The Implications of Liberal Credit Terms to Customers

What are the implications of extending more liberal credit terms to customers?

Adequate discussion plus an example would be nice.

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Business, Business Policy
Year 4
Credit terms
1. What are the implications of extending more liberal credit terms to customers? Adequate discussion pls an example would be nice.
Extending more liberal credit terms -→ Sales Growth → Less cash flow → Ties working capital up
There are two extreme ways to look at credit if you grant credit directly. One is not to grant credit to anyone, and the other is to grant customers all the credit they want. Neither extreme is, of course, wise. There is, however, a wide range of possible credit policies, which deserve consideration. The range stretches from liberal extension of credit with a liberal collection policy to strict extension of credit with strictly enforced collection dates. A liberal credit policy involves the granting of credit to people without extensive checking to see whether they will be able to make payments. In a strict credit policy, a customer’s financial background is checked thoroughly, before credit is granted. Collection policies, on the other hand, refers to method of repayment. A liberal collection policy allows extensions of repayments to later dates, whereas a strict collection policy demands that payments be made right on schedule.

Extending more liberal credit terms helps the company sell to more customers. Thus, sales growth usually requires more working capital as illustrated in Credit cards and direct credit – increases sales and also affect the two closely related vital financial factors, cash flow and working capital, though they have widely different impact (as shown below)
Thus, it increases customers and sales, and impacts both cash flow and working capital as shown below:

Example 1: Cash Flow

When you receive immediate payment for merchandise your sales and your collections are identical. If you grant credit, either through a credit card or directly, you will, at first, receive less payments than the sales value of the merchandise you have sold. This is especially true in the first year but also occurs whenever you increase the amount of credit you grant to your customers, or when you extend it for a longer time. Whether and how much you will reduce your cash receipts depends, of course, on the terms of credit and to what extent credit will increase your sales. For those customers who pay their bills in full once a month, there will merely be a delay of one month. For those who pay in installments, however, the delay can be significantly longer.

Example 2: Working Capital

Credit sales are the same as loans; you must have the money to pay your costs on these sales. When credit sales are large, this means that capital is tied up in credit and cannot be used for purchase of inventory or other business purposes. This is discussed in greater detail later at

Example 3: Situational

What combination to choose depends a great deal upon the type of business you are in. If you are a travel agent, for instance, who has to pay the airlines and steamship companies promptly, and are involved with large sums and small profit margins, you cannot afford to extend credit liberally. You must extend credit only to people who can convince you that they will pay promptly. On the other hand, if you are extending credit for a highly profitable low cost item, you can afford to be much more liberal. How liberal your credit policy should be, also depends on the policies of your competitors and the extent to which your business depends on credit for the volume you need to be profitable. It also depends on your ability to handle credit–financially and in the time you have available for collection work.

Example 4: Situational

11. If you were deciding on revolving credit in your business where people are buying regularly but where individual purchases are rarely more than$100, how much credit would you allow the following two people?

A. Female applicant: 12 years at the present address; employed for 18 years; current annual income $12,000; local checking account and local savings account. She owns a small home estimated at $30,000 with a $10,000 mortgage remaining.

B. Male applicant: 9 months at current address; 3 1/2 years at previous address; current annual income is $10,000; local savings and checking accounts. He rents an apartment for $200.00 a month. He has an open balance of $600.00, a personal loan with a bank and makes monthly payments of $30.00.

Example 5: Businesses are often more concerned with the amount of credit to extend versus individual customers (although they work hand in hand)

How? By evaluating the impact (cost/benefit) of offering more liberal credit terms.

In evaluating the benefits and costs of granting credit you have to look at both sides: the benefits, which the credit brings you, and the costs. The benefits are chiefly the extra business you obtain because you grant credit. If all competitors are conveniently located and they grant credit, you can assume that you would lose a large proportion of the business that is now transacted on credit, if you had a no-credit policy. On the other hand, if only a relatively small proportion of your business is credit business, then you gain relatively little benefit from offering credit. How much benefit you derive from offering credit is a judgment that you have to make based on the conditions in your business.

Benefits from credit

A simple form which you may use in calculating the benefits derived from credit is given:

1. How much business, in dollars, did you do on credit last year?……………………………..$ 50,000

2. Review this business and determine how much of the business you would have
obtained if you did not grant credit…………………………………………………………………………………$ 10,000

3. Line 1 – Line 2 (indicates the amount of your business which was a direct result of the
credit you extended)……………………………………………………………………………………………………$ 40,000

4. Line 3 x the % net profit you make ($40,000 x .20)…………………………………………………………$ 8,000

5. What is your annual cost of billing customers and of keeping the credit records?………..$ 600

6. What is the cost of credit reference checks, e.g., credit bureaus, etc.?…………………….$ 150

7. How much did you lose in debts which customers never paid?………………………………$ 1,200

8. What is the cost of money you have tied up in credit?………………………………………….$ 400

9. Total cost of granting direct credit (add together lines 5 through 8 and total)……………$ 2,350

10. Benefit in net profit, which credit brings you (Line 4 – Line 9)……………………………..$ 5,650

An analysis like this can give you an idea of how much you benefit from the direct credit you grant to customers. Note that granting credit, in this example, requires that you invest $4000 in credit to your customers. This $4000 has to be available. If you cannot obtain it, it will hurt your ability to carry adequate stock.

Example 6: A similar analysis can be made when you use credit cards.

In the example above, granting credit and the way it was being granted appeared to be profitable. It is, of course, worthwhile to compare this with alternate ways of granting credit. For instance, you could use credit cards and, on the assumption that the credit card company would charge a 5% discount, the calculations might look as follows:

Discount on credit card charges (5% x $50,000) = $2,500

Cost of checking larger purchases
(phone calls and time spent calling): = $500

Total costs: = $3,000

Comparing this cost with the cost of direct credit shows that direct credit brings in $650 more profit than credit cards for this particular retailer. (Credit cards cost $3000 annually as compared to $2350 for direct credit.)

Still another way to revise and possibly save on granting of credit would be to make more detailed checks on credit risks. This could be based on a very detailed study of the characteristics of people on whom losses have been encountered in the past. This would result in a somewhat tighter policy, which may be the least expensive way to operate the business. A tight credit policy would, of course, result in somewhat less business, but then it takes $5.00 of sales to make up for every dollar of credit lost, in the example shown above. ($1.00 lost divided by .20 net profit margin =$5.00 of sales)

All these estimates are, of course, difficult to make. Nevertheless, an attempt to make reasonable estimates can give you a lot of information about the impact which credit is likely to have on your business.

Note: The article uploaded below (for convenience) has an interesting view, and is somewhat related. Working capital management plays a critical role in a company’s quest to maximize its shareholder value, but also ties into customer creditworthness and lendings policies. For example, a key component of shareholder value is the cost of capital, and credit risk is its driver. Did you ever stop to think that how you judge a borrower’s working capital management skills may impact its cost of capital? What if you judge the firm to be too easygoing in collecting its receivables, too overstocked in inventory, too slow in paying its trade suppliers, and too thin in its cash reserves? Is the customer then too risky to bank even with extra risk premium added to the rate? Of course, these mental adjustments would boost your borrower’s cost of debt and ultimately decrease the firm’s shareholder value. However, if your borrower pays a little more attention now to managing its working capital, the future boost to cash flow could pay off in more cash flow later that increases shareholder value and improves your customer’s creditworthiness.


Bid Credits: 2 Deadline: March 17, 2006, 12:48 am EST

The impact of working capital investment on the value of a company
Dev Strischek
In this article, Dev Strischek describes how to use a popular shareholder valuation tool to quantify the impact of working capital management for use in both credit decisioning and in the financial advisory role. Lenders will be able to show their customers how receivables, inventory; and payables management can increase or decrease their companies’ net worth and share value.
Four hundred years ago, English philosopher Francis Bacon observed, “And money is like muck, not good except it be spread.” Bacon has described the principal property of working capital, the ubiquitous yet ambiguous financial term for the balance sheet’s collection of current assets and liabilities that aggregately fertilize and nurture a company’s growth.
Working capital management plays a critical role in a company’s quest to maximize its shareholder value. A key component of shareholder value is the cost of capital, and credit risk is its driver. Did you ever stop to think that how you judge a borrower’s working capital management skills may impact its cost of capital? What if you judge the firm to be too easygoing in collecting its receivables, too overstocked in inventory, too slow …

Solution Summary
By example and discussion, this solution examines in detail the implications of extending more liberal credit terms to customers.

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