Question 5 (a)

Consequences of lengthening and shortening the credit period

6 marks

Time to write
About 12 minutes
Topic
Receivables management

Question

Question 5 (a) · 6 marks

Discuss the consequences of lengthening and of shortening of credit period by firm.

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

12 minfor 6 marks

Read from the question

  • DiscussEach point named and explained, not just listed.

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 Consequences of lengthening the credit period 3 marks 5 min
  3. 2 Consequences of shortening the credit period 2 marks 3 min
  4. 3 The trade-off that decides the period 1 mark 2 min
  5. Check: every ask answered, key terms underlined 1 min

Short on time? Trim steps 1 and 2 evenly rather than skip one: each is capped at its own marks. End with step 3 in a line or two.

Try it first. About 12 minutes for 6 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

The credit period is the time allowed to customers to pay. Together with the cash discount it decides how much the firm has invested in receivables. Changing it moves sales, costs, risk and liquidity in opposite directions.

Picture itConsequences of lengthening and shortening the credit period

1'Pay next month'—the boxes fly off the van and every arm in the lane is full.

Consequences of lengthening the credit periodHigher sales and profit; larger investment in receivables; more bad debts and collection costs.

2Cash on delivery only: fewer takers at the door, but the money is in hand today.

Consequences of shortening the credit periodLower investment in receivables and better liquidity; possible loss of sales and profit.

Consequences of lengthening the credit period (a more liberal policy)

  1. Higher sales. Existing customers buy more and new customers are attracted, especially where competitors allow longer terms.
  2. Larger investment in receivables. Customers take longer to pay, so more capital is tied up in debtors and has to be financed.
  3. More bad debts. Debts stay outstanding longer, and the easier terms draw in additional customers, some of them less creditworthy, so bad-debt losses are likely to rise.
  4. Higher costs of collection, credit investigation and maintaining more accounts.
  5. Lower liquidity, because cash comes in later.

Consequences of shortening the credit period (a tighter policy)

  1. Lower sales, since some customers move to firms that give more time.
  2. Smaller investment in receivables and quicker collection, which releases funds for other uses.
  3. Fewer bad debts and lower collection costs, because debts are collected sooner and the tighter terms tend to keep the firm's credit with its more reliable customers.
  4. Higher liquidity.
  5. Lower profit from the lost sales volume.

The decision. Neither direction is right in itself. The finance manager should lengthen the period only so far as the extra contribution from the additional sales exceeds the extra cost of carrying the larger receivables, the additional bad debts and the collection costs. The optimum is the trade-off between cost, profitability and liquidity.

Where the 6 marks sit

#ComponentMarks
1Consequences of lengthening the credit period3
2Consequences of shortening the credit period2
3The trade-off that decides the period1
Total6
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