Companies formulate credit terms to determine various variables used to offer credit to customer in purchasing goods and services (Lee, & Lee, 2006). Credit terms usually address percentages of discounts that the customer should be offered upon purchase of certain quantities of a product. These terms also express the number of days that are allowed before the payment of the products is made by customers. Credit terms also specify penalties that the customer will be liable to pay in case of delayed payments. A company should consider various factors when formulating credit terms to its customers. The company should consider its cash-flow position and industry in which it operates. The company should also analyse credit terms that its supplier is offering (Lee, & Lee, 2006).
Reasons for offering credit terms to customer
Companies offer customer with credit services on a number of reasons. There are two major reasons why companies are more than willing to grant customers goods on credit terms. The most important reason why companies do this is to enhance marketing (Lee, & Lee, 2006). Companies are conscious that customers are more willing to buy on credit terms than on cash terms. Furthermore, the company managers are aware that competitors use credit terms to lure customer into buying their products. Therefore, company finance and marketing managers work hand in hand to determine the most attractive credit terms that the company can offer its customer. The rationale of offering company goods and services to customer on credit terms is the general understanding that not all customers have the capacity to buy goods on cash payments (Lee, & Lee, 2006). Additionally, selling goods on credit to customers induces customers to buy more products. This enables the company to increase volumes of products sold. The ultimate result of credit facilities to the customer is that companies are able to achieve their marketing goals (Vishwanath, 2006).
The second reason for offering credits to customers is for the company to consolidate its market share. Offering goods and services on credit serves a greater benefit by establishing customer loyalty. Companies offer constant credit to customers as a strategy especially in the manufacturing industry to consolidate customer base. Credit sales have a direct link to increase in company profitability (Lee, & Lee, 2006). The growth in company revenues, when compared to other competitors, results to the company acquiring substantive competitive advantage in the market place. Credit terms also help the company to expand vertically. The revenues generated can be used to gain strategic access to vital raw materials from supplier. This situation is common where there are few suppliers of raw material and a large number of manufacturing firms competing for one common resource. The revenues generated can be used to acquire large volumes of raw material (Lee, & Lee, 2006).
Importance of cash
From the study carried out, it has been established that cash is not important in financial management of companies. Cash is neither profit nor loss to a company. Cash takes two forms. Cash can either be in the form of cash in-flow or assets. Cash flow only earns when it is in use, and it has no economic value when left idle. When cash is in-flow, it contributes greatly to a business enterprise (Bhattacharyya, 2004). On the other hand, idle cash does not contribute to any earning for the business.
Business assets, such as machines and equipment, are very vital to the overall profitability of a company. However, they cannot be compared comprehensively to the role played by cash in the overall business profitability (Bhattacharyya, 2004). Companies cannot afford to let such fixed assets remain idle for long since it negatively affects the revenues. Without cash, companies cannot afford to pay suppliers and salaries of its workers. Cash is similar to fixed assets. In this case, if left idle, the cash may have a negative impact on company revenues. When a company buys a new machine, the machine should be used. If this is not the case, the company is going to incur a fixed cost and depreciation. Similarly, if cash is left idle, it has an impact on company profitability. Basing on the above arguments, cash can be seen as a lifeline of most companies and thus cannot be ignored. According to Bhattacharyya (2004), “growth of business depends upon cashability of profits, not profits per se as reflected in the income statement,” (p.257). From this argument, cash should not be disregarded by companies during financial management planning. Companies should realise the importance of cash in the overall in the operation of business enterprises.
It is important for companies to consider offering goods and services to customers on credit. Credit contributes to increases in volumes of sales of the company and plays a major role in enabling the company to acquire competitive advantage in the marketplace. Therefore, company managers should develop proper credit terms to attract customers. As discussed above, companies should not neglect cash during financial management and planning. The role played by cash in the profitability of the company cannot just be ignored by managers in financial management. Managers should recognise the role of cash as a crucial component in financial management.