Facing strong competition, a firm adopts a liberal credit policy towards its customers. What is the most likely effect on the firm?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → Its debtors rise, increasing its working capital requirement.
Option (1) Its creditors rise, reducing its working capital requirement. — Incorrect. Creditors are the suppliers to whom the firm owes money. They rise when the firm buys on credit from suppliers. A liberal credit policy is about the credit the firm gives to its customers, so creditors do not change.
Option (2) Its debtors rise, reducing its working capital requirement. — Incorrect. Debtors do rise. But money owed by debtors has not yet come in, so more of the firm’s funds stay blocked. The working capital requirement goes up.
Option (3) Its debtors rise, increasing its working capital requirement. — Correct. A liberal credit policy gives customers more time to pay, so debtors rise. Until they pay, the firm must run its business with its own funds. So it needs more working capital. Strong competition often forces a firm to offer such credit.
Option (4) Its creditors rise, increasing its working capital requirement. — Incorrect. Creditors come from credit the firm takes from its suppliers. More creditors would reduce the working capital requirement, and credit given to customers does not create creditors at all.
Credit allowed to customers raises debtors and the working capital requirement. Credit availed from suppliers raises creditors and lowers it.
NCERT (2026-27 Edition): “6. Credit Allowed: Different firms allow different credit terms to their customers. These depend upon the level of competition that a firm faces as well as the credit worthiness of their clientele. A liberal credit policy results in higher amount of debtors, increasing the requirement of working capital.” “7. Credit Availed: Just as a firm allows credit to its customers it also may get credit from its suppliers. To the extent it avails the credit on purchases, the working capital requirement is reduced.” |