Question 5 (a)

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, the credit period of a 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 3 marks 5 min
  3. 2 Consequences of shortening 2 marks 3 min
  4. 3 Trade-off and conclusion 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. Its length, with the discount offered, determines the size of the investment in receivables. Changing it is a trade-off between profitability and cost or liquidity.

Picture itLengthening 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

  1. Higher sales and profit: a longer period attracts new customers and raises sales to existing ones, which may also be needed to match competitors' terms.
  2. Larger investment in receivables: more funds are tied up in debtors for longer, with a higher cost of financing them.
  3. More bad debts and collection costs: credit reaches less creditworthy customers, who may also pay late, raising bad debts, collection, investigation and clerical costs.
  4. Lower liquidity: cash comes in later.

Consequences of shortening the credit period

  1. Lower investment in receivables and better liquidity: cash is collected sooner and funds are released.
  2. Fewer bad debts and lower collection costs, as credit is concentrated on prompt payers.
  3. Possible loss of sales and profit: customers may move to competitors offering longer credit.

Conclusion. The credit period should be lengthened only so long as the extra contribution from higher sales exceeds the extra costs (cost of funds, bad debts, collection), and shortened only so long as the savings exceed the profit lost.

Where the 6 marks sit

#ComponentMarks
1Consequences of lengthening3
2Consequences of shortening2
3Trade-off and conclusion1
Total6
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