Credit policy of a company: The perils of too much credit | Value Research Credit Policy: Is too much credit harmful to a business? Learn to evaluate a company’s credit policy with this simple ratio.

The perils of too much credit

Learn to evaluate a company's credit policy with this simple ratio

The debtors-to-sales ratio or accounts-receivable-to-sales ratio is a handy metric that has to be monitored regularly as it could potentially serve as a warning sign. This ratio is calculated by dividing the accounts receivable by the total sales. It indicates the proportion of consumers who have purchased goods or services on credit rather than paying cash upfront.

Since accrual-based accounting recognises sales regardless of whether or not cash is received, managers can get aggressive and sell on easy terms of credit. This is not a good practice as it risks customers delaying or defaulting on payments later. And therefore, it is important to ensure that there is no sudden unexplained spike in the proportion of customers buying on credit.

One caveat: while this metric only gives us the proportion of sales made on credit, it doesn't talk about the quality of credit. If credit has been given to high-quality customers or if adequate security has been taken from them, there is absolutely nothing wrong with this. Also, it doesn't say anything about the duration of the credit period.

Case in point: Swaraj Engines
Swaraj Engines has reported an increase in its debtors-to-sales ratio from 0.5 per cent in FY20 to 11.5 per cent in FY21. This may not be a problem per se because it only supplies engines to Mahindra & Mahindra, a large profitable company. However, any further increase in this ratio will stretch Swaraj's working capital position. Similarly, in FY21, Paras Defence and Space Technologies reported a debtors-to-sales ratio of 66.2 per cent, which indicates that a very high proportion of the company's customers are buying on credit.

Also in the series:

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Which is better: ROE or ROCE?

How to value an enterprise

What is the cash conversion cycle? Why does it matter?

Why free cash flow is king

Why you should check the current assets

Keep an eye on the liabilities

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