ) in weeks minus proposed credit policy at period ( I ) in weeks) *

(probability of failing to meet the commitment at that period) * Total time /2 *

opportunity cost per event (period )

CARRYING COST:

= Carrying cost per credit policy * Total time /2 * credit policy ( I )

While

TOTAL COST = OPPORTUNITY COST + CARRYING COST:

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So the final and optimum policy = 4 Weeks = 30 Days

As shown in Figure :

Results:

The Optimum Collection Policy = 4 weeks

Summary:

The problem of defining optimum credit policy is setup and solved by using U curve

technique, even we use some assumption as Poisson distribution to reflect the

probability of failure of the customer to meet the commitments that made it for the

company but the results shows that the company can develop it own figures to reflect

the reality, the ratio of carrying cost to the cost of losing opportunity is constant for

optimum policy ( for this case ) so the company can evaluate these costs by knowing

one of them to develop the right credit policy.

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