What are the positive and negative effects of a credit policy on the cash conversion cycle and revenues? Please explain in detail!
Definition of Cash Conversion Cycle from Investopedia:
“The cash conversion cycle (CCC) is one of several measures of management effectiveness. It measures how fast a company can convert cash on hand into even more cash on hand. The CCC does this by following the cash as it is first converted into inventory and accounts payable (AP), through sales and accounts receivable (AR), and then back into cash. Generally, the lower this number is, the better for the company. Although it should be combined with other metrics (such as return on equity and return on assets) it can be especially useful for comparing close competitors because the company with the lowest CCC is often the one with better management.”
In short, CCC is the time elapsed when the company buys the raw material, changes it to inventory, sells it to customers and receives the cash into its coffers. The lower the CCC, the better for the business and revenues.
Every firm seeks to lower the CCC but because of the nature of nowadays trade system, when selling goods one to another, firms do not expect to receive the payment for goods sold immediately. The unpaid bills, or trade credit, constitute the most of a firm’s accounts receivable. The remainder is called consumer credit, which are bills awaiting payment from the final customer. Therefore, any firm must have a credit policy to deal with its customers encompassing four main aspects:
1. Terms of sales. Cash on Delivery (COD) or Cash before delivery (CBD) may be suitable for irregular customers, but most of the transactions are made on credit, that is, the customer receives the goods and will ...