Professional Documents
Culture Documents
Chap 5
Chap 5
A / /R A R
Payment Sent Cash Payment Sent Cash Received Received Accounts Collection Accounts Collection < Inventory > < Receivable > < Float > < Inventory > < Receivable > < Float > Time ==> Time ==>
Sale Sale
Accounts Accounts < Payable > < Payable > Invoice Received Invoice Received
Payment Sent 2005 by Thomson Learning, Inc. Cash Disbursed Payment Sent Cash Disbursed Copyright
Learning Objectives
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Define credit policy and indicate its components. Describe the typical credit-granting sequence. Apply net present value analysis to credit extension decisions. Define credit scoring and explain limitations. List the elements in a credit rating report. Describe how receivables management can benefit from EDI.
Trade credit arises when goods sold under delayed payment terms Traced to Romans due to obstacles faced in transferring money through various trading areas Credit terms are taken for granted today Value can be added by managing three areas:
aggregate investment in receivables credit terms credit standards
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Over-investing in receivables can be costly ...but, if credit terms are not competitive, then lost sales can be costly
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Conclusion
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Minimize bad debts and outstanding receivables Maintain financial flexibility Optimize mix of company assets Convert receivables to cash in a timely manner Analyze customer risk Respond to customer needs
Credit Terms
Credit Standards
Length of terms Security Amounts involved Resource transferred (goods vs. money) Extent of analysis
Financial Motive Operating Motive Contracting Motive Pricing Motive All reasons are related to market imperfections
Financial Motive
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Potential of getting a higher price Sellers raise capital at lower rates than customers and have cost advantages vis-a-vis banks due to:
similarity of customers the information gathered in the selling process lower probability of default (the goods purchased are an essential element of the buyers business) seller can more easily resell product if payment is not made.
Operating Motive
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Respond to variable and uncertain demand Change credit terms rather than:
install extra capacity, building or depleting inventories, or forcing customers to wait.
Buyer gets to inspect goods prior to payment Seller has less theft with separation of collection and product delivery
Pricing Motive
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Zero net working capital objective Improved internal and external credit-related information Electronic commerce
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S - EXP(S) NPV = ----------------- - VCR(S) 1 + iCP Where: NPV = net present value of the credit sale VCR = variable cost ratio S = dollar amount of credit sale EXP = credit administration and collection expense ratio i = daily interest rate CP = collection period for sale
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Credit terms
credit period cash discount
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Credit limit
maximum dollar level of credit balances
Collection procedures
how long to wait past due date to initiate collection efforts methods of contact whether and at what point to refer account to collection agency
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Credit-Granting Decision
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Development of credit standards Gathering necessary information Credit analysis: applying credit standards Risk analysis
Grant-Granting Sequence
Order and credit request received New/increased credit limit Yes Size of proposed credit limit Large Indepth Indepth credit invest. credit invest. Medium Moderate credit invest. No Yes Material change in customer status No Redo credit investigation
Check new A/R Check new A/R total vs credit lmt total vs credit lmt Record disposition Extend Credit No Yes Set up,post A/R, ship
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Credit Standards
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Gathering Information
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credit reporting agencies, e.g.. Dun & Bradstreet credit interchange bureaus, NACM bank letters references from other suppliers financial statements field data gathered by sales reps
Nonfinancial
concerned with willingness to pay, character
Financial
ability to pay, financial ratios etc.. (other Cs of credit)
Example of decision rule: If gross income is equal to or grater than $20,000 and the applicant has not been delinquent and gross income per household member is equal to or greater than $12,000 and debt/equity ratio is equal to or greater than 30% but less than 50% and personal property is equal to or greater than $50,000, then grant credit.
Competition Operating cycle Type of good (raw materials vs finished goods, perishables, etc.) Seasonality of demand Consumer acceptance Cost and pricing Customer type Product profit margin
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Cash Discounts
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The lower the VC, the higher the feasible discount Based on companys cost of funds Consider timing effect when changing discounts Should be based on products price elasticity Higher the bad debt experience, higher the optimal discount
51% of firms always took cash discount 40% sometimes 9% take discount and pay late Study found that 4 or 5 companies would be more profitable if cash discount was eliminated
Discounts appear to be changed to match competitors, not inflation or interest rates The higher a firms contribution margin, the more likely the firm should be to offer discounts. A price cut is thought to have more impact than instituting a cash discount The more receivables a firm has, does not necessarily relate to use of penalty fees The greater amount of receivables does not relate to a more active credit evaluation.
Copyright 2005 by Thomson Learning, Inc.
Seller may also issues electronic invoices and be paid electronically using an EDI-capable bank so that remittance data can be automatically read by sellers A/R system Trend is for use of data transmission to automate the cash application process
Summary
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Management of A/R is influenced by what competitors are doing not by shareholder wealth considerations. Proper use of NPV techniques can ensure that credit decisions enhance shareholder value.