The answer to this question is depends … depends on what? Many entrepreneurs will be able to answer, it depends on the client, it depends on the industry, it depends on how much credit, for how long, it depends on the cost, etc. Even some would probably answer with a resounding NO.
One of the ways to analyze what the correct answer should be is to analyze these three costs:
Investment in accounts receivable
A good tactic to calculate the investment in accounts receivable is to take annual sales on credit and multiply them by the ratio between the average number of credit days and 360.
If your company sells around $400,000 annually on credit and on average grants 30 days of credit, the investment in accounts receivable is:
Administrative cost of collection
It is the cost that is incurred to operate and manage the credit department of the company.
For example, a collection department for two people, an administrative and a debt collector, with the following salaries:
- Salary of an administrative: $6,000
- Monthly salary of a collector: $2,500
The annual cost of this department would be:
Cost of bad accounts
Usually this is calculated using historical information, and represents the percentage of accounts receivable that could not be collected.
Using the same example, if annual credit sales are around $400,000 and in the last 3 years, the percentage of bad accounts of 2.5% then:To make the decision to grant credit, it must now be evaluated whether it is profitable to sell on credit. For this, it analyzes the contribution of sales to credit compared to the cost that has just been calculated.
In this example, the contribution is less than the cost of giving credit.
Having a credit policy can help grow a company. However, it is very important to understand what the contribution is and the cost. The previous exercise represents an example where giving 30 days of credit is not recommended.
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