## **Learning Outcomes**

After reading this article, you will be able to evaluate proposals for changes in credit policy, identify the main costs and benefits associated with altering terms, and calculate the impact on profit, financing charges, and customer behaviour. You will understand how to advise on the acceptability of credit changes from a financial management standpoint for the ACCA Financial Management (FM) exam.

## **ACCA Financial Management (FM) Syllabus**

For ACCA Financial Management (FM), you are required to understand the practical and financial implications of accounts receivable policy. This article covers:

- The purpose and management objectives of accounts receivable
- How to implement and monitor company credit policy
- Cost–benefit analysis of changes in credit terms
- The impact of offering early settlement discounts
- Calculation of the effect of changes in receivables on profits and financing costs
- The evaluation of factoring and invoice discounting alternatives

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What are two main financial benefits and two main costs of relaxing a company’s credit policy?
2. A business is considering increasing its customer credit period by 30 days. What effects might this have on sales, receivables, and financing costs?
3. True or false? Offering an early settlement discount always increases cash flow and company profit.
4. Briefly explain how to calculate the additional finance required if a company extends its average collection period.
5. Outline one risk associated with loosening credit criteria for customers.

## **Introduction**

Decisions about how much credit to offer customers are central to working capital management and directly affect both cash flow and profitability. Financial managers must weigh the possible benefits of increased sales against the costs of higher investment in receivables and the risk of bad debts. Evaluating proposals to relax or tighten credit terms requires systematic cost–benefit analysis and an understanding of the financial consequences of policy changes.

> **Key Term: Credit policy**
> The set of rules a business uses to decide which customers receive credit, the length and terms of credit, and the process for collection.

## **Cost–Benefit Evaluation of Credit Policy Changes**

Adjusting a company’s credit policy—such as extending payment periods, relaxing customer acceptance criteria, or offering discounts—can have significant impacts. Financial decisions must be based on comparing all likely costs and benefits arising from the proposed change.

### Assessing the Benefits

The main benefit of more generous credit terms is usually increased sales, as new or existing customers may order more. This may boost revenue and profit, especially in competitive industries where credit is a sales tool.

Other possible benefits:

- Reduced inventory costs if faster turnover follows the increase in sales
- Greater customer loyalty and repeat business

### Identifying the Costs

Changing credit terms can increase costs in several ways:

- **Financing Cost:** A longer average collection period increases investment in receivables. If this is financed through overdraft or other borrowing, interest costs rise.
- **Risk of Bad Debts:** Looser controls or extended credit may incur extra irrecoverable debts.
- **Administrative & Collection Costs:** More accounts to monitor may mean higher staff or service costs.
- **Discount Costs:** If early settlement discounts are introduced, their cost must be compared to the financing savings.

> **Key Term: Early settlement discount**
> An incentive, expressed as a percentage, offered to customers for paying their invoices before the due date.

### Steps in Evaluating Credit Policy Changes

1. **Estimate incremental sales volumes.** What additional sales will result from the policy change?
2. **Calculate incremental contribution.** Determine the additional gross margin generated by new sales, net of variable costs.
3. **Assess the increase in receivables.** Longer credit periods mean average receivables increase by the extra value of credit days.
4. **Work out additional financing cost.** Multiply the increase in receivables by the firm's cost of capital or borrowing rate.
5. **Estimate additional bad debts (if any).** Increased exposure may raise the percentage of sales never collected.
6. **Compute costs of discounts (if offered).** Forecast uptake of the discount and the related cost.
7. **Allow for any change in collection/admin expenses.**
8. **Determine the net effect on profit.** Incremental contribution less all incremental costs.

### **Worked Example 1.1**

A company’s annual sales are \$2 million. It offers customers 30-day credit. The finance manager proposes extending credit to 60 days, estimating that sales will rise by 10% but 2% of new sales will become bad debts. The overdraft interest rate is 10%. Only variable costs (at 60% of sales) are incurred on extra sales. Calculate the impact on annual profit and funding required.

> **Answer:**
>
> 1. Incremental sales: \$2,000,000 × 10% = \$200,000
> 2. Incremental contribution: \$200,000 × (1 – 0.60) = \$80,000
> 3. Increase in receivables: Additional 30 days’ credit on all sales
>
> - New average receivables: \$2,200,000 × 60/365 = \$361,644
> - Previous average receivables: \$2,000,000 × 30/365 = \$164,384
> - Incremental investment: \$361,644 – \$164,384 = \$197,260
>
> 1. Additional financing cost: \$197,260 × 10% = \$19,726
> 2. Additional bad debts: \$200,000 × 2% = \$4,000
> 3. Net profit effect: \$80,000 – \$19,726 – \$4,000 = **\$56,274**
>    The company earns an extra \$56,274 per year but must finance an additional \$197,260 in receivables.

### Changes Involving Early Settlement Discounts

When considering offering an early settlement discount (e.g., 2% off if paid in 10 days), the financial manager must compare:

- The cost of discounts taken (discount rate × sales qualifying for discount)
- The saving in financing cost (due to lower average receivables)
- Possible reduction in bad debt risk

> **Key Term: Cost of financing receivables**
> The interest or opportunity cost incurred by having capital tied up in customer debts until paid.

### **Worked Example 1.2**

A company has annual credit sales of \$1,000,000 and receivables averaging 45 days. It considers a 2% discount for payment within 10 days, expecting 50% of customers to accept and the average collection period to fall to 25 days. The cost of funding receivables is 8% p.a.

> **Answer:**
>
> 1. Pre-discount receivables: \$1,000,000 × 45/365 = \$123,288
> 2. Post-discount receivables: \$1,000,000 × 25/365 = \$68,493
> 3. Reduction in receivables: \$54,795
> 4. Financing cost saving: \$54,795 × 8% = \$4,384
> 5. Discount cost: 50% of \$1,000,000 × 2% = \$10,000
> 6. Net effect: \$4,384 saving – \$10,000 cost = **\$5,616 decrease in profit** (before any reduction in bad debts or admin costs considered).

### Considering Increased Credit Risk

Relaxing credit standards can boost sales but also increase bad debt losses. The financial impact must factor in any change in the percentage of sales lost as irrecoverable debts.

> **Key Term: Bad debt**
> An amount owed by a customer that is unlikely to be collected, resulting in a loss to the business.
>
> **Key Term: Factoring**
> An arrangement in which a business sells its trade receivables to a third party (the factor) to receive immediate cash and potentially admin and risk management services.
>
> **Key Term: Invoice discounting**
> A method where a company uses unpaid sales invoices as collateral for a short-term loan from a lender.

### **Exam Warning**

Be careful not to ignore the cost of additional investment in receivables when sales increase or credit terms are extended. Also, do not assume all extra sales are equally profitable—consider variable cost margins and potential rise in bad debts.

### **Revision Tip**

When practising exam questions, always lay out the incremental cash flows step by step—show how sales volume, contribution, financing, bad debts, discounts, and admin costs change before combining them. This reduces careless arithmetic errors.

## **Summary**

The decision to alter a company's credit policy must weigh the financial benefits of higher sales and contribution against increased costs from financing, bad debts, administration, and possible discount costs. A stepwise cost–benefit calculation is essential for proper advice.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define credit policy and its main components
- Identify typical benefits and costs of changing credit terms
- Calculate incremental profit and required receivables funding from policy changes
- Appraise the financial outcome of offering early settlement discounts
- Evaluate the effect of increased credit risk and bad debts
- Recognise when to recommend or reject a proposed credit change based on overall profit impact

## **Key Terms and Concepts**

- Credit policy
- Early settlement discount
- Cost of financing receivables
- Bad debt
- Factoring
- Invoice discounting

Receivables and credit policy - Cost–benefit evaluation of credit changes