Transac'on

Banking
Course Code: FIN3120B
Instructor: Anand Srinivasan
Office: Biz1 building (Mochtar Riady Building)
Room: 07-45
Telephone: 6516-8434 (work), 9009-2385 (cell).
Consulta'on: Open door policy or by prior
appointment.
E-mail: bizas@nus.edu.sg

1
 What is transac'on banking?
•  Banking for corporates to manage their
–  Working capital – receivables and payables
–  Payments
–  Liquidity
–  Cash
–  Investments and other services (for larger firms)
•  Other func'ons that are also housed in
transac'on banking – securi'es services such as
se_lement and custody, regulatory compliance.
2
 What is transac'on banking?
•  Important parts of transac'on banking will
involve
–  Reduc'on of the cash cycle
–  Supply chain finance
–  Trade finance
•  Ul'mately, a transac'on in transac'on
banking involves the movement of cash and
the streamlining and op'miza'on of this
process.

3
 Building blocks
•  How companies manage their
–  working capital
–  Cash
–  Inventories
–  Payments to suppliers
–  Collec'ons from customers
–  Fund their short term requirements for financing
–  Interac'ons between growth and short term
financial requirements
–  Since payment systems impact the speed of all
this, we will also study payment systems.
4
Transac'on banking versus investment
banking (merchant banking)
•  Frequency of interac'on
•  Number of transac'ons
•  Type of deal
•  Technological investments
•  Costs of switching
•  Informa'on bank has about firm
•  Rela'onship development
•  Nature of compe''on

5
 Review of financial statements
Sources and uses of cash
Ra'o analysis
External financing needed
Working capital cycle
Cash cycle

6
 Sources and Uses of Cash
•  Balance sheet iden'ty (rearranged)
–  NWC + fixed assets = long-term debt + equity
–  NWC = cash + other CA – CL
–  Cash = long-term debt + equity + CL – CA other than cash –
fixed assets
•  Sources
–  Increasing long-term debt, equity, or current liabili'es
–  Decreasing current assets other than cash, or fixed assets
•  Uses
–  Decreasing long-term debt, equity, or current liabili'es
–  Increasing current assets other than cash, or fixed assets

7
 Illustra'on
TVS Motor Company Limited, an Indian
automobile company.
h_p://www.tvsmotor.com/tvsbrief.asp
Given – Income statement (consolidated profits
and loss account, Balance Sheet, Cash flow
Statement.
Goal – Analyze the sources and uses of cash for
fiscal year 2013.
See excel sheet
8
 Financial Models
•  Investment in new assets – determined by
capital budge'ng decisions
•  Degree of financial leverage – determined by
capital structure decisions
•  Cash paid to shareholders – determined by
dividend policy decisions
•  Liquidity requirements – determined by net
working capital decisions

9
 Financial Planning Ingredients
•  Sales Forecast – many cash flows depend directly on the level of
sales (ojen es'mate sales growth rate)
•  Pro Forma Statements – sekng up the plan as projected (pro
forma) financial statements allows for consistency and ease of
interpreta'on
•  Asset Requirements – the addi'onal assets that will be required to
meet sales projec'ons
•  Financial Requirements – the amount of financing needed to pay
for the required assets
•  Plug Variable – determined by management decisions about what
type of financing will be used (makes the balance sheet balance)
•  Economic Assump'ons – explicit assump'ons about the coming
economic environment

10
 Percent of Sales Approach
•  Some items vary directly with sales, others do not.
•  Income Statement
–  Costs may vary directly with sales - if this is the case, then
the profit margin is constant
–  Deprecia'on and interest expense may not vary directly
with sales – if this is the case, then the profit margin is not
constant
–  Dividends are a management decision and generally do
not vary directly with sales – this affects addi'ons to
retained earnings

11
 Percent of Sales Approach
•  Balance Sheet
–  Ini'ally assume all assets, including fixed, vary directly
with sales.
–  Accounts payable also normally vary directly with sales.
–  Notes payable, long-term debt, and equity generally do
not vary with sales because they depend on management
decisions about capital structure.
–  The change in the retained earnings por'on of equity will
come from the dividend decision.
•  External Financing Needed (EFN)
–  The difference between the forecasted increase in assets
and the forecasted increase in liabili'es and equity.

12
 Percent of Sales and EFN
•  External Financing Needed (EFN) can also be calculated
as:

⎛ Assets ⎞
⎜ ⎟ × ΔSales
⎝ Sales ⎠
Accounts payable
− × ΔSales
Sales
− (Profit Margin × Projected Sales) × (1 − d )

Dividend payout ra'o = d = Dividend / Net Income

Reten'on ra'o = b = Retained earnings / Net Income = 1-d
Profit margin = Net Income / Sales
See Excel

Illustra'on
Let us compare TVS with its compe'tors in
terms of external financing needed.

14
800

700

600

500

400

300

200

100

0
0% 5% 10% 15% 20% 25%

Gross New financing needed Financing from A/P

Financing from retainted earnings Net New financing needed

Varia'on of external Financing needed with sales

growth rate for TVS Motor Company in 2013
15
 External Financing and Growth
•  At low growth levels, internal financing (retained
earnings) may exceed the required investment in
assets.
•  As the growth rate increases, the internal
financing will not be enough, and the firm will
have to go to the capital markets for financing.
•  Examining the rela'onship between growth and
external financing required is a useful tool in
financial planning.
16
 The Internal Growth Rate
•  The internal growth rate tells us how much the firm
can grow assets using retained earnings as the only
source of financing.
ROA × b
Internal Growth Rate =
1 - ROA × b

See excel

17
 The Sustainable Growth Rate
•  The sustainable growth rate tells us how much the
firm can grow by using internally generated funds
and issuing debt to maintain a constant debt ra'o.

ROE × b
Sustainabl e Growth Rate =
1 - ROE × b


See excel

18
 Determinants of Growth
•  Profit margin – opera'ng efficiency
•  Total asset turnover – asset use efficiency
•  Financial leverage – choice of op'mal debt
ra'o
•  Dividend policy – choice of how much to pay
to shareholders versus reinves'ng in the firm

19
 Summary
•  We learnt that growing firms need to finance
themselves.
•  Firms growing too fast can suffer from
financing deficit.

20
 The Operating
Cycle
Raw material
purchased Finished goods sold
Cash received

Order Stock
Placed Arrives

Inventory period Receivable period

Time
Payable period

Firm receives invoice

Cash cycle
Cash paid for materials

Operating cycle
21
 The Opera'ng Cycle
•  Opera'ng cycle – 'me between delivery of raw
material and collec'ng the cash from sale of the
finished goods.
•  Inventory period – 'me required to purchase and
sell the inventory
•  Accounts receivable period – 'me required to collect
on credit sales
•  Opera'ng cycle = inventory period + accounts
receivable period

22
 The Cash Cycle
•  Cash cycle
–  Amount of 'me we finance our inventory
–  Difference between when we receive cash from the sale and
when we have to pay for the raw materials.
•  Accounts payable period – 'me between purchase of
raw materials and payment for the inventory
•  Cash cycle = Opera'ng cycle – accounts payable
period

23
 Inventory Ra'os
•  I
•  Days sales in inventory =
= how much 'me an item stays in inventory

Intui'on:
Say a firm produced 1 car per day, inventory at the beginning of the
year was 100, and end of year inventory was also 100.

How many days would the car produced on Jan 1 be in the inventory
before being sold, assuming that the company sells items in the order of
produc'on (FIFO).

24
 Inventory Ra'os
If the firm is selling at a uniform rate (1 car per day), then the car
on Jan 1 will be sold on the 101’st day of the year, thus, will be in
inventory for 100 days.

This is the days sales in inventory.

Other ways of gekng the same number

25
 Inventory Ra'os
DSI = Average Inventory (in units) /Units sold per day

Units sold per day = Annual sales($)/{Price per unit * 365}

DSI = 365 * Average Inventory (units) * Price per unit
Annual Sales ($)

= 365 * Average Inventory (units) * Price per unit
Cost of Goods sold * (1+Profit Margin)

26
 Inventory Ra'os

DSI = 365 * Average Inventory (units) * Cost per unit ($)
Cost of Goods sold ($)

= 365 * Average Inventory ($)
Cost of Goods sold ($)

= 365 / Inventory Turnover

Remember: We assume no increase or decrease in inventory from
beginning to end of year.

27
 Inventory Ra'os
•  R
•  Days sales in inventory =
= how much 'me an ajer selling is the money received

Intui'on:
Say a firm produced 1 car per day, and 1 car is sold for $10, A/R at the
beginning of the year was 100, and end of year A/R was also 100.

How many days ajer the car sold on Jan 1 would the company receive
the money.

28
 Inventory Ra'os
It will be paid on the 11th day from Jan 1.

Our sales per day are $10 (1 unit per day).
A/R is $100. So, 100/10 = 10 days.
(assuming no change in A/R in these 10 days).

In terms of annual sales, sales per day = annual sales / 365.
Receivable period = Accounts Receivable ($) / Sales per day ($)
= Accounts Receivable ($) * 365 / Annual Sales ($)
= 365/ Receivable Turnover

29
 Compu'ng receivable Ra'os
•  Receivable turnover=​𝑆𝑎𝑙𝑒𝑠/𝐴𝑐𝑐𝑜𝑢𝑛𝑡
𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 
•  Receivable period =​365/𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 

Some'mes, receivable period is called average collec'on period.

30
 Compu'ng payable Ra'os
•  Payable turnover=​𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑/
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 
•  Payable period =​365/𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 

31
 The Operating
Cycle for TVS in
2013
Raw material
purchased
Cash received

Order Stock Receivable period

Placed Arrives
Inventory period 14.6 days
39 days

Time
Payable period
87.2 days
Firm receives invoice Cash cycle
-43.6 days

Cash paid for materials

32
Operating cycle
 Finding
TVS in 2013 has a large nega've cash cycle!
Is this good, bad or irrelevant?

33
 Short-Term Financial Policy
•  Size of investments in current assets
–  Flexible (conserva've) policy – maintain a high ra'o of current assets
to sales
–  Restric've (aggressive) policy – maintain a low ra'o of current assets
to sales
•  Financing of current assets
–  Flexible (conserva've) policy – less short-term debt and more long-
term debt
–  Restric've (aggressive) policy – more short-term debt and less long-
term debt

34
Op'ons for short term financing
•  Unsecured Loans
–  Line of credit
–  Commi_ed vs. noncommi_ed
–  Revolving credit arrangement
–  Le_er of credit
•  Secured Loans
–  Accounts receivable financing
•  Assigning
•  Factoring
–  Inventory loans
•  Blanket inventory lien
•  Trust receipt
•  Field warehouse financing
•  Commercial Paper
•  Trade Credit

35
 Carrying vs. Shortage Costs

•  Managing short-term assets involves a trade-off between

carrying costs and shortage costs
–  Carrying costs – increase with increased levels of current
assets, the costs to store and finance the assets
–  Shortage costs – decrease with increased levels of current
assets
•  Trading or order costs
•  Costs related to safety reserves, i.e., lost sales and customers, and
produc'on stoppages

36
37
38
39
Temporary vs. Permanent Assets

•  Temporary current assets

–  Sales may be seasonal
–  Addi'onal current assets are needed during the “peak” 'me
–  The level of current assets will decrease as sales occur
•  Permanent current assets
–  Firms generally need to carry a minimum level of current
assets at all 'mes
–  These assets are considered “permanent” because the level is
constant, not because the assets aren’t sold

40
41
42
43
 Choosing the Best Policy
•  Cash reserves
–  High cash reserves mean that firms will be less likely to experience
financial distress and are be_er able to handle emergencies or take
advantage of unexpected opportuni'es
–  Cash and marketable securi'es earn a lower return and are zero NPV
investments
•  Maturity hedging
–  Try to match financing maturi'es with asset maturi'es
–  Finance temporary current assets with short-term debt
–  Finance permanent current assets and fixed assets with long-term
debt and equity
•  Interest Rates
–  Short-term rates are normally lower than long-term rates, so it may
be cheaper to finance with short-term debt
–  Firms can get into trouble if rates increase quickly or if it begins to
have difficulty making payments. May not be able to refinance the
short-term loans
•  Have to consider all these factors and determine a
compromise policy that fits the needs of the firm
44
45
 Cash Budget
•  Forecast of cash inflows and ouxlows over the next
short-term planning period
•  Primary tool in short-term financial planning
•  Helps determine when the firm should experience
cash surpluses and when it will need to borrow to
cover working-capital requirements
•  Allows a company to plan ahead and begin the search
for financing before the money is actually needed

46
 Example: Cash Budget Informa'on Part I

•  Pet Treats Inc. specializes in gourmet pet treats

•  Sales es'mates (in millions)
Q1=500; Q2=600; Q3=650; Q4=800; Q1 next yr = 550
•  Accounts receivable
–  Beginning receivables = $250
–  Average collec'on period = 30 days
•  Accounts payable
–  Purchases = 50% of next quarter’s sales
–  Beginning payables = 125
–  Accounts payable period is 45 days
 Example: Cash Budget
Information Part II
•  Other expenses
–  Wages, taxes and other expense are 25% of sales
–  Interest and dividend payments are $50
–  A major capital expenditure of $325 is expected in the
second quarter
•  The ini'al cash balance is $100 and the company
maintains a minimum balance of $50
 Example: Cash Budget
– Cash Collec'ons
•  Average Collec'on Period = 30 days, ! that 2/3 of sales
are collected in the quarter made and the remaining 1/3
in the following quarter
•  Beginning receivables of $250 will be collected in the
first quarter

Q1 Q2 Q3 Q4

Beginning Receivables 250 167 200 217

Sales 500 2 600 650 800

1 3
Cash Collections 3 583 567 633 750

Ending Receivables 167 200 217 267

 Example: Cash Budget
– Cash Disbursements
•  Payables period is 45 days, so half of the purchases
will be paid for in each quarter and the remaining will
be paid the following quarter
•  Beginning payables = $125
50% of [50% of next Q Sales]
50% of [50% of $600]

Q1 Q2 Q3 Q4

Payment of accounts 275 313 362 338

Wages, taxes and other expenses 125 150 163 200

Capital expenditures 325

Interest and dividend payments 50 50 50 50

Total cash disbursements 450 838 575 588

 Example: Cash Budget
– Net Cash Flow and Cash Balance
Q1 Q2 Q3 Q4

Total cash collections 583 567 633 750

Total cash disbursements 450 838 575 588

Net cash inflow 133 -271 58 162

Beginning Cash Balance 100 233 -38 20

Ending cash balance 233 -38 20 182

Minimum cash balance -50 -50 -50 -50

Cumulative surplus (deficit) 183 -88 -30 132

51
Example: Compensa'ng Balance

•  We have a $500,000 line of credit with a 15%

compensa'ng balance requirement. The quoted
interest rate is 9%. We need to borrow $150,000 for
inventory for one year.
–  How much do we need to borrow?
•  150,000/(1-.15) = 176,471
–  What interest rate are we effec'vely paying?
•  Interest paid = 176,471(.09) = 15,882
•  Effec've rate = 15,882/150,000 = .1059 or 10.59%
•  Using financial calculator, PV=150,000; FV= -
(150,000+15,882)=-165,882; N=1; CPT I = 10.588%

52
 Example: Factoring
•  Last year your company had average accounts
receivable of $2 million. Credit sales were $24
million. You factor receivables by discoun'ng them
2%. What is the effec've rate of interest?

–  APR = 12(.02/.98) = .2449 or 24.49%

–  EAR = (1+.02/.98)12 – 1 = .2743 or 27.43%

53
Cash and Liquidity Management

•  Understand the importance of float and how it

affects the cash balance
•  Understand how to accelerate collec'ons and
manage disbursements
•  Understand the advantages and disadvantages of
holding cash and some of the ways to invest idle
cash

54
 Outline
•  Reasons for Holding Cash
•  Understanding Float
•  Cash Collec'on and Concentra'on
•  Managing Cash Disbursements
•  Inves'ng Idle Cash

55
 Reasons for Holding Cash
•  Specula've mo've
–  hold cash to take advantage of unexpected opportuni'es
•  Precau'onary mo've
–  hold cash in case of emergencies
•  Transac'on mo've
–  hold cash to pay the day-to-day bills
•  Agency mo've
–  Managers want a quiet life, not to be bothered by creditors.

56
 Understanding Float
•  Float – difference between cash balance recorded in the cash
account and the cash balance recorded at the bank
•  Disbursement float
–  Generated when a firm writes checks
–  Available balance at bank – book balance > 0
•  Collec'on float
–  Checks received increase book balance before the bank credits the
account
–  Available balance at bank – book balance < 0
•  Net float = disbursement float + collec'on float

57
 Example: Types of Float
You have $3,000 in your checking account which is also
reflected in your books. You just deposited $2,000 and
wrote a check for $2,500.
• What is the collec'on float?
–  For the check deposited: Float = available balance – book
balance = -$2,000
• What is the disbursement float?
–  For the check wri_en: Float = available balance – book balance=
$2500
• What is the net float?
–  Net float = 2500 – 2000 = $500
• What is your book balance?
–  Book balance = $3000 + 2000 – 2500 = $2500
• What is your available balance?
–  Available balance = $3000 58
 Example: Measuring Float
•  Size of float depends on the dollar amount and the 'me delay
•  Delay = mailing 'me + processing delay + availability delay
•  Suppose you mail a check each month for $1,000 and it takes
3 days to reach its des'na'on, 1 day to process, and 1 day
before the bank makes the cash available
•  What is the average daily float (assuming 30-day months)?
–  Method 1: (3+1+1)(1,000)/30 = 166.67
–  Method 2: (5/30)(1,000) + (25/30)(0) = 166.67

59
 Example: Cost of Float
Cost of float is the opportunity cost of not being able to
use the money. Suppose the average daily float is $3
million with a weighted average delay of 5 days.
•  What is the total amount unavailable to earn
interest?
–  5*3 million = 15 million
•  What is the NPV of a project that could reduce the
delay by 3 days if the cost is $8 million?
–  Immediate cash inflow = 3*3 million = 9 million
–  NPV = 9 – 8 = $1 million

60 19-60
 Cash Collec'on

Payment Payment Payment Cash

Mailed Received Deposited Available

Mailing Time Processing Delay Availability Delay

Collection Delay

One of the goals of float management is to try to reduce the

collection delay. There are several techniques that can reduce
various parts of the delay.

61
Example: Accelera'ng Collec'ons Part I

Your company does business na'onally, and currently, all

checks are sent to the headquarters in Kuala Lumpur. You
are considering a lock-box system that will have checks
processed in three different states: Johor, Penang and
Sarawak. The Kuala Lumpur office will con'nue to process
the checks it receives in house.
•  Collec'on 'me will be reduced by 2 days on average
•  Daily interest rate on government bills = .01%
•  Average number of daily payments to each lockbox is 5,000
•  Average size of payment is $500
•  The processing fee is $.10 per check plus $10 to wire funds to a
centralized bank at the end of each day.

62
 Example: Accelera'ng Collec'ons Part II

•  Benefits
–  Average daily collec'ons = 3(5,000)(500) = 7,500,000
–  Increased bank balance = 2(7,500,000) = 15,000,000
•  Costs
–  Daily cost = .1(5,000) + 3*10 = 530
–  Present value of daily cost = 530/.0001 = 5,300,000
•  NPV = 15,000,000 – 5,300,000 = $9.7 million
•  The company should accept this lock-box proposal.
•  Alterna've method:
•  Invest 15 million at .01% per day = 1500$
•  Daily cost = 530, savings = 970$ per day.

63
 Cash Disbursements

•  Slowing down payments can increase disbursement

float – but it may not be ethical or op'mal to do this
•  Controlling disbursements
–  Zero-balance account
–  Controlled disbursement account

64 19-64
 Inves'ng Cash
•  Money market – financial instruments with an original
maturity of one year or less
•  Temporary Cash Surpluses
–  Seasonal or cyclical ac'vi'es: buy marketable securi'es with
seasonal surpluses, convert securi'es back to cash when
deficits occur
–  Planned or possible expenditures: accumulate marketable
securi'es in an'cipa'on of upcoming expenses

65 19-65
66
Characteris'cs of Short-Term Securi'es

•  Maturity
–  firms ojen limit the maturity of short-term investments to
90 days to avoid loss of principal due to changing interest
rates
•  Default risk
–  avoid inves'ng in marketable securi'es with significant
default risk
•  Marketability
–  ease of conver'ng to cash
•  Taxability
–  consider different tax characteris'cs when making a
decision

67
 Credit Policy Management
•  Understand the key issues related to credit management
•  Understand the impact of cash discounts
•  Be able to evaluate a proposed credit policy
•  Understand the components of credit analysis

68
 Credit Management: Key Issues

•  Gran'ng credit generally increases sales

•  Costs of gran'ng credit
–  Chance that customers will not pay
–  Financing receivables
•  Credit management examines the trade-off between
increased sales and the costs of gran'ng credit

69
 Components of Credit Policy

•  Terms of sale
–  Credit period
–  Cash discount and discount period
–  Type of credit instrument
•  Credit analysis – dis'nguishing between “good” customers
that will pay and “bad” customers that will default
•  Collec'on policy – effort expended on collec'ng receivables

70
 The Cash Flows from
Gran'ng Credit

Credit Sale Check Mailed Check Deposited Cash Available

Cash Collection

Accounts Receivable

71
 Terms of Sale

•  Basic Form: 2/10 net 45

–  2% discount if paid in 10 days
–  Total amount due in 45 days if discount not taken
•  Buy $500 worth of merchandise with the credit terms given
above
–  Pay $500(1 - .02) = $490 if you pay in 10 days
–  Pay $500 if you pay in 45 days

72
 Example: Cash Discounts
•  Finding the implied interest rate when customers do not take
the discount

•  Credit terms of 2/10 net 45

–  Periodic rate = 2 / 98 = 2.0408%
–  Period = (45 – 10) = 35 days
–  365 / 35 = 10 periods per year

•  APR = periodic rate x number of periods per year

= 2.0408% x 10 = 20.41%

•  EAR = (1.020408)10 – 1 = 22.39%
73
 Credit Policy Effects
•  Revenue Effects
–  Delay in receiving cash from sales
–  May be able to increase price
–  May be able to increase total sales
•  Cost Effects
–  Cost of the sale will s'll be incurred even though the cash from the
sale has not been received
–  Cost of debt: must finance receivables
–  Probability of nonpayment: some percentage of customers will not
pay for products purchased
–  Cash discount: some customers will pay early and pay less than the full
sales price

74
 Example: Evalua'ng a Proposed Policy

•  Your company is evalua'ng a switch from a cash only policy

to a net 30 policy. The price per unit is $100, and the variable
cost per unit is $40. The company currently sells 1,000 units
per month. Under the proposed policy, the company expects
to sell 1,050 units per month. The required monthly return is
1.5%.
•  What is the NPV of the switch?
•  Should the company offer credit terms of net 30?

75
 Example: Evalua'ng a Proposed Policy
Cash only policy
Month
1 2 3
Current quan'ty sold per month, Q 1000 1,000 1,000
Price per unit, P 100 100 100
Variable cost per unit, v 40 40 40
Cash flow under old policy 60,000 60,000 60,000

Company switches to net 30 days on sales. The receipt of (1050*$100) is deferred by 1 month.
Month
1 2 3
New quan'ty sold per month, Q' 1050 1,050 1,050
Price per unit, P 0 100 100
Variable cost per unit, v 40 40 40
Cash flow under new policy -42,000 63,000 63,000

CF under new policy - CF under old policy -102,000 3,000 3,000

76
Example: Evalua'ng a Proposed Policy

•  Incremental cash inflow

(100 – 40)(1,050 – 1,000) = 3,000
•  Present value of incremental cash inflow
3,000/.015 = 200,000
•  Cost of switching
100(1,000) + 40(1,050 – 1,000) = 102,000
•  NPV of switching
200,000 – 102,000 = 98,000
•  Yes, the company should switch

77
 Total Cost of Gran'ng Credit
•  Carrying costs
–  Required return on receivables
–  Losses from bad debts
–  Costs of managing credit and collec'ons
•  Shortage costs
–  Lost sales due to a restric've credit policy
•  Total cost curve
–  Sum of carrying costs and shortage costs
–  Op'mal credit policy is where the total cost curve is minimized

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 Credit Analysis

•  Process of deciding which customers receive credit

•  Gathering informa'on
–  Financial statements
–  Credit reports
–  Banks
–  Payment history with the firm
•  Determining Creditworthiness
–  5 Cs of Credit
–  Credit Scoring

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 Example: One-Time Sale
•  π is the likelihood that customer will default.
•  NPV = -v + (1 - π)P / (1 + R)
•  Your company is considering gran'ng credit to a new
customer. The variable cost per unit is $50; the current price
is $110; the probability of default is 15%; and the monthly
required return is 1%.
•  What is the NPV of this one-'me sale?
–  NPV = -50 + (1-.15)(110)/(1.01) = 42.57
•  What is the break-even probability?
–  0 = -50 + (1 - π)(110)/(1.01)
–  π = .5409 or 54.09%

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 Example: Repeat Customers
•  NPV = -v + (1-π)(P – v)/R
•  In the previous example, what is the NPV if we are looking at
a repeat customer?
•  NPV = -50 + (1-.15)(110 – 50)/.01 = 5,050
•  Repeat customers can be very valuable (hence the
importance of good customer service)
•  It may make sense to grant credit to almost everyone once, as
long as the variable cost is low rela've to the price
•  If a customer defaults once, you don’t grant credit again

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 Example: Repeat Customers
•  Correct arguments: one period default probability is π, or one
period non-default probability is 1- π.
•  Two period non default probability is (1- π)2.
•  In the long run, company will almost surely default.
•  Can mul'ply expected cash flow by each of these factors to
arrive at correct NPV.

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 Credit Informa'on

•  Financial statements
•  Credit reports on customer’s payment history with other
firms
•  Banks
•  Payment history with the company

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 Five Cs of Credit

•  Character – willingness to meet financial

obliga'ons
•  Capacity – ability to meet financial obliga'ons out
of opera'ng cash flows
•  Capital – financial reserves
•  Collateral – assets pledged as security
•  Condi'ons – general economic condi'ons related
to customer’s business

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 Summary of credit policy
Key Trade off
•  Increasing customers versus increasing default risk

•  No credit – no default risk – smaller customer base

•  High credit – high default risk – larger customer base

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 Summary of first set of notes
•  Short term financial management creates a
corporate requirement for financing
–  Cash cycle
•  Credit policy
•  Supplier policy
–  Growth
–  Short term investment policy

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