Question

Describe the incremental analysis approach for evaluating a proposed credit policy change. How can risk be incorporated into the analysis?

As a general rule, is it more likely that a company would increase its profitability if it tightened or loosened its credit policy? Explain.

Answer 1

1. Analysis of proposed credit policy changes using incremental approach:

To evaluate the change in the credit policy alternative projected income statements can be compared. One can also develop data that shows an incremental effect of the proposed change without developing the financial statements. The second approach is more preferable because the firm would change the credit policies in specific divisions or products & not throughout the board. It may not be possible to develop corporate income statements. But the two approaches are based on the same data & hence must produce the same results.

In case of incremental analysis, an attempt is made to determine both increase and decrease in the costs & sales that are associated with given tightening of credit policy. Incremental profit is nothing but the difference between incremental sales & incremental costs. If the expected incremental profit is positive & is sufficient for compensating the risks involved then the proposal to change the credit policy can be accepted.

2. An optimum credit policy is something that can maximize the firm’s value. This value is maximized when the incremental rate of return also known as the marginal return is equal to the marginal cost of capital used to finance the firm’s investment. The required rate of return is not equal to the borrowing rate. More the risk on investment more the required rate of return.

A firm’s profit is maximized when the total cost is minimized for a given level of revenue. If the firm is loosening its credit policy then the position of accounts receivable becomes more risky because of increase in slow paying & defaulting accounts.

In sum, we may state that the goal of the firm’s credit policy is to maximize the value of the firm. To achieve this goal, the evaluation of investment in accounts receivable should involve the following four steps:

• Estimation of incremental operating profit
• Estimation of incremental investment in accounts receivable.
• Estimation of incremental rate of return of investment.
• Comparison of the incremental rate of return with the required rate of return.