The cost of giving credit and changing your credit terms arises principally from four sources: increase in bad debts, loss of profit due to discounted settlement terms, financing cost of trade receivables, and any loss in overall sales. You would need to quantify these to determine the cost of giving credit.

The following is a relatively simple method to do this. Note that it is based on estimates, which might not be readily available for you.

Assume you change your credit terms from 3/10 net 30 (3% discount within 10 days payment, normal terms are 30 days) to 5/15 net 60. You estimate that credit sales will increase from 40% to 60%, the number of credit customers taking the discount increases from 20% to 30%, and bad debts of total sales increases from 2% to 5%. Existing debtors days is 20 days, and new debtors days is 28 days. The cost of financing debtors remains the same at 10% (the before tax opportunity cost of working capital/financing; use after tax if you are considering long-term change). You also estimate total sales increases by 20% from CU100m to CU120m, and your gross profit margin remains the same at 30%.

Your cost would be the following:

**Cost = xGP - xBD - xD - xTR**

where,

x = change,

GP = gross profit

BD = cost of bad debts

D = cost of settlement discount

TR = cost of trade receivables

**xGP** = 120m*30% - 100m*30% = 6m

**xBD** = 3%*120m - 2%*100m = 1.6m

**xD** = 5%*30%*60%*120m (because 60% of sales are now on credit, and 30% of these take the settlement discount of 5%) - 3%*20%*40%*100m = 1.08 - 0.24 = 0.84m

**xTR** = the cost of financing **current** debtors and **new** debtors.

Cost of financing current debtors is done by using the increase in debtor days:

(8 days*100m / 365)*10% = 0.22m**

The cost of financing new debtors is done by using the cost of an increase in sales at new debtor days (i.e., new debtor days * sales change * (1-GP margin); in this case, it will cost us 70% of sales (as GP margin is 30%) to finance the 20m increase in sales):

(28 days*20m*70%/365)*10% = 0.11m

Therefore, xTR = 0.11m + 0.22m = 0.33m

Thus, the cost of changing your credit terms is = 6m - 1.6 - 0.84 - 0.33 = 3.23m

With this, you should change your policy, as you will be receiving a benefit of CU3.23m.

I hope this helps. Rather get an understanding of the concept behind the above, as opposed to copying and pasting the calculation within your own business, as the methods by which you derive the estimates used in the example could vary. The principle remains the same, though.

** Note we divide by 365 here as we are using debtors days to work out the cost of trade receivables. Debtors days are calculated as follows:

Debtors days = (Trade receivables/Sales)*365

We rework the formula as follows:

Trade receivables = (Debtors days * Sales)/365