Chapter 20:

Credit Management

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Learning Objectives

How firms manage their receivable and the basic

components of a firm’s credit policies

How to analyze the decision by a firm to grant credit

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 Credit Management
• Granting credit can increases sales

• However, there are costs of granting credit

 Chance that customers will not pay
 Firms has to bear the costs of carrying the receivables

• Credit management examines the trade-off between

increased sales and the costs of granting credit

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Components of Credit Policy
• Terms of sale
 Credit period
 Cash discount and discount period
 Type of credit instrument

• Basic Form: 2/10 net 45

 2% discount if paid in 10 days
 Total amount due in 45 days if discount not taken

• Buy $1000 worth of merchandise with the credit terms given above
 Pay $1000(1 - 0.02) = $980 if you pay in 10 days
 Pay $1000 if you pay in 45 days

 Credit analysis: distinguishing between “good” customers that will pay

and “bad” customers that will default

• Collection policy – effort on collecting receivables 4

Credit Policy Effects
• Revenue Effects
 Delay in receiving cash from sales
 Enable firm to charge higher price
 May increase quantity of sales

• Cost Effects
 Cost of the sale is still incurred even though the cash from the
sale has not been received (paying inventory / merchandise)
 Cost of debt – finance the receivables, resulting the cost of
short term borrowing
 Probability of nonpayment
 Cash discount 20-5
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Evaluating a proposed policy

• Locust Software is evaluating to change its current policy to

net one month (30 days). Suppose the price of their system
is $49, variable cost $20 and with cash policy usually they
can sell for 100 units. Mean while, if Locust does switch to
net 30 days on sales, the quantity sold rise to 110. if the
required return is 2% per month, should Locust switch?

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Calculate Switch NPV

• Incremental Cash inflow = (P-v) (Q2-Q1)

= ($49-20) x (110-100)
= $290
• Present value of incremental cash flow
• $290/0.02 = $14,500
• Cost of switching
• PXQ1 + v(Q2-Q1)= 4900+200= $5,100
• NPV of switching
• -$5,100 + $14,500 =$9,400
• Yes the company should switch
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Credit analysis

• Process of deciding whether or not to extend credit to customers

• Credit Information:
 Financial statements
 Credit reports
 Banks
 Payment history with the firm
• Determining Creditworthiness
 5 Cs of Credit: character, capacity, capital, collateral, and
conditions
 Credit Scoring
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When Should Credit be Granted? A One-Time Sale

• NPV = -v +

• v = variable cost per unit

•  = probability that a customer will not pay
• P = price per unit
• R = required return on receivables
• If the NPV is positive, then credit should be granted

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Example

• Based on Locust case study, decide whether Locust should

grant new customer credit request! Assume there is 20%
chance that customer will run and not pay Locust. What is the
break even probability?

Answer
• = $18.43, positive, so we accept.
• Breakeven-> NPV equal to 0
• 0=-20+
• 58.4%
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Repeat customers….

• NPV = -v +
• In the previous example, what is the NPV if we are looking at
repeat business?
• =$1,140
• 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 don’t grant credit again 11

Cost of Switching

• Cost of switching credit policy if only Q change

= =[PQ + V(Q2-Q)]

• Cost of switching credit policy if the Variable cost and Q

change
= -[P1Q1 + Q1(V2-V1) + V2(Q2-Q1)

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Practice

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Evaluating Credit Policy

A new customer has placed an order for eight turbine engines. The variable cost is
$1.6 million per unit, and the credit price is $1.87 million each. Credit is extended
for one period, and based on historical experience, payment for about 1 out of
every 200 such orders is never collected. The required return is 2.9% per period.
a. Assuming that this is a one-time order, should it be filled? The customer will
not buy if credit is not extended.
b. What is the break-even probability of default in part (a)?
c. Suppose that customers who don’t default become repeat customers and place
the same order every period forever. Further assume that repeat customers
never default. Should the order be filled? What is the break-even probability
of default?
d. Describe in general terms why credit terms will be more liberal when repeat
orders are a possibility.
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Credit Policy Evaluation

• The Harrington Corporation is considering a change in its cash-

only policy. The new terms would be net one period. Based on
the following information, determine if Harrington should
proceed or not. The required return is 2.5% per period.
Current Policy New Policy
Price per unit $ 91 $ 94
Cost per unit $ 47 $ 47
Unit sales per month 3,850 3,940

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