Scribd Logo
Upload

Welcome to Scribd!

  • Topic 9 - Credit Management

    Uploaded by

    Ajmal Khan
    6 views14 pages

    Copyright

    © © All Rights Reserved

    Available Formats

    PDF or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    Report this Document

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    6 views14 pages

    Topic 9 - Credit Management

    Uploaded by

    Ajmal Khan

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    of 14
    _ 542 PART SEVEN: SHORT TERM FINANCIAL DECISIONS . When companies sell their products, they sometimes demand cash on deliv- ery, but in most cases they allow a delay in payment. If you turn back to the balance sheet in Table 19.1, you can see that accounts receivable constitute oon the average more than one-third of a firm’s current assets. These receiv- . ables include. both trade credit to other firms and conswurier credit to retail customers. The former is by far the larger and will therefore be the main focus of this chapter. Credit management involves the following steps, which we will discuss in tum. First, you must establish the terms of sale on which you propose to sell your goods. How long are you going to give customers to pay their bills? Are you prepared to offer a cash discount for prompt payment? Second, you must decide what evidence you need that the customer owes you money. Do you just ask the buyer to sign a receipt, or do you insist on a more formal JOU? Third, you must considé? Which customers are likely to pay their bills. This is called credit analysis. Do you judge this from the customer's past payment record or past financial statements? Do you also rely on bank references? Fourth, you must decide on credit policy. How much credit are you prepared to extend to each customer? Do you play safe by tuming down any doubtful prospects? Or do you accept the risk of a few bad debts as part of the cost of building up a large regular clientele?, Fifth, after you have granted credit, you have the problem of collecting the money when it becomes due, This is called collection policy. How do you keep track of payments and pursue slow payers? If all goes well, this is the end of the matter. But sometimes you will find that the customer is bankrupt and cannot pay. In this case you need to understand how bankruptey works. After studying the chapter you should be able to © Measure the implicit interest rate on credit. © Understand when it makes sense to ask the customer for a formal OU. @ Explain how firms can assess the probability that a customer will pay. © Decide whether it makes sense to grant credit to that customer. © Summarize the bankruptcy procedures when firms cannot pay their credi- tors. : (CHAPTER 21; CREDIT MANAGEMENT AND BANKRUPTCY $43 21d TERMS OF SALE Not all business transactions involve credit. For example, if you are supplying goods to a wide variety of irregular customers, you may require cash on delivery. (COD). And if you are producing goods to the customer's specification or incurring heavy delivery costs, then it may be sensible to ask for cash before delivery (CBD). Tus you must establish the terms of sale. Soine contracts provide for progress payments as work is cartied out. Tor example, a large consulting contract might call for 30 percent payment after completion of field research, 30 percent more on submission of a draft report, and the remaining 40 percent when the project is finally completed. When we look at transactions that do involve credit, we encounter a wide variety of arrangements (and a wide variety of jargon). Each industry seems to have its ‘own typical payment terms. These terms have a rough logic. For example, the seller ‘will naturally demand earlier payment if its customers ere financially less secure, if their accounts are small, or if the goods are perishable or quickly resold. ‘When you buy goods on credit, the supplier will state a final payment date. To encourage you to pay before the final date, itis common to offer a cash discount for prompt settlement. For example, a manufacturer may require payment within 30 ! days but offer a 5 percent discount to customers who pay within 10 days. These terms would be referred to as 5/10, net 30: i 5 / 10, net 30 I 1 t 1 percent discount numberof days that number of days for early payment discount is available before payment is due i Similarly, if a firm sells goods on terms of 2/30, net 60, customers receive # 2 percent discount for payment within 30 days or else must pay in full within 60 days. i If the terms are simply net 30, then customers must pay within 30 days of the invoice date, and no discounts are offered for early payment. For many items that are bought regularly, itis inconvenient to requige separate : payment for each delivery. A common solution is to pretend that all sales during the month in fact occur at the end of the month (EOM). Thus goods may be sold on ee of 10, 20M. 60, Ths allows the customer a cash discount of 8 percent iF tie Bilis peid within 10 days of the end of the month; otherwise the full payment {is due within 60 days of the invoice date, When purchases are subject to. seasonal fluctuations, manufacturers often ‘encourage customers to take early delivery by allowing them to delay payment until the usual order season. This practice is known as season dating. For example, summer products might have terms of 2/10, net 30, but the invoice might be dated May 1 even if the sale takes place in February. The discount is then available until | | May 10, and the bill is not due until May 30. i Firms that buy on credit are in effect borrowing money from theif suppliers. OF ‘course, 2 free loan is always worth having. But if you pass up a cash discount, then the loan may prove to be very expensive. For example, a customer who buys on terms of 3/10, net 30 may decide to forgo the cash discount and pay on the thirtieth j day. The customer obtains an extra 20 days’ credit by deferring payment from 10 to, 30 days after the sale but pays about 3 percent more for the goods. This is i cquivalent to borrowing money at a rate of 743 percent a year. To see. why, 544” PART SEVEN: SHORT TERM FINANCIAL DECISIONS SELF-TEST 21,1 open account: Agreement whereby sales ere made with no formal debt conraet consider an order of $100, If the firm pays within 10 days, it gets a 3 percent discount and pays only $97. If it waits the full 30 days, it pays $100. The extra 20 days of credit increase the payment by the fraction 3/97 = .0309, ot 3.09 percent. ‘Therefore, the implicit interest charged to extend the trade credit is 3,09 percent per 20 days. There ace 365/20 = 18,25 twenty-day periods in a year, so the effective annual rate of interest on the loan is (1.0309)!#25 — 1 = 743, or 74.3 percent. Of course any firm that delays payment beyond day 30 gains a cheaper loan but damages its reputation for creditworthiness. EXAMPLE 211 Trade Credit Rates ‘What would happen to the implied interest rate on the trade credit ifthe discount for carly payment were reduced to 2/10, net 30? The discount for prompt payment is only $2, so the per-period discount falls to 2/98 = .0204, or 2.04 percent. This is equivalent to an annual interest rate of Effective annual rate = (1,0204)!224 ~ 1 = .446, oF 44.6% ‘You might wonder why the effective interest rate on trade credit is typically so high. Past of the rate should be viewed as compensation for the costs the firm anticipates in collecting from slow payers. After all, at such steep effective rates, ‘most purchasers will choose to pay early and receive the discount. Therefore, you might interpret the choice to stretch payables as a sign of financial difficulties. t follows that the interest rate you charge to these firms should be high. ‘What would be the effective annual interest rate in Example 21.1 ifthe terms of the loan were 2/10, net 607 Why is the rate lower? 2.2 CREDIT AGREEMENTS ‘The terms of sale define the amount of any credit but not the nature of the contract, Repetitive sales are almost always made on open account and involve only an implicit contract. There is simply a record in the seller's books and a receipt signed by the buyer. Sometimes you might want a more formal agreement that the customer owes you money, Where the order is very large and there is no complicating cash discount, the customer may be asked to sign a promissory note. This is just a straightforward JOU, worded along the following lines: New York April 1, 1994 Sinty days after date I promise to pay to the order of the XYZ Company one thousand dollars ($1000) for value received. Signature credit analysis: procedure 10

    You might also like