Receivables are near the terminating point of the operating cycle. When raw material has been converted into finished goods, the final product is sold by the firm. Some of the sales are done on a spot basis while the remaining sales are made on credit. The extent of credit sales varies from industry to industry and within an industry. The period of the credit depends upon the position of the firm in the industry. If the firm has a monopoly position, a period of credit would be very low. If the industry consists of a large number of players in keen competition with each other, the period of credit would tend to be fairly long. Also, during periods of demand recession, even a firm in a monopoly the situation might be forced to extend credit in order to promote sales.
Receivables are generally referred to by the name of “Sundry Debtors” in the books of account, Strictly speaking, Sundry Debtors refer to receivables created in the course of operation of the working capital cycle, i.e. those persons which owe payment to the firm for goods supplied or services rendered. Thus sundry debtors represent an intermediate stage between reconversion of finished goods into cash. So long as the sundry debtors persist, the firm is strained of cash. So, logically the firm seeks to minimize the level of sundry debtors.
The period of credit allowed to debtors also depends upon the industry practice. This period of credit has two components. The first component is a small period of a week to ten days which is normally allowed in all industries and no interest is charged on the amount due. The second component is the larger one, the length of which varies from industry to industry, and interest is usually charged for this period. In the alternative, the firm may charge full invoice value for payment made after the credit period and allow a discount for spot payments.
Apart from the Sundry Debtors, the cash flow of the firm is also affected by Loans and Advances made to suppliers, subsidiaries, and others. These advances are not exactly working capital advances but nevertheless, these are treated as current assets because these are assumed to be recoverable or converted into inventory, fixed assets, or investments within one year.
Credit policy can have a significant influence on sales. In theory, the firm should lower its quality standard for accounts accepted as long as the profitability of sales generated exceeds the added costs of the receivables. What are the costs of relaxing credit standards? Some arise from an enlarged credit department, the clerical work of checking additional accounts and servicing the added volume of receivables. We assume for now that these costs are deducted from the profitability of additional sales to give a net profitability figure for computational purposes. Another cost comes from the increased probability of bad-debt losses.
To assess the profitability of a more liberal extension of credit, we must know the profitability of additional sales, the added demand for products arising from the relaxed credit standards, the increased slowness of the average collection period, and the required return on investment. Suppose a firm’s product sells for ` 10 a unit, of which `8 represents variable costs before taxes, including credit department costs. The firm is operating at less than full capacity, and an increase in sales can be accommodated without any increase in fixed costs. Therefore, the contribution margin of an additional unit of sales is the selling price less variable costs involved in producing the unit, or `10 – `8 = `2.