Chapter 6

Credit Policy and Collections

Order
Order Order
Order Sale
Sale Payment
PaymentSent
Sent Cash
Cash
Placed
Placed Received
Received Received
Received
Accounts
Accounts Collection
Collection
<<Inventory
Inventory>> << Receivable
Receivable >> << Float
Float >>

Time
Time==>
==>
Accounts
Accounts Disbursement
Disbursement
<< Payable
Payable >> << Float
Float >>

Invoice
InvoiceReceived
Received Payment
PaymentSent
Sent  2005Cash
Copyright Cash Disbursed
Disbursed
by Thomson Learning, Inc.
Objectives

 Specify advantages of NPV in evaluating credit policy

alternatives.
 Calculate the NPV of alternative credit policies and
select the best policy.
 Identify the 3 major traditional measures of collection
patterns, calculate them, and understand their flaws.
 Calculate and interpret uncollected balance
percentages and relate to traditional measures.
 Describe present corporate credit policy practices.
 List and explain the major differences encountered
when extending credit internationally.

Copyright  2005 by Thomson Learning, Inc.

Evaluate Changes in Credit Policy

 Credit term change decision variables

– effect on dollar profits
– sales effect
– receivables effect
– return on investment effect
 84% can estimate:
– default probability
– credit limits
– opportunity cost of funds invested in receivables
– company’s overall cost of capital

Copyright  2005 by Thomson Learning, Inc.

Incremental Profit vs NPV

 Financial statement approach

 NPV approach

Copyright  2005 by Thomson Learning, Inc.

 Changing Credit Terms, EQ 6.1

ZZNN==

[(1+g)S
[(1+g)SEE](1-d
](1-dNN)P
)PNN(1-b
(1-bNN))//(1
(1++iDP
iDPNN))PV
PVdiscount
discountpmts
pmts

++[(1+g)S
[(1+g)SEE](1-P
](1-PNN)(1-b
)(1-bNN))//(1
(1++iCP
iCPNN)) PV
PVnon-discount
non-discountpmts
pmts

--VCR
VCR[(1+g)S
[(1+g)SEE]] PV
PVvariable
variablecost
costpmts
pmts

--EXP
EXPNN[(1+g)S
[(1+g)SEE]]//(1
(1++iCP
iCPNN)) PV
PVcredit
creditexpense
expensepmts
pmts
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 Changing Credit Terms, EQ 6.2

ZZEE==

SSE(1-d )P (1-b ) / (1 + iDP ) PV

PVdiscount
discountpmts
E(1-dEE)PEE(1-bEE) / (1 + iDPEE) pmts

++SSE(1-P )(1-b ) / (1 + iCP ) PV

PVnon-discount
non-discountpmts
E(1-PEE)(1-bEE) / (1 + iCPEE) pmts

--VCR
VCR(S
(SEE)) PV
PVvariable
variablecost
costpmts
pmts

--EXP
EXPEESSEE //(1
(1++iCP
iCPEE)) PV
PVcredit
creditexpense
expensepmts
pmts
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Changing Credit Terms, EQ 6.3, 6.4

EQ 6.3 ZZ == ZZNN--ZZEE

EQ6.3

Decision
DecisionRule:
Rule:

IFZZ>>00 then
IF thenAccept
Acceptpolicy
policychange
change

IFZZ<<00then
IF thenReject
Rejectpolicy
policychange
change

EQ 6.4NPV
EQ6.4 NPV==ZZ//ii
Copyright  2005 by Thomson Learning, Inc.
Monitoring Collections

 Receivables turnover
– least favored technique

 Days sales outstanding, DSO

– ranked almost as high as aging schedules

 Aging schedules
– ranked as most favored technique

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Problem

 All three traditional measures have a serious flaw

– All three are influenced by sales trends
– Choice of averaging period impact turnover and DSO

 Increasing sales tends to:

– improve aging schedules
– worsen DSO and turnover

Copyright  2005 by Thomson Learning, Inc.

Solution

 Uncollected Balance Percentage

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Collection Procedures

 Typical collection effort

– initial contact within 10 days of delinquency
– then reminder letter followed by phone call
– sales force notified
– last resort, reference to collection agency/legal action
 Collection agency
– Phase 1 - computer generated collection letter, when accounts are 45 to 90
days past due
– Phase 2 - commissioned collectors used
 Companies tend to be more aggressive the larger the
receivables balance
 Companies understand the good-will tradeoff when
selecting collection methods

Copyright  2005 by Thomson Learning, Inc.

Evaluating the Credit Department

 Reducing investment in receivables

– reduce invoice float
– fine-tune credit administration and credit policy
– outsourcing and automating
– reduce discrepancies and deductions
– improve monitoring and collections using benchmark data
 Organizational integration and key account
management
– develop better understanding of needs and wants of key accounts
– prioritize accounts by potential value
– make credit terms and policies integral part of well designed
sales and marketing offering

Copyright  2005 by Thomson Learning, Inc.

International Credit Management

 Credit policy analysis

– lengthening terms increases exchange rate risk
– also increases default risk
– harder to get D&B reports
– harder to get bank credit information
 Modifying monitoring and collections
– legal remedies for late payment or nonpayment differ by
country

Copyright  2005 by Thomson Learning, Inc.

Summary

 This chapter developed the framework for applying the

NPV model to credit policy decisions.
 The NPV approach was applied to changes in credit
standards, the credit period, cash discounts.
 Traditional monitoring tools include aging, DSO and
receivables turnover.
 Improved monitoring measure
– uncollected balance percentage
– a reliable and unbiased measure of customer payment behavior
 Collection procedures were reviewed.
 The chapter concluded with a look at benchmarking and
the impact of foreign sales.

Copyright  2005 by Thomson Learning, Inc.