The average collection period depends on:
a) Credit standards which is the maximum risk of acceptable credit accounts
b) Credit period which is the length of time for which credit is granted
c) Discount given for early payments
d) The firm’s collection policy.
a) CREDIT STANDARDS
A firm may follow a lenient or a stringent credit policy. The firm following a lenient credit policy tends to sell on credit to customers on a very liberal terms and credit is granted for a longer period.
A firm following a stringent credit policy on the other hand, sell on credit on a highly selective basis only to those customers who have proven credit worthiness and who are financially strong.
A lenient credit policy will result in increased sales and therefore increased contribution margin. However, these will also result in increased costs such as:
Increased bad debt losses
Opportunity cost of tied up capital in receivables
Increased cost of carrying out credit analysis
Increased collection cost
Increased discount costs to encourage early payments
The goal of the firm’s credit policy is to maximise the value of the firm. To achieve this goal, the evaluation of investment in receivables should involve the following steps:
Estimation of incremental operating profits from increased sales
Estimation of incremental investment in account receivable
Estimation of incremental costs
Comparison of incremental profits with incremental costs
b) CREDIT TERMS
Credit terms involve both the length of the credit period and the discount given. The terms 2/10, n/30 means that a 2% discount is given if the bill is paid before the tenth day after the date of invoice otherwise the net amount should be paid by the 30th day.
In considering the credit terms to offer the firm should look at the profitability caused by longer credit and discount period or a higher rate of discount against increased cost.
Varying the discount involves an attempt to speed up the payment of receivables. It can also result in reduced bad debt losses.
d) COLLECTION POLICY
The firm’s collection policy may also affect our analysis. The higher the cost of collecting account receivables the lower the bad debt losses. The firm must therefore consider whether the reduction in bad debt is more than the increase in collection costs.
As saturation point increased expenditure in collection efforts does not result in reduced bad debt and therefore the firm should not spend more after reaching this point.