Credit and collection policies


Economic conditions, product pricing, product quality, and the firm’s credit policies are the chief influences on the level of a firm’s accounts receivable. All but the last of these influences are largely beyond the control of the financial manager. As with other current assets, however, the manager can vary the level of receivables in keeping with the trade-off between profitability and risk. Lowering credit standards may stimulate demand, which, in turn, should lead to higher sales and profits. But there is a cost to carrying the additional receivables, as well as a greater risk of bad-debt losses. It is this trade-off that we wish to examine.

The policy variables we consider include the quality of the trade accounts accepted, the length of the credit period, the cash discount (if any) for early payment, and the collection program of the firm. Together, these elements largely determine the average collection period and the proportion of credit sales that result in bad-debt losses. Each element in turn has to be analyzed holding constant certain of the others as well as all external variables that affect the average collection period and the ratio of bad-debts to credit sales. In addition, it is assumed that the evaluation of risk is sufficiently standardized so that degrees of risk for different accounts can be compared objectively.

Credit and Collection Policy Formulation if done properly helps ‘Break Down Barriers Between marketing and Finance’

Credit and collection policies share a relationship with marketing (sales and customer service) policies. For example, processing credit orders efficiently affects sales and customer satisfaction. In fact, it is useful to think of a company’s credit and collection policies as part of the product or service that a business is selling. Therefore, the marketing manager and financial manager should actively cooperate in developing credit and collection policies. Usually, the financial manager is subsequently responsible for carrying out these policies. However, permanent, cross-functional teams involving finance and marketing personnel are becoming quite common—especially when it comes to implementing collection policies.

Credit Standards

Credit policy can have a significant influence on sales. If our competitors extend credit liberally and we do not, our policy may have dampening effect on our firm’s marketing effort. Credit is one of the many factors that influence the demand for a firm’s product. Consequently, the degree to which credit can promote demand depends on what other factors are being employed.

In theory, the firm should lower its quality standard for accounts accepted as long as the profitability of sales generated exceeds the added costs of the receivables. What are the costs of relaxing credit standards? Some arise from an enlarged credit department, the clerical work involved in checking additional accounts, and servicing the added volume of receivables. The assumption is that these costs are deducted from the profitability of additional sales to give a net profitability figure for computational purposes. Another cost comes from the increased probability of bad-debt losses.

Finally, there is the opportunity cost of committing funds to the investment in additional receivables instead of to some other investment. The additional receivables result from

1. Increased sales.
2. A longer average collection period.

If new customers are attracted by the relaxed credit standards, collecting from these less creditworthy customers is likely to be slower than collecting from existing customers. In addition, a more liberal extension of credit may cause certain existing customers to be less conscientious about paying their bills on time.