The Credit Period

The credit period is the basic length of time for which credit is granted. The credit period varies widely from industry to industry, but it is almost always between 30 and 120 days. If a cash discount is offered, then the credit period has two components: the net credit period and the cash discount period.

The net credit period is the length of time the customer has to pay. The cash discount period is the time during which the discount is available. With 2/10, net 30, for example, the net credit period is 30 days and the cash discount period is 10 days.

The Invoice Date The invoice date is the beginning of the credit period. An invoice is a written account of merchandise shipped to the buyer. For individual items, by convention, the invoice date is usually the shipping date or the billing date, not the date that the buyer receives the goods or the bill.

Many other arrangements exist. For example, the terms of sale might be ROG, for receipt of goods. In this case, the credit period starts when the customer receives the order. This might be used when the customer is in a remote location.

With EOM dating, all sales made during a particular month are assumed to be made at the end of that month. This is useful when a buyer makes purchases throughout the month, but the seller only bills once a month.

For example, terms of 2/10th, EOM tell the buyer to take a 2 percent discount if payment is made by the 10th of the month; otherwise the full amount is due. Confusingly, the end of the month is sometimes taken to be the 25th day of the month. MOM, for middle of month, is another variation.

Seasonal dating is sometimes used to encourage sales of seasonal products during the off-season. A product sold primarily in the summer (suntan oil?) can be shipped in January with credit terms of 2/10, net 30. However, the invoice might be dated May 1, so that the credit period actually begins at that time. This practice encourages buyers to order early.

Length of the Credit Period Several factors influence the length of the credit period. Two important ones are the buyer's inventory period and operating cycle. All else equal, the shorter these are, the shorter the credit period will be.

From Chapter 19, the operating cycle has two components: the inventory period and the receivables period. The buyer's inventory period is the time it takes the buyer to acquire inventory (from us), process it, and sell it. The buyer's receivables period is the time it then takes the buyer to collect on the sale. Note that the credit period we offer is effectively the buyer's payables period.

By extending credit, we finance a portion of our buyer's operating cycle and thereby shorten that buyer's cash cycle (see Figure 19.1). If our credit period exceeds the buyer's inventory period, then we are not only financing the buyer's inventory purchases, but part of the buyer's receivables as well.

Furthermore, if our credit period exceeds our buyer's operating cycle, then we are effectively providing financing for aspects of our customer's business beyond the

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VII. Short-Term Financial Planning and Management

21. Credit and Inventory Management

© The McGraw-Hill Companies, 2002

CHAPTER 21 Credit and Inventory Management immediate purchase and sale of our merchandise. The reason is that the buyer effectively has a loan from us even after the merchandise is resold, and the buyer can use that credit for other purposes. For this reason, the length of the buyer's operating cycle is often cited as an appropriate upper limit to the credit period.

There are a number of other factors that influence the credit period. Many of these also influence our customer's operating cycles; so, once again, these are related subjects. Among the most important are:

1. Perishability and collateral value. Perishable items have relatively rapid turnover and relatively low collateral value. Credit periods are thus shorter for such goods. For example, a food wholesaler selling fresh fruit and produce might use net seven days. Alternatively, jewelry might be sold for 5/30, net four months.

2. Consumer demand. Products that are well established generally have more rapid turnover. Newer or slow-moving products will often have longer credit periods associated with them to entice buyers. Also, as we have seen, sellers may choose to extend much longer credit periods for off-season sales (when customer demand is low).

3. Cost, profitability, and standardization. Relatively inexpensive goods tend to have shorter credit periods. The same is true for relatively standardized goods and raw materials. These all tend to have lower markups and higher turnover rates, both of which lead to shorter credit periods. There are exceptions. Auto dealers, for example, generally pay for cars as they are received.

4. Credit risk. The greater the credit risk of the buyer, the shorter the credit period is likely to be (assuming that credit is granted at all).

5. Size of the account. If an account is small, the credit period may be shorter because small accounts cost more to manage, and the customers are less important.

6. Competition. When the seller is in a highly competitive market, longer credit periods may be offered as a way of attracting customers.

7. Customer type. A single seller might offer different credit terms to different buyers. A food wholesaler, for example, might supply groceries, bakeries, and restaurants. Each group would probably have different credit terms. More generally, sellers often have both wholesale and retail customers, and they frequently quote different terms to the two types.

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