Advanced Corporate

Finance
Credit Management

Key Concepts and Skills

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

28-2

Chapter Outline
28.1
28.2
28.3
28.4
28.5
28.6

Credit and Receivables

Terms of the Sale
Analyzing Credit Policy
Optimal Credit Policy
Credit Analysis
Collection Policy

28-3

Credit Management: Key

Issues
What is Credit?
Granting credit generally increases sales
Costs of granting credit
Chance that customers will not pay
Financing receivables
Credit management/Credit Policy decision
examines the trade-off between increased
sales and the costs of granting credit

28-4

28.1 Components of Credit

Policy
Terms of sale
Credit period
Cash discount and discount period
Type of credit instrument
Credit analysis distinguishing between good
customers that will pay and bad customers that
will default
Collection policy effort expended on collecting
receivables
28-5

The Cash Flows from Granting

Credit
Credit Sale Check Mailed

Check Deposited

Cash Available

Cash Collection
Accounts Receivable

28-6

Investment in Receivables
A firms ACP is 30 days, then, at any given time,
there will be 30 days worth of sales outstanding.
If credit sales run $1,000 per day, the firms
accounts receivable will then be equal to 30 days
$1,000 per day = $30,000, on average.

28.2 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
Net Credit Period
Net Discount Period
Beginning of Credit Period
Invoice Date: Shipping Date, Billing Date
ROG
EOM e.g. 2/10
28-8

Length of Credit Period

Buyers inventory period, payables
period
Perishability and Collateral Value
Consumer Demand
Credit Risk
Size of Account
Competition
Consumer Type

26.2 The Operating Cycle and the

Cash Cycle
Raw material
purchased

Finished goods sold

Cash
received

Order
Stock
Placed Arrives

Inventory period

Accounts receivable period

Time

Accounts payable period

Firm receives invoice

Cash paid for materials

Operating cycle
Cash cycle

Cash Discounts
Benefits: Speed up Collections
Cost: Discounts, cant charge higher
prices if customer pays during cash
discount period

Example: Cash Discounts

Example 1
Credit terms of 2/10 net 60
buyer who places an order for 1,000
The buyer has the option of paying $1,000
(1 .02) = $980 in 10 days, or paying the full
$1,000 in 60 days
Example 2
Credit terms of Net 30
Customer has 30 days from the invoice date
to pay the entire $1,000, and no discount is
offered for early payment
28-12

Example: Cash Discounts

Finding the implied interest rate when customers do not

take the discount 2/10 net 30
When a cash discount is offered, the credit is essentially
free during the discount period
By giving up the discount, the buyer effectively gets 30
10 = 20 days credit
Credit terms of 2/10 net 30
The order is for $1,000. The buyer can pay $980 in 10
days or wait another 20 days and pay $1,000.
The buyer is effectively borrowing $980 for 20 days and
that the buyer pays $20 in interest on the loan.
Period rate = 20/ 980 = 2.0408%
Period = (30 10) = 20 days
365 / 20 = 18.25 periods per year
EAR = (1.020408)18.25 1 = 44.6%
The company benefits when customers choose to forgo
discounts
28-13

Cash Discount & ACP

A firm currently has terms of net 30 and an average

collection period (ACP) of 30 days.
It offers terms of 2/10, net 30, then perhaps 50
percent of its customers (in terms of volume of
purchases) will pay in 10 days. The remaining
customers will still take an average of 30 days to
pay.
What will the new ACP be? If half of the customers
take 10 days to pay and half take 30, then the new
average collection period will be
New ACP = .50 10 days + .50 30 days = 20 days

28-14

Other Credit Instruments in

India
Export financing: In order to offset
the disadvantage of higher interest
rates in India faced by units
competing in export markets banks
extend concessional financing for
exports
The export financing can be broadly
classified into:
Pre-shipment credit
Post-shipment credit

15

Other Credit Instruments in

India
Forfaiting :It enables an exporter to
discount his export receivables with
an agency called forfaiter
An extension of factoring services in
international trade.
frees the exporter from the commercial
and political risks inherent in
international trade, as forfaiting is
mostly done on without recourse
basis
16

28.3 Credit Policy Effects

Revenue Effects
Delay in receiving cash from sales
May be able to increase price
May increase total sales

Cost Effects
Cost of the sale is still 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
28-17

Example: Evaluating a Proposed Policy Part I

Your company is evaluating a switch from a cash
only policy to a net 30 policy. The price per unit is
Rs.100, and the variable cost per unit is Rs.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?
28-18

Example: Evaluating a Proposed

Policy Part II
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(1,050-1000) = 102,000
NPV of switching
200,000 102,000 = 98,000
Yes, the company should switch
28-19

28.4 Total Cost of Granting

Credit
Carrying costs
Required return on receivables
Losses from bad debts
Costs of managing credit and collections
Shortage costs
Lost sales due to a restrictive credit policy
Total cost curve
Sum of carrying costs and shortage costs
Optimal credit policy is where the total cost
curve is minimized
28-20

Figure 28.1

28-21

28.5 Credit Analysis

Process of deciding which customers
receive credit
Gathering information
Determining Creditworthiness
5 Cs of Credit
Credit Scoring

28-22

Example: One-Time Sale

NPV = -v + (1 - )P / (1 + R)
Your company is considering granting
credit to a new customer. The variable cost
per unit is Rs.50; the current price is
Rs.110; the probability of default is 15%;
and the monthly required return is 1%.
NPV = -50 + (1-.15)(110)/(1.01) = 42.57
What is the break-even probability?
0 = -50 + (1 - )(110)/(1.01)
= .5409 or 54.09%
28-23

Example: Repeat Customers

NPV = -v + (1-)(P v)/R
In the previous example, what is the NPV if we are
looking at repeat business?
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
relative to the price
If a customer defaults once, you dont grant credit
again
28-24

Credit Information
Financial statements
Credit reports with customers payment
history to other firms
Banks
Payment history with the company

28-25

Five Cs of Credit
Character willingness to meet financial
obligations
Capacity ability to meet financial
obligations out of operating cash flows
Capital financial reserves
Collateral assets pledged as security
Conditions general economic conditions
related to customers business
28-26

28.6 Collection Policy

Monitoring receivables
Keep an eye on average collection period relative
to your credit terms
Use an aging schedule to determine percentage of
payments that are being made late
Collection policy
Delinquency letter
Telephone call
Collection agency
Legal action
28-27