VIDYA VIKAS MANDAL’S

SHREE DAMODAR COLLEGE OF COMMERCE & ECONOMICS

POST-GRADUATE DEPT OF COMMERCE

M.COM PART-1, SEM- 1

ISA-3

NAME – SRISHTI PATEL

ROLL NO. – 2029

SUBJECT- ADVANCE FINANCIAL MANAGEMENT

TOPIC: EVALUATION OF CREDIT POLICY

SUBJECT TEACHER- MS. SHERYL DA SILVA, ASST. PROFESSOR,

DEPT. OF COMMERCE (M.COM)

DATE OF SUBMISSION: 11 TH DECEMBER 2020

CREDIT POLICY

A credit policy is a framework that outlines quantum of credit to be granted to customers. It also takes
into account guidelines for collection of accounts in arrears. These decisions directly impact the working
capital requirements and bad debts losses and hence it plays an important role in finances of a business.

EVALUATION OF CREDIT POLICY

A company must adopt a proper credit policy after systematic evaluation of various alternatives available
to them, so as to reach optimum level of profits. The selection of appropriate policy for a company is one
of the vital tasks of finance manager. Every credit policy will result in particular turnover level. Normally,
longer the credit period, higher will be the turnover, and therefore, larger would be the profit of the
company and vice versa.

Although, the increase in turnover will result in higher contribution, concomitantly, company will face
hike in other costs. These costs may include:

1. Increase in investments in debtors (Opportunity cost of investment in debtors)

Generally, higher amount of outstanding debtors are result of increase in credit period, which
simultaneously results in blockage of company’s fund in debtors, which may earn a return if
invested somewhere else (opportunity cost for additional investment). So, increase in the cost of a
company is the result of higher debtors.
2. Increase in bad debtors
More customers are attracted towards the company which follows longer credit period policy. The
firm will have to suffer the cost of bad debts, when some customers turns out to be defaulters. So,
longer the credit period, higher will be the sales which concomitantly increases the chances of bad
debts.
3. Other costs
Increase in the debtors is bundled with some other expenses too which may include:
i. Cost of collection such as factoring fees etc.
ii. Administrative costs such as cost of investigation of creditworthiness
iii. Defaulting costs such as partial recovery on account of full settlement or discount on
prompt payment
So, with increase in credit period the company enjoys the benefit of higher profit on one hand, while on
the other hand, the company has to suffer some additional costs. The company must opt for the policy
which gives them highest net profits. While evaluating the different credit policy the comparison of the
cost and benefits related to each credit policy must be done.
To understand the evaluation of credit policy following example is considered;

Damodar traders whose present sales are 12 lakhs per annum and an average collection period
of 30 days wants to adopt a more liberal policy with a view to enhance sales revenue. The selling
price per unit is Rs. 6, the average cost per unit is Rs. 4.5 and variable costs per unit are Rs. 4.
The current level of bad debts loss is 1%. The required rate of return on additional investment
is 20%. A study executed by a management consultant reveals the following information:

1. Credit policy A- Increase in collection period by 10 days – increase in sales by Rs. 60,000-
present anticipated default rate 1.5%.
2. Credit policy B- Increase in collection period by 45 days – increase in sales by Rs. 1,80,000-
present anticipated default rate 4%

Evaluate the different credit policy.

Solution

Evaluation of Credit Policy

Particulars Present Policy Credit Policy A Credit Policy B

 
Amount(Rs.) Amount(Rs.) Amount(Rs.)
Credit Sales 12,00,000 12,60,000 13,80,000
No. of Units 2,00,000 2,10,000 2,30,000
Variable cost 8,00,000 8,40,000 9,20,000
Fixed cost 1,00,000 1,00,000 1,00,000
Total cost 9,00,000 9,40,000 1.30,000
Bad debts losses 12,000 18,900 55,200
Expected Profits (A) 2,88,000 3,01,100 3,04,800
Total cost 9,00,000 9,40,000 10,20,000
Collection period 30 40 75
Rate of Return 20% 20% 20%
Opportunity Cost (B) 15,000 20,889 42,500
Net Benefits/ Profits (A-B) 2,73,000 2,80,211 2,62,300

Working Note

I. Fixed cost = [ Average Cost per unit – Variable Cost per unit] x No. of units sold
= [4.5 – 4] x 2, 00,000
 = Rs. 1, 00,000
Note: Fixed cost remain fixed for all the levels of production.

II. Opportunity cost = Total cost x Collection period x Rate of return

360 100

Present policy = 9,00,000 x 30 x 20 = Rs. 15,000

360 100

Credit policy A = 9,40,000 x 40 x 20 = Rs. 20,889

360 100

Credit Policy B = 10,20,000 x 75 x 20 = Rs. 42,500

360 100

As it can be observed, increase in credit period leads to higher level of sales but at the same time there is
addition to the bad debts losses and opportunity cost of investment in debtors, resulting the net expected
benefits to fall after a certain level of increase. Hence credit policy A justifies the purpose and thus must
be opted.