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A business has legal freedom to determine the terms of credit under which it offers its products. These terms can vary from an extreme of demanding that cash shall accompany an order to a billing at a future date with several months allowed thereafter before payment is due. Or sales can be made on an installment contract basis with no down payment and small monthly payments spread over several years. Economically, the freedom of a firm to set its terms of sale is much more limited. Each trade has its customary terms of credit extension, and competitive pressures compel uniformity as to cash discounts, methods of invoicing, and terms quoted. New entrants into a field of activity arc forced to offer at least as favorable treatment as that already being given. The same credit terms are generally quoted to all customers who are "standard credit risks." Less favorable terms ranging down to a cash payment accompanying an order may apply to progressively poorer risks. Sometimes, however, an alteration of credit terms is used as a competitive device in place of price adjustments to add new customers or hold old ones. These are usually granted on a selective basis as economic conditions and competitive pressures demand. Within the framework of a company's established credit policies the amount of receivables held by a firm varies directly with changes in the volume of credit sales. An increase in sales expands receivables and they decline with a reduction in sales, although a decrease in sales due to deteriorating economic conditions also slows collections somewhat. Generally, however, the credit terms of a firm and its credit standards remain fairly constant. Even the payment policies of customers and credit collection practices of the seller are relatively fixed. Assumption of Credit Risks Before a bank lends to a customer it makes a thorough analysis of that customer's credit standing to determine the danger that a loss may occur. Minimizing losses is essential in view of the low rate of interest charged. Finance companies, in turn, demand higher rates of interest, can assume more risks, and expect a higher percentage of losses. Business suppliers can accept still greater degrees of credit risk because of the high comparative margin on which they operate in relation to the credit extended. If a business could sell all the products it produces for immediate cash payments instead of obligations to pay the same amounts in the future there would be no reason for it to incur die cost of extending credit and to assume the risks associated with carrying accounts receivable. Selling on credit, however, is a means of increasing sales and profits, and the terms of that credit are often established by customary practice in each particular trade. A lower price or some other concession is necessary to induce immediate cash payments. It is obvious that a supplier will not extend credit to any customer if it is certain that he will not pay his obligation. However, there are varying degrees of uncertainty, and losses are measured on a percentage basis. A firm must decide the cost of the additional business that can be obtained by extending liberal credit as compared with the additional revenue. This is not to be done with respect to each order as an isolated phenomenon but in terms of continuity. If credit is extended it is to be assumed that there will be a flow of orders except from those customers who do not pay their accounts. This flow of income and its costs, including debt losses, are to be compared with the results if stricter credit procedures are maintained. Moreover, die costs used for these computations are not average costs but the marginal or additional costs associated with the extra business. Therefore, the credit losses may be substantial before the risky business becomes undesirable. Calculations of cost vary, however, with changes in economic conditions. If business conditions are good and the capacity of a firm is almost completely utilized it will not pay to continue poor risks since there are good risk customers to absorb the volume. When business falls off, poorer risks can be taken on—although it must be realized that failures are likely to increase at such a time because of increased competition for a smaller market. Rates of business failure increase at such times. Classof1.com offers Finance Homework Help
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