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Q.2
A.2.
Q.3.
A.3.
Q.4.
A.4.
What is the role of credit terms and credit standards in the credit policy of a firm?
Credit standards are criteria to decide to whom credit sales can be made and how
much. If the firm has soft standards and sells to almost all customers, its sales
may increase but its costs in the form of bad-debts losses and credit
administration will also increase. The firm will have to consider the impact in
terms of increase in profits and increase in costs of a change in credit standards or
any other policy variable.
Credit standards influence the quality of firms customers, i.e., the time
taken by customers to repay credit obligation, and the default rate. The time taken
by customers to repay debt can be determined by average collection period
(ACP). Default risk can be measured in terms of bad-debt losses ratiothe
proportion of uncollected receivables. Default risk is the likelihood that a
customer will fail to repay the credit obligation. The estimate of probability of
default can be determined by evaluating the character, i.e., willingness of
customer to pay; customers ability to pay and prevailing economic and other
conditions. Based, on above, firm may categorize customers into three kinds, viz.,
good accounts, bad accounts and moderate accounts.
The conditions for extending credit sales are called credit terms and they
include the credit period and cash discount. Cash discounts are given for receiving
payments before than the normal credit period. All customers do not pay within
the credit period. Therefore, a firm has to make efforts to collect payments from
customers.
The length of time for which credit is extended to customers is called the
credit period. A firms credit policy may be governed by the industry norms. But
depending on its objective, the firm can lengthen the credit period. The firm may
tighten the credit period, if customers are defaulting too frequently and bad-debt
losses are building up.
Q.5.
A.5.
What are the objectives of the collection policy? How should it be established?
The primary objective of collection policy is to cause increase in sales, and to
speed up the collection of the dues. The collection policy should ensure prompt
and regular collection, keep down collection costs and bad debts within limits and
to maintain collection efficiency.
The collection procedure should be clearly defined in such a manner that
the responsibility to collect and the follow up should be clearly defined. This
responsibility may be entrusted to the separate credit department or accounts or
sales department. Besides the general collection policy, firm should lay down
clear cut collection procedures for past dues or delinquent accounts.
Q.6.
What shall be the effect of the following changes on the level of the firms
receivables?
a) Interest rate increases
b) Recession
c) Production and selling costs increases
d) The firm changes its credit term from 2/10 net 30 to 3/10 net 30
A.6.
As the interest rate increases, the total cost of production increases resulting into
more investment in receivables.
During the recession, the sales level decreases, so the investment in
receivables is supposed to reduce. But the reduction may not take place on
account of delayed recovery of amount due from customers by firm. So, this may
also cause the investment in receivables to increase.
The increases in production and selling costs result to more investment in
receivables.
When company changes its terms from 2/10 net 30 to 3/10 net 30, this
should normally result into reduction in the level of investments in receivables.
But at the same moment, more customers may be willing to avail cash discount
resulting into increase in discount costs.
Q.7.
The credit policy of a company is criticized because the bad debt losses have
increased considerably and the collection period has also increased. Discuss
under what conditions this criticism may not be justified.
Generally it is a bad credit policy if bad debts increase and collection period also
increases. But in certain cases, once the company has recovered its fixed costs,
selling to marginal customers may be quite profitable as the contribution ratio
may be quite high. This raises the possibility of increased bad debts and high
collection policy, but at the same time high profits. The company should assess
the probability of the extent of default and the probability of higher payoffs.
A.7.
Q.8
A.8
Q.9.
A.9.
How would you monitor receivables? Explain the pros and cons of various
methods.
A firm needs to continuously monitor and control its receivables to ensure the
success of collection efforts. Following are the methods to monitor and evaluate
the management of receivables:
1. Collection period method: The average collection period is calculated,
and can be compared with the firms stated credit period to judge the
collection efficiency. The average collection period measures the quality
of receivables since it indicates the speed of their collectibility. Collection
period only provides an aggregate picture. Further, it does not provide
very meaningful information about outstanding receivables when sales
variations are quite high.
2. Aging schedule: It breaks down receivables according to the length of the
time for which they have been outstanding. It helps to spot out slowpaying customers. It also suffers from the problem of aggregation, and
does not relate receivables to sales of the same period.
3. Collection experience matrix: In this method, the firm tries to relate
receivables to the sales of the same period. In this method, sales over a
period of time are shown horizontally and associated receivables
vertically, in a tabular form; thus, a matrix is constructed. This method
indicates which months sales receivables are uncollected. It helps to focus
efforts on the collection month-wise.