Page 264 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes The implication of relaxed credit standards is more credit, a larger credit department to service
accounts and related matters and increase in collection costs.
A relaxation in credit standard implies an increase in sales, which in turn, leads to higher
average accounts receivables. Further, relaxed standards would enable credit to get extended to
even less creditworthy customers, resulting in longer period to pay over dues. The reverse will
happen if credit standards are tightened.
Further, changing credit standards can also be expected to change the volume of sales. As
standards are relaxed, sales are expected to increase; conversely a tightening is expected to cause
a decline in sales.

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Caution It must be kept in mind that with relaxation in credit standards, bad expenses will
go up.
The effect of alternative credit standards is illustrated in the following example:

Example: A firm is currently selling a product at 10 per unit. The most recent sales (all
credit) were 60,000 units. The variable cost per unit is 6 and the average cost per unit given a
sales volume of 60,000 units is 8. The firm’s total fixed cost is 120,000. The average collection
period may be assumed to be 30 days.
The firm is contemplating a relaxation of credit standards that is expected to result in a 15 per
cent increase in rupee sales. The average collection would increase to 45 days with no change in
bad debt expenses. The increase in collection expenses may be assessed to be negligible. The
firms required return on investment is 15 per cent.

Should the firm relax the credit standard?
Solution:
Current Plan:

Sales Revenue 60,000 × 10/- 600,000
Less Cost:
Variable 60,000 × 6 360,000
Fixed 120,000 480,000
Profit on Sales 120,000

Less: Interest @ 15% on average receivables
1 month credit period hence avg. receivables

6
æ 8 ´ 60,000 + ´ 9000 ö
Cost of sales ç è 360 ÷ = 40,000 × 0.15 6,000
ø
Net Profit 114,000
Proposed Plan
Sales Revenue 60000 × 1.15 × 10 690,000

Less cost:

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