Chapter 28

CREDIT MANAGEMENT

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 OUTLINE

• Terms of Payment

• Credit Policy Variables

• Credit Evaluation

• Credit Granting Decision

• Control of Accounts Receivable

• Credit Management in India

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 TERMS OF PAYMENT

• Cash Terms

• Open Account

• Consignment

• Bill of Exchange

• Letter of Credit

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 CREDIT POLICY VARIABLES

The important dimensions of a firm’s credit policy are:

• Credit standards

• Credit period

• Cash discount

• Collection effort

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 CREDIT STANDARDS

Liberal Stiff

• Sales Higher Lower

• Bad debt loss Higher Lower

• Investment Larger Smaller

in receivables

• Collection costs Higher Lower

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IMPACT ON RESIDUAL INCOME
OF RELAXATION

RI = [S(1 – V) - Sbn] (1 – t ) – k  I

where RI = change in residual income

S = increase in sales

V = ratio if variable costs to sales

bn = bad debt loss ratio on new sales

t = corporate tax rate

I = increase in receivables investment

 Centre for Financial Management , Bangalore
 EXAMPLE
Pioneer Limited is considering relaxing its credit
standards.
S = Rs.15 million, bn = 0.10, V = 0.80,
ACP = 40 days, k = 0.10, t = 0.4
RI = [15,000,000 (1 – 0.80) – 15,000,000 x 0.10] (1 – 0.4)
15,000,000
– 0.10 x x 40 x 0.80
360

= Rs.766,667

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 CREDIT PERIOD

Longer Shorter

• Sales Higher Lower

• Investment in Larger Smaller

receivables

• Bad debts Higher Lower

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IMPACT ON RESIDUAL
INCOME OF LONGER CREDIT PERIOD

RI = [S(1 – V) - Sbn] (1 – t ) – k  I

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 INCREASE IN RECEIVABLES
INVESTMENT

S0 S
I = (ACPn – ACP0) + V (ACPn)
360 360

where: I = increase in receivables investment

ACPn = new average collection period (after lengthening
the credit period)
ACP0 = old average collection period
V = ratio of variable cost to sales
S = increase in sales
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 EXAMPLE

Zenith Limited is considering extending its credit period

from 30 to 60 days.
S = Rs.50 million, S = Rs.5 million, V = 0.85,
bn = 0.08, k = 0.10, t = 0.40

RI = [5,000,000 x 0.15 – 5,000,000 x 0.08] (0.6)

50,000,000 5,000,000
– 0.10 (60 – 30) x + 0.85 x 60 x 360
360

= [750,000 – 400,000] (0.6) – 0.10 [4,166,667 + 708,333]

= – 277,500
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LIBERALISING THE CASH
DISCOUNT POLICY

RI = [S(1 – V) - DIS] (1 – t ) + k  I

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DECREASING THE RIGOUR
OF COLLECTION PROGRAMME

RI = [S(1 – V) - BD] (1 – t ) – k  I

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 ERRORS IN CREDIT EVALUATION

In assessing credit risks, two types of errors occur :

Type I error A good customer is misclassified as a

poor credit risk

Type II error A bad customer is misclassified as a good

credit risk

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 TRADITIONAL CREDIT ANALYSIS
Five Cs of Credit

Character : The willingness of the customer to honour

his obligations

Capacity : The operating cash flows of the customer

Capital : The financial reserves of the customer

Collateral : The security offered by the customer

Conditions : The general economic conditions that
affect the customer
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 SEQUENTIAL CREDIT ANALYSIS
Should
credit be
granted?

Strong Character
Weak

Capacity Capacity

Strong Strong
Weak Weak
Capital
Capital Capital Capital

Strong Weak Strong Weak

Strong Weak Strong Weak
Excellent risk Dangerous
Fair risk Doubtful risk
risk

How much
credit
should be
granted ?

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 NUMERICAL CREDIT RATING INDEX

Factor Factor Rating Factor

weight 5 4 3 2 1 score

Past payment 0.30  1.20

Net profit margin 0.20  0.80
Current ratio 0.20  0.60
Debt-equity ratio 0.10  0.40
Return on equity 0.20  1.00

Rating index 4.00

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 DISCRIMINANT ANALYSIS

Z = 1 Current ratio + 0.1 Return on equity

+
Current
+ +
ratio
+ +
+
+
° + + +
° ° +
+ +
°
° ° +
° °
°
+ +
° ° °
Return on equity
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 RISK CLASSIFICATION SCHEME

Risk Class Description

1 Customers with no risk of default

2 Customers with negligible risk of default (default rate less than 2
percent)
3 Customers with little risk of default (default rate between 2 percent
and 5 percent)
4 Customers with some risk of default (default rate between 5 percent
and 10 percent)
5 Customers with significant risk of default (default rate in excess of 10
percent)

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 CREDIT GRANTING DECISION
Expected Pre-tax Profit
p (Revenue – Cost) – (1 – p) Cost

Rev – Cost
r pay s
to me
Cus
p
Custome
r default
s
d it – Cost
cre (1 – p)
fer
Of
Re f
use
cred
it
0

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 EXAMPLE

ABC Company is considering offering credit to a

customer. The probability that the customer would pay is
0.8 and the probability that the customer would default is
0.2. The revenues from the sale would be Rs.1,200 and the
cost of sale would be Rs.800.

The expected profit from offering credit, given the

above information, is:

0.8 (1,200 – 800) – 0.2 (800) = Rs.160

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 REPEAT ORDER

Expected profit on Probability of payment Expected profit on

initial order + and repeat order x repeat order

[ p1(REV1 – COST1) – (1-p1) COST1]

+ p1 x [ p2 (REV2 – COST2) – (1-p2) COST2]

[0.9 (2000-1500) – 0.1(1500)]

+ 0.9 [0.95 (2000-1500) – 0.05 (1500)]

= 660

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DECISION TREE FOR GRANTING CREDIT

s 5
Pay p = 0.9
1

it
cred Def
ault
er
Off (1 –
p1 ) =
s
0.05
s
Pay
= 0.9
p1

re dit
ffer c De
O fa ult
(1
– p1 ) s
=0
.1

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 CONTROL OF ACCOUNTS
RECEIVABLES

• Days’ Sales Outstanding

• Ageing Schedule

• Collection Matrix

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 COLLECTION MATRIX

Percentage of Receivables January February March April May June

Collected During the Sales Sales Sales Sales Sales Sales

Month of sales 13 14 15 12 10 9
First following month 42 35 40 40 36 35
Second following month 33 40 21 24 26 26
Third following month 12 11 24 19 24 25
Fourth following month - - - 5 4 5

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 SUMMING UP
• The important dimensions of a firm’s credit policy are : credit
standards, credit period, cash discount, and collection effort
• In general, liberal credit standards tend to push sales up by
attracting more customers. However, this is accompanied by a
higher incidence of bad debt loss, a larger investment in
receivables, and a higher cost of collection. Stiff credit standards
have opposite effects.
• Three broad approaches are used for credit evaluation :
traditional credit analysis, numerical credit scoring, and
discriminant analysis.
• The traditional approach to credit analysis calls for assessing a
prospective customer in terms of the five Cs of credit, viz.
character, capacity, capital, collateral, and conditions.
• Three methods are commonly employed for monitoring accounts
receivable : days’ sales outstanding, ageing schedule, and
collection matrix.  Centre for Financial Management , Bangalore