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Not sure if you should extend the credit period you offer customers? This practical example will help you decide

by , 23 April 2014
One of the crucial steps you need to take when managing debtors is to determine the credit period you offer to customers (when they need to pay). If you've already set a credit period in your credit policy, and are considering extending it, read on for a practical example that can help you with this.

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Should you extend customer credit or not? That is the question…

Below, the Practical Accountancy Loose Leaf gives a practical example that may help you decide whether or not you should extend the credit period you offer to customers

Example: Right now, Russian Beard LTD offers one month credit, but the company is considering changing it to two.

It's doing this because it expects credit relaxation to produce an annual increase in sales equal to 25% of its current sales volume. This because:

Selling price per unit R10

Variable cost per unit R8.50

Current annual sales R2 400 000

The required Return on Investment is 20%.

Let's assume the 25% increase in sales results in R100 000s worth of additional stocks and R20 000s worth of additional creditors.

Now the big question is: Should Russian Beard extend the credit period they offer to customers if:

  • All customers take the longer, two-month credit;
     
  • Existing customer don't change their payment habits and only new customers take a full two-month credit period.

Let's have a look at the solution: According to the loose-leaf, changing the credit policy only make sense if the rate of return on the additional investment in working capital is more than 20%:

Extra profit:

Contribution/sales ratio (profit margin): 15%

Increase in sales revenue R600 000 (i.e. R2.4m x 25%)

Increase in contribution and profit: R90 000

a) Take a look at the extra investment if all debtors take two months credit

Average debtors after the sales increase (2/12 x R3 000 000) R500 000

Less current average debtors (1/12 x R2 400 000)           R200 000

Increase in debtors                                                                  R300 000
Increase in inventory                                                               R100 000
                                                                                                     R400 000

Less increase in creditors     R20 000

Net increase in working capital investment   R380 000

Return on extra investment                        R90 000 = 23.68%
                                                                         R380 000


b) Take a look at the extra investment if only the new debtors take two months credit

Increase in debtors (2/12 of R600 000)    R100 000

Increase in stocks                                         R100 000

                                                                         R200 000

Less increase in creditors                           R20 000

Net increase in working capital investment R180 000

Return on extra investment = 50%

 

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The bottom line: In both cases (a) and (b), the new credit policy is worthwhile because the return on investing the additional capital increases. And that's exactly what you should consider if you're looking at extending the credit period you offer to customers. Only do it if it's worth your while financially.



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