P2.2 Flashcards
Set of rules that includes the firm’s credit period, discounts, credit standards, and collection procedures offered
Credit policy
Four variables of credit policy
Credit period
Discounts
Credit standards
Collection policy
Length of time customers are given to pay for their purchases
Credit period
Customers prefer longer credit period, so lengthening the period will stimulate sales.
Credit period
Price reductions given for early payment
Discounts
This specifies what the percentage reduction is and how rapidly payment must be made to be eligible for this
Discount
Financial strength customers must exhibit to qualify for credit.
Credit standard
Factors considered for business customers include ratios such as the customer’s debt and interest coverage ratios, the customer’s credit history
Credit standards
Degree of toughness in enforcing the credit terms
Collection policy
Why credit policy important?
Major effect on sales
Influences the amount of funds tied up in receivable
Affects bad debt losses
Debt arising from credit sales and recorded as an account receivable by the seller and as an account payable by the buyer
Trade credit
Types of trade credit
Free trade credit
Costly trade credit
Trade credit that is obtained without a cost, and it consist of all trade credit that is available without giving up discount.
Free trade credit
Trade credit over and above the free trade credit
Costly trade credit
Nominal annual cost of trade credit
[Discount÷(100-discount)]×[365÷(days credit is outstanding-discount period)]
Effective annual rate (EAR) or effective annual cost of trade credit
First answer and the second answer is the exponent then less than one.
Important source of short-term financing for business organizations, evidenced by promissory notes
Bank loans
Document specifying the terms and conditions of a loan including the amount, interest rate, and repayment schedule
Promissory note
Key feature of most promissory notes
Amount
Maturity
Interest rate
Frequency of principal and interest payments
Collateral or security for loans
Vary for different types of borrowers at any given point in the time and for all borrowers over time
Cost of bank loans
Issued by small enterprises
Promissory notes
Issued by big companies
Commercial paper
Loans that has a collateral
Secured loan
General classes of receivables
Trade receivables
Non-trade receivables
Refers to claims arising from the sale of merchandise or services in the ordinary course of business operations
Trade Receivables
Represent claims arising from sources other than the sale of merchandise or services in the ordinary course of business
Non-trade receivables
Factors that affect the size of receivables
Term credits
Paying practices of the customers
Collection policies
Volume of credit sales
Level of accounts receivable depends on the length of the term of credit; common expectation is that the longer the term of sale, the higher the level of account receivable
Term credit
Firms with customers who prolong payments are expected to have a higher level of receivables
Paying practices of the customer
Firms with lenient collection policy have higher levels of receivables than firms with a stricter collection policy
Collection policies
Firms that mostly grant sales on credit have a higher level of receivable
Volume of credit sales
The process of determining, handling, and administering accounts receivables related to sale and credit policies
Account Receivables Management
One of the factors that influence account receivable; exists from the time goods are sold or services are rendered on account
Float on receivable
Purposes why firms invest in account receivables
Increase current sales volume
Retain the current sales
Possible costs to be expected by the company
Bad debt expense
Variable and fixed cost
Cost of capital
Cash discount
Credit policy
A/R with the possibility of non-collection by the firm selling good or services
Bad debt expense
Incurred when companies grant credits to customers who do not have a good credit standing, or customers who fail to pay their obligation because of a downturn in the economy
Bad debt expense
As sales increase, variable cost also increase. Fixed cost, on the other hand, do not change as long as they are within the relevant range
Variable and fixed costs
As the level of account receivables rises, the cost of funds invested in the accounts receivable also increases. The concept of cost of capital in the account receivable is the same as the concept of placing money in a special time deposit
Cost of capital
Normally given to entice prompt payment of obligation
Cash discount
Results to a decline in net income due to a deduction of cash discount from the invoice price
Cash discount
The ain idea is to accelerate the cash inflows and to reduce the level of level of account receivable
Cash discount
Influences a firm’s sales, cost of sales and profit
Credit policy
Credit policy tend to result to a higher volume of sales due to a higher baseline of customer; higher cost is also imminent
Lax Credit policy
Credit policy will have a lower baseline because trade credits are given only to customers with high credit standard; results, to less cost and risk in the process
Tighter credit policy
Establishes a firm’s proposal on how the goods and services are to be sold
Term credit
The length of time in which the credit sales are allowed
Credit period
A deduction from the account receivable provided that the customer paid its obligation within the discount period
Cash discount
The length of time in which the cash discount is offered
Discount period
Means that a more lenient term than from the existing practice of the company is implemented
Relaxing term credit
Company should determine whether the rate if return on the incremental income against the incremental capital is greater than or equal to the minimum required rate of return
Relaxing term credit
Difference between the proposed increase and the current working capital requirement
Incremental working capital requirement
Incremental income÷ incremental working capital requirement
Minimum required rate of return
Incremental net income÷incremental working capital
Rate of return
A firm may consider offering credit to customers with higher-than-normal risk rating. However, instead of offering a longer credit period, the firm will offer a shortened period compensated by a discount
Shortening credit period
Guideline followed by the company in giving credit sales to customer
Credit standards
Refers to the financial strength and credit worthiness a customer must exhibit in order to qualify for credit
Credit Standard
Customer does not qualify the regular credit term, they still purchase from the firm under??
More restrictive term
Uncertainty that the party on the other side of the negotiation will abide by the agreement
Credit risk
Five C’s of Credit
Character
Capacity
Capital
Condition
Collateral
Refers to the moral and ethical quality of the individual who is responsible for paying the loan
Character
Applicant’s ability to pay off the credit extended, as judged by the financial statement analysis focusing on cash flows available to pay debt obligations
Capacity
Level of financial resources available to the company seeking the loan
Capital
Current general and industry-specific economic states, and any unique situation surrounding a specific transaction
Conditions
Consist of assets pledged by the customer; also includes economic value of these assets in the case of default
Collateral
Sources of credit information
Financial statements
Credit-rating agencies
Commercial bank
Trade checking
