The below mentioned article provides a study note on trade debt.
There is a time lag between provision of goods and services and the receipt of cash for them. This time lag can result in a firm’s working capital requirements from banks. Any increase in time lag, will cause serious liquidity problems and sometimes can cause insolvency of the firm. Economic conditions of business can influence the type and amount of credit to be offered to the customers.
In boom periods, when the demand is more for the product, risk can be minimized by entice new customers into business. In case of recession, the business has to sustain with existing market and simultaneously minimizing the credit risk. High risk customers are often profitable, if the risk is properly managed.
The customer may require a credit limit of Rs. 1,00,000, on standard terms, he may deserve Rs. 75,000 credit limit. The supplier might choose instead to offer Rs. 50,000 credit limit, together with a discount policy to encourage early payment.
There are two types of credit generally offered to the customers:
i. Trade Credit:
These credits issued by a business to another business. For example, an invoice state that payment is expected within 30 days of the date of invoice. In effect, this gives 30 days credit to the customer.
ii. Consumer Credit:
This credit is generally offered to the end-consumer. For example, the consumer durables dealer offer hire purchase terms to the customers, whereby the consumer takes out to repay the goods purchased. Failure to repay will result in the goods being repossessed.
Costs of Granting Credit:
The costs involved in extension of credit to the customers are as follows:
i. Carrying Costs:
This cost includes the interest on capital blocked in the receivables balances, the administration costs associated with the credit decision making and controlling of debtors balances, cost of keeping the records of credit sales and payments, cost of collection of payments from customers, opportunity cost of capital than can be employed elsewhere than in receivables balances.
ii. Defaulting Costs:
There are also costs associated with the risk of default – a certain portion of receivables will never pay, and will become ‘bad debts’ which has to be written off from the profits of the firm. It includes the legal charges, costs of filing the suit, costs of enforcing the suit etc.
iii. Administration Costs:
The costs relating to the administration of receivables is as follows:
(a) Screening the potential customers for granting credit.
(b) Accounting, recording and processing costs of debtors balances.
(c) Expenditure incurred for credit control checks.
(d) Cost incurred for sending invoices and statements of accounts to individual customers.
(e) Chasing-up of slow paying debtors.
(f) Costs of contacting customer.
(g) Costs of collecting cheques, outstation cheque collection charges.
(h) Costs of phone calls, reminders and follow-up.
(i) Costs incurred for classification of queries.
(j) Recording receipt of cash and processing on individual customer records.
(k) Use of office space, processing equipment and remuneration of sales force involved in debtors collection etc.
If the firm intends to increase its sales, it should resort to sell its products by extending credit. This would bring in cost to the firm in the form of interest loss on debtors balances, administration cost of debtors balances, default risk.
The increase in profit due to increase in credit sales is offset by the above costs. On the other hand, if the firm intend to avoid the said costs, it should sell its products for cash, means lower sales and lower profit. However, there is saving in costs of maintaining receivables.
Therefore, the firm is required to make a thorough analysis of extending credit. When the sales on credit terms are extended to the customers, the firm will consider the level of default risk attached to it. With every sale there is some risk that the customers will not be able to pay, but with large companies the risk is minimal and with small and illiquid companies the risk of non-payment might be high.
Jupiter Ltd. is selling its products on credit basis and its customers are associated with 5% credit risk i.e., there is a chance of 5 customers out of 100 customers will turn bad. Its annual turnover is expected at Rs. 5,00,000 if credit is extended and if no credit is given the sales would be at 60% there on. Suggest the profitability of extending credit and cash sales.
It can be observed from the above calculations that the net profit will be same under two methods of sales and if the firm intends to increase the turnover, it can extend credit to the customers. If the firm is risk averse it can sell on cash basis even at reduced turnover with no risk.
Costs of Denying Credit:
In a competitive market, if the competitors grants credit, it will be difficult for the firm to deny credit to customers, at least extend some special inducements to increase the sales or to withstand in the market. Generally the customers prefer to purchase goods on credit, and is not willing to pay until he satisfies with the goods as regards quality and specifications.
The sale of goods on credit avoids the necessity for refunds in respect of defective goods. Unless the monopoly market prevails, it is very difficult to sell all goods on cash basis. The reduction in sales limits the profitability of the firm.