Page 169 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes trade credit. In other words, it increases investment in receivables and bad debt loss.
On the other hand, shortening of the credit period (existing) will lead to lower sales,
decrease investment in debtors, and reduce the bad debt loss. A firm should finalize
the decision relating to credit period [either lengthening or shortening credit period]
only after cost, benefit analysis. If the change in net profit is positive, it is better to
go for credit period and vice versa.
(b) Cash Discount: The second part of credit terms is cash discount. Cash discount represents
a percent reduction in sales or purchase price allowed for early payment of invoices.
It is an incentive for credit customers to pay invoices in a timely fashion. In other
words, it encourages the customers to pay credit obligations within a specified
period of time, which will be less than the normal credit period. It is generally
stated, as percentage of sales. Cash discount terms specify, the repayment terms
required of all credit customers, which involve rate of cash discount.

Example: ‘2/20 net 60’, which means creditor (sells) grants 2 per cent discount, if debtor
(buyer) pays his/her accounts with 20 days after beginning of the credit period.
Financial managers before going to offer cash discount, he/she is suppose to estimate
the change in net profit, it is positive, then he can go for providing cash discount and
vice versa.
(c) Cash Discount Period: It refers to the duration in which the discount can be availed
from collection of receivable and is influenced by the cash discount period. Extension
of cash discount period may prompt some more customer to avail discount and
more payments, which will release additional funds. But extension of cash discount
period will result in late collection of funds, because the customers who are able to
pay will have less cash discount thus now they may delay their payments. It will
increase collection period of the firm. Hence, financial manager has to match the
effect on collection period of the firm. Hence, financial manager has to match the
effect on collection period with the increased cost associated with additional
customers availing the discount.
3. Collection Policy: This is the third aspect in receivables management. The collection of a
firm is the procedures passed to collect amount receivables, when they become due. It is
needed because all customers do not say the bill receivables in time collection procedures
includes monitoring the state of receivables, dispatch of letters to customers whose due
date is approaching, electronic and telephonic advice to customers around the due date,
thereat of legal action to overdue customers, and legal action against overdue accounts.
Customers may be divided into two categories such as slow payer and non-payers. Hence,
there is a need for accelerating collections from slow payers and reduce bad debt losses.
Collection policies may be divided in to two categories:
(a) Strict/rigorous, and

(b) Lenient/lax collection policy.
Adoption of strict collection policy tends to decrease sales, reduces average collection
period, bad debt percentage, and increases the collection expenses. On the other hand,
lenient collection policy will increase sales average collection period, bad debt losses, and
reduce collection expenses. Financial manager has to see the benefits and costs from
adopting one credit policy, if the change in net profit is positive, he/she has to go with
new credit policy and vice versa.

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