Unit 2 Part 7 Credit Management Rashid Usman Ansari Reference Prasanna Chandra FM Credit Period Credit Period refers to the length of time customers are allowed to pay for their purchases ID: 1001320
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1. Individual Current Assets ManagementUnit 2 Part 7Credit Management Rashid Usman AnsariReference: Prasanna Chandra, FM
2. Credit PeriodCredit Period refers to the length of time customers are allowed to pay for their purchases.It generally varies from 15 to 60 days, in some cases 90 days.If no credit is allowed, credit period would be Zero.If a firm allows 40 days credit, its credit terms are stated as ‘net 40’.
3. ContinuedImpact of relaxing (lengthening) the Credit Period Pushes the sales up by inducing existing customers to purchase more and attracting new customers. Higher incidence of Bad Debts. Larger investment in ReceivablesShortening of credit period would have just the reverse influences.Effect of lengthening the credit period on residual income is analysed in the manner similar to the one we used in credit standards, as the influences are the same: ∆ RI = [ ∆S (1-V)- ∆S bn] ( 1-t) – k ∆I However, in this case, ∆I is calculated differently. All else is the same as in credit standards.
4. ContinuedTo calculate increased investment in receivables, following formula is used: ∆I = (ACPn – ACPo ) [ So ÷ 360 ] + V (ACPn )X (∆S ÷ 360) ACPn = Average Credit Period, New ACPo = Average Credit Period, Old So = Old Sales ∆S= Additional, Incremental sales on account of increase in credit period. Illustration Zenith Ltd. Currently provides 30 days of credit to its customers. Its present level of sales is Rs. 50 million. The firm’s cost of capital is 10% and the ratio of variable costs to sales is .85. Zenith is considering extending its credit period to 60 days. Such and extension is likely to push sales up by Rs. 5 million. The bad debt proportion on additional sales would be 8%. The tax rate for the firm is 40%. Evaluate the effect of lengthening the credit period on residual income.
5. Solution ∆RI = [ 50,00,000 (1-.15) – 50,00,000 X .08] ( 1-.40) - .10 [ (60-30) X (500,00,000÷ 360) + .85 X 60 X (50,00,000÷ 360 )]= [7,50,000 – 4,00,000] (.6) - .10[41,66,667 + 7,08,333] = - 2,77,500Since the impact on residual income is negative credit period should not be relaxed/ changed.