Question 5 OR (b)
Credit policy and the role of credit terms
6 marks
- Time to write
- About 12 minutes
Question
Question 5 OR (b) · 6 marksWhat is a credit policy? Explain the role played by "credit policy terms" in credit policy.
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
Read from the question
- What…?Explain…Two asks in one question: answer both.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Meaning of credit policy and its trade-off 2 marks 3 min
- 2 Credit terms explained, with an example 1 mark 2 min
- 3 Credit period, cash discount and discount period: role of each 3 marks 5 min
- Check: every ask answered, key terms underlined 1 min
Easy marks
- Step 1 opens with the meaning: a one-line definition, the quickest mark in it.
Short on time? Trim steps 1 and 3 evenly rather than skip one: each is capped at its own marks.
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.
Credit policy. A firm's credit policy is the set of decisions that govern its sales on credit: to whom credit is given (credit standards), on what terms (credit terms), and how the debts are collected (collection policy). It determines both the quantity and the quality of the firm's receivables. A liberal policy raises sales and profit but also bad debts, collection costs and the funds tied up in debtors; a tight policy does the reverse and improves liquidity. The optimum policy is where the trade-off between cost, profitability and liquidity is best: credit is liberalised only as far as the extra revenue covers the extra cost.
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.
Credit terms are the conditions on which credit is granted. They are usually stated in a form such as "3/15 net 60": a 3% discount if paid within 15 days, otherwise the full amount within 60 days. They have three parts, each with its own role:
- Credit period. The time allowed to customers for payment. A longer period attracts new customers and raises sales, often under competitive pressure, but it increases the investment in receivables and the risk of bad debts. The length of the credit period and the discount allowed determine the size of the investment in receivables.
- Cash discount. An incentive for early payment that speeds up collections and releases funds. It has a cost, so it should be offered only if its cost is less than what the firm earns on the funds released.
- Discount period. The period within which the discount may be taken. A longer discount period may induce more customers to take the discount and pay, but those who already paid early may now pay later.
Role. By setting these terms the firm controls how fast its sales turn into cash, and so balances the extra profit from credit sales against the cost of financing receivables, bad debts and collection.
Where the 6 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Meaning of credit policy and its trade-off | 2 |
| 2 | Credit terms explained, with an example | 1 |
| 3 | Credit period, cash discount and discount period: role of each | 3 |
| Total | 6 |
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