Credit Standards – II

At any point of time the company would be interested in examining the effect of change in credit standards. This is done by comparing the profitability generated by lowering down the credit standards and the added cost of accounts receivable. So long as the profitability is more than the added cost the company can lower down the credit standards. It is important to determine the costs of lowering down the credit standards and also to find out the impact on profitability of the company. Lowering down of the credit standards would have the following effects. 

• Increase in average collection period
  
• Increase in sales
  
• Increase in account receivable investment
  
• Increase in bad debt losses
  
• Increase in servicing cost of account receivable.

 

The effect of lowering down the credit standards on key variables such as sales and investment in accounts receivable can be quantified and can be used in analyzing the cost vs. benefits of such changes. Lowering down investment in life insurance is not lowering down credit standards. At the same time the costs such as increase in bad debt losses and increase cost of monitoring and servicing the accounts receivable should also be considered. It may be very difficult for the firm to make any distinction between the credit standards for new customers and existing customers. Relaxing the credit standards for the new customers would have certainly some impact on the payment behavior of existing customers. The firm may experience all this in increase in average collection period.