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Lenient Trade Credit Policy

Discuss the benefits and costs of instituting a more lenient trade credit policy. Why might firms decide to do this?

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RESPONSE:

1. Discuss the benefits and costs of instituting a more lenient trade credit policy. Why might firms decide to do this?

Indeed, trade credit has long been an important source of financing for corporations. One possible reason for misconceptions about trade credit is that it is not primarily financial in nature, but instead reflects production and marketing decisions. One measure of trade credit policy used in the research is each firm's days of sales outstanding, DSO, computed as accounts receivable per dollar of daily sales (see abstract at the end of this response for further discussion).

Some of the reported advantages of instituting a more lenient trade credit policy are to differentiate their products, guarantee or signal of quality products, firm reputation and to encourage product demand. The main disadvantages are: lower profit margins and increased bad debt. Thus, a firm with a variable demand, often initiates a more lenient trade credit policy, for example, to encourage product demand. It is also used for quality products, which take a longer time to manufacture due to the quality and testing, etc. And, smaller firms with a smaller proportion of fixed assets, and those that are less profitable often extend more trade credit.

Let's look at some of the theories and research to support these ideas.

There are different theories, however, about trade credit policy. The product differentiation hypothesis for trade credit, for example, says that business managers use trade credit like advertising to differentiate their products. Prior studies of this hypothesis conclude that higher profit margins induce managers and firms to increase trade credit and vice versa. (http://links.jstor.org/sici?sici=0046-3892(199324)22%3A4%3C117%3ATCQGAP%3E2.0.CO%3B2-O#abstract).

As mentioned above, managers use a trade credit as a way to guarantee product quality, rather than as a means of financing less creditworthy firms. Thus, a more lenient trade credit policy is often linked to higher quality goods, with the idea that it takes longer to produce quality goods. Managers also adjust trade credit and profit margins for a perturbation in marginal costs. A lenient policy, with increased trade credit is also used to maintain revenue by encouraging product demand. However, Blazenko and Vandezande (2003) contradicted this relationship, however, ...

Solution Summary

This solution discusses the benefits and costs of instituting a more lenient trade credit policy and reasons why firms might decide to do this.

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