This variable deals along with the granting of credit. On one great all the customers are granted credit and conversely, none of them are granted credit irrespective of their credit rating, but in nowadays competitive environment it is impossible. Usually liberal credit standards initiate increased sales accompanied through higher incidence of bad debts, tying of funds in accounts receivable and raised cost of credit collection. Tight or stiff credit standards lead to reduced sales, lower incidence of bad debts, reduced investment in accounts receivable and reduced collection cost.
The quantitative consequence of relaxing the credit standards on profit can be estimated through the equation 1:
? NP = [? S (1 - V ) - ? S bn ](1 - t) - k?I ............(1)
Here
? NP = Change in net profit
? S = Increase in sales
V = Ratio of variable cost to sales
bn = Bad debt ratio on new sales
T = Tax rate
K = Cost of capital
? I = raise in receivable investment
? I = (? S/360) . ACP . V
(? S/360) = Average daily change (increase in sales)
ACP = Average collection period
Here let us see how each element of equation 1 affects net profit. ? S (1-V) shows the raise in gross incremental profit, because of relaxed credit standard and for this reason gross profit, is explained as Sales-Variable cost. ? Sbn computes the bad debts upon incremental sales. The first part of the equation [ ? S (1-V) - ? Sbn] (1-t) shows the post tax operating profit arising from of incremental sales and k ? I measures the post tax opportunity cost of capital locked in extra investment on account of relaxed credit standards. The pre-tax operating profit is multiplied via (1-t) so as to get past tax operating profit.