Credit Management

SESSION
#9
Credit Management
CF-II (Term III) 2012
#9
Faculty: Prof. Kulbir Singh (IMT-Nagpur)
Slide 2
Key Concepts and Skills
Understand typical credit terms
Understand the process used for deciding
whether or not to grant credit
Understand how to evaluate outstanding
PROF. KULBIR SINGH (IMT-NAGPUR)
Understand how to evaluate outstanding
receivables
Slide 3
Chapter Outline
1. Terms of the Sale
2. The Decision to Grant Credit: Risk
and Information
3. Optimal Credit Policy
4. Credit Analysis
5. Collection Policy
6. How to Finance Trade Credit
Slide 4
1. Terms of the Sale
The terms of sale are composed of
Credit Period
Cash Discounts
Credit Instruments
Example:
2/10, net 30
Net 60
Seasonal Sales.3/10,net 60,May 01 dating
Slide 5
Credit Period
Credit periods vary across industries.
Generally a firm must consider three
factors in setting a credit period:
The probability that the customer will not pay
The size of the account
The extent to which goods are perishable
Lengthening the credit period generally
increases sales
Slide 6
The Cash Flows of Granting Credit
Credit sale
is made
Customer
mails check
Firm
deposits
check
Bank credits
firms
account
Lengthening the credit period effectively reduces the
price paid by the customer..but it increases sales
Accounts receivable
Cash collection
Time
Slide 7
Cash Discounts
Often part of the terms of saleto speed
up the collection of receivables.
There is a tradeoff between the size of the
discount and the increased speed and rate
of collection of receivables.
An example would be 3/10, net 30
An example would be 3/10, net 30
The customer can take a 3% discount if s/he
pays within 10 days.
In any event, s/he must pay within 30 days.
Slide 8
The Interest Rate Implicit in 3/10,
net 30
A firm offering credit terms of 3/10, net 30 is essentially offering
their customers a 20-day loan.
To see this, consider a firm that makes a $1,000 sale on day 0.
Some customers will pay on day 10 and take the discount.
$970
Other customers will pay on day 30 and forgo the discount.
0 10 30
$970
0 10 30
$1,000
Slide 9
0 10 30
+$970
$1,000
A customer that forgoes the 3% discount to pay on day 30 is
borrowing $970 for 20 days and paying $30 interest:
The Interest Rate Implicit in 3/10,
net 30
0 10 30
365 20
) 1 (
000 , 1 $
970 $
R +
=
970 $
000 , 1 $
) 1 (
365 20
= + R
% 35 . 74 7435 . 0 1
970 $
000 , 1 $
20
365
= =
= R
Slide 10
Credit Instruments
Most credit is offered on open accountthe
invoice is the only credit instrument.
Promissory notes are IOUs that are signed
after the delivery of goods.
Commercial drafts call for a customer to pay a
specific amount by a specific date. The draft is
sent to the customers bank. When the
sent to the customers bank. When the
customer signs the draft, the goods are sent.
Bankers acceptances allow a bank to
substitute its creditworthiness for that of the
customer, for a fee.
Conditional sales contracts let the seller retain
legal ownership of the goods until the
customer has completed payment.
Slide 11
2. The Decision to Grant Credit:
Risk and Information
Consider a firm that is choosing between
two alternative credit policies:
In God we trusteverybody else pays cash.
Offering their customers credit.
The only cash flow of the first strategy is:
Q
0
(P
0
C
0
)
Slide 12
The Decision to Grant Credit:
The expected cash flows of the credit
strategy are:
h Q
0
P
0

C
0
Q
0

0 1
and get paid in 1 period
by h% of our customers.
We incur costs up
front
Slide 13
The Decision to Grant Credit:
NPV
cash
= Q
0
(P
0
C
0
)
h Q
0
P
0

(1 + R )
C
0
Q
0

+ NPV
credit
=
The NPV of the cash only strategy is:
The NPV of the credit strategy is:
(1 + R
B
)
C
0
Q
0
+ NPV
credit
=
1. The delayed revenues from granting credit:
2. The immediate costs of granting credit:
3. The probability of repayment: h
4. The discount rate: R
B
P
0
Q
0

C
0
Q
0

The decision to grant credit depends on four
factors:
Slide 14
Example of the Decision to Grant
Credit
A firm currently sells 1,000 items per
month on a cash basis for $500 each.
If they offered terms net 30, the marketing
If they offered terms net 30, the marketing
department believes that they could sell
1,300 items per month.
The collections department estimates that
5% of credit customers will default.
The cost of capital is 10% per annum.
Slide 15
Credit
No Credit Net 30
Quantity sold 1,000 1,300
Selling price $500 $500
Unit cost $400 $425
Probability of payment 100% 95%
Credit period (days) 0 30
Discount rate per
annum 10%
Slide 16
Credit
The NPV of cash only = 1,000($500 $400)
= $100,000
= $100,000
The NPV of Net 30:
1,300$5000.95
1,300$425 +
(1.10)
30/365
= $60,181.58
Slide 17
Credit
How high must the credit price be to make
it worthwhile for the firm to extend credit?
The NPV of Net 30 must be at least as big as
the NPV of cash only:
'
95 . 0 300 , 1 P
365 / 30
'
0
) 10 . 1 (
95 . 0 300 , 1
425 $ 300 , 1 000 , 100 $

+ =
P
95 . 0 300 , 1 ) 10 . 1 ( ) 425 $ 300 , 1 000 , 100 ($
'
0
365 / 30
= + P
50 . 532 $
95 . 0 300 , 1
) 10 . 1 ( ) 425 $ 300 , 1 000 , 100 ($
365 / 30
'
0
=
+
= P
Slide 18
The Value of New Information about
Credit Risk
The most that we should be willing to pay for
new information about credit risk is the present
value of the expected cost of defaults:
$0
(1 + R
B
)
C
0
Q
0

+ NPV
default
= (1 h)

(1 h)
(1 + R
B
)
C
0
Q
0

NPV
default
= (1 h)
C
0
Q
0

(1 h) = $4251,300(1 0.95) = $27,625
In our earlier example, with a credit price of
$500, we would be willing to pay $27,625 for a
perfect credit screen.
Slide 19
Future Sales and the Credit Decision
Customer pays
h = 100%
Customer pays
(Probability = h)
Information is
revealed at the
end of the first
We face a more certain credit
decision with our paying
customers:
Give
credit
(Probability = h)
Customer
defaults
(Probability = 1 h)
Our first decision:
We refuse further
sales to deadbeats.
end of the first
period:
Give
credit
Do not
give credit
Do not
give credit
Slide 20
Carrying
Costs
Total (Credit) costs (curve)
Costs in
dollars
C
* Level of credit extended
At the optimal amount of credit, the incremental cash
flows from increased sales are exactly equal to the
carrying costs from the increase in accounts receivable.
Opportunity costs
Slide 21
Optimal Credit Policy
Trade Credit is more likely to be granted if:
1. The selling firm has a cost advantage over other
lenders.
2. The selling firm can engage in price discrimination.
3. The selling firm can obtain favorable tax treatment.
3. The selling firm can obtain favorable tax treatment.
4. The selling firm has no established reputation for
quality products or services.
5. The selling firm perceives a long-term strategic
relationship.
The optimal credit policy depends on the
characteristics of particular firms.
Slide 22
4. Credit Analysis
Credit Information
Financial Statements
Credit Reports on Customers Payment
History with Other Firms
Banks
Banks
Customers Payment History with the
Firm
Slide 23
Credit Analysis
Credit Scoring:
The traditional 5 Cs of credit
Character
Capacity
Capital
Capital
Collateral
Conditions
Some firms employ sophisticated
statistical models
Slide 24
5. Collection Policy
Collection refers to obtaining payment
on past-due accounts.
Collection Policy is composed of:
The firms willingness to extend credit as
reflected in the firms investment in
reflected in the firms investment in
receivables
Collection effort
Slide 25
Average Collection Period
Measures the average amount of time
required to collect an account receivable:
Average Collection Period =
Accounts receivable
Average daily sales
For example, a firm with average daily sales of
$20,000 and an investment in accounts receivable
of $150,000 has an average collection period of
Average daily sales
7.5 days =
$150,000
$20,000/day
Slide 26
Accounts Receivable Aging
Schedule
Shows receivables by age of account
The longer an account has been unpaid,
the less likely it is to be paid.
Slide 27
Collection Effort
Most firms follow a protocol for customers
that are past due:
1. Send a delinquency letter
2. Make a telephone call to the customer
2. Make a telephone call to the customer
3. Employ a collection agency
4. Take legal action against the customer
Slide 28
Collection Effort
There is a potential for a conflict of
interest between the collections
department and the sales department.
You need to strike a balance between
You need to strike a balance between
antagonizing a customer and being taken
advantage of by a deadbeat.
Slide 29
Factoring
The sale of a firms accounts receivable to
a financial institution (known as a factor)
The firm and the factor agree on the basic
credit terms for each customer.
The factor pays an agreed-
Firm
Factor
Customer
Customers send
payment to the
factor.
The factor pays an agreed-
upon percentage of the
accounts receivable to the
firm. The factor bears the
risk of nonpaying
customers.
Goods
Slide 30
6. How to Finance Trade Credit
There are three general ways of financing
accounting receivables:
1. Secured Debt
Referred to as asset-based receivables financing.
The predominant form of receivables financing.
2. Captive Finance Company
Large companies with good credit ratings often form a
finance company as a subsidiary of the firm.
3. Securitization
Occurs when the selling firm sells its accounts
receivable to a financial institution, which then pools
the receivables and sells securities backed by these
assets.
Slide 31
Quick Quiz
Explain a credit term quoted 2/10, net 30.
Discuss the process used for evaluating
the creditworthiness of potential
customers.
customers.
Identify the optimal credit policy.

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