CF-II (Term III) 2012

SESSION

#9

Credit Management

Faculty: Prof. Kulbir Singh (IMT-Nagpur)

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Key Concepts and Skills

Understand typical credit terms Understand the process used for deciding whether or not to grant credit Understand how to evaluate outstanding receivables

PROF. KULBIR SINGH (IMT-NAGPUR)

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Chapter Outline
1. 2. 3. 4. 5. 6. Terms of the Sale The Decision to Grant Credit: Risk and Information Optimal Credit Policy Credit Analysis Collection Policy How to Finance Trade Credit

PROF. KULBIR SINGH (IMT-NAGPUR)

1. Terms of the Sale

The terms of sale are composed of
Credit Period Cash Discounts Credit Instruments

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Example:
2/10, net 30 Net 60 Seasonal Sales.3/10,net 60,May 01 dating

PROF. KULBIR SINGH (IMT-NAGPUR)

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Credit Period
Credit periods vary across industries. Generally a firm must consider three factors in setting a credit period:
The probability that the customer will not pay The size of the account The extent to which goods are perishable

Lengthening the credit period generally increases sales

PROF. KULBIR SINGH (IMT-NAGPUR)

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The Cash Flows of Granting Credit

Lengthening the credit period effectively reduces the price paid by the customer..but it increases sales Credit sale is made Customer mails check Firm deposits check Bank credits firms account Time Cash collection Accounts receivable
PROF. KULBIR SINGH (IMT-NAGPUR)

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Cash Discounts
Often part of the terms of saleto speed up the collection of receivables. There is a tradeoff between the size of the discount and the increased speed and rate of collection of receivables. An example would be 3/10, net 30
The customer can take a 3% discount if s/he pays within 10 days. In any event, s/he must pay within 30 days.

PROF. KULBIR SINGH (IMT-NAGPUR)

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The Interest Rate Implicit in 3/10, net 30

A firm offering credit terms of 3/10, net 30 is essentially offering their customers a 20-day loan. To see this, consider a firm that makes a $1,000 sale on day 0.

Some customers will pay on day 10 and take the discount. $970 0 10 30

Other customers will pay on day 30 and forgo the discount. $1,000 0 10 30
PROF. KULBIR SINGH (IMT-NAGPUR)

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The Interest Rate Implicit in 3/10, net 30

A customer that forgoes the 3% discount to pay on day 30 is borrowing $970 for 20 days and paying $30 interest: $1,000 +$970 0 10 30

$1,000 $970 = (1 + R) 20 365

$1,000 R= $970
365 20

(1 + R)

20 365

$1,000 = $970

1 = 0.7435 = 74.35%
PROF. KULBIR SINGH (IMT-NAGPUR)

Credit Instruments
Most credit is offered on open accountthe invoice is the only credit instrument. Promissory notes are IOUs that are signed after the delivery of goods. Commercial drafts call for a customer to pay a specific amount by a specific date. The draft is sent to the customers bank. When the customer signs the draft, the goods are sent. Bankers acceptances allow a bank to substitute its creditworthiness for that of the customer, for a fee. Conditional sales contracts let the seller retain legal ownership of the goods until the customer has completed payment.

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PROF. KULBIR SINGH (IMT-NAGPUR)

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2. The Decision to Grant Credit: Risk and Information

Consider a firm that is choosing between two alternative credit policies:
In God we trusteverybody else pays cash. Offering their customers credit.

The only cash flow of the first strategy is: Q0 (P0 C0)

PROF. KULBIR SINGH (IMT-NAGPUR)

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The Decision to Grant Credit: Risk and Information

The expected cash flows of the credit strategy are:
C0 Q0
0 We incur costs up front

h Q0 P0
1 and get paid in 1 period by h% of our customers.

PROF. KULBIR SINGH (IMT-NAGPUR)

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The Decision to Grant Credit: Risk and Information

The NPV of the cash only strategy is: NPVcash = Q0 (P0 C0) The NPV of the credit strategy is: h Q0 P0 NPVcredit = C0 Q0 + (1 + RB) The decision to grant credit depends on four factors: 1. The delayed revenues from granting credit: P0 Q0
2. The immediate costs of granting credit: C0 Q0 3. The probability of repayment: h 4. The discount rate: RB
PROF. KULBIR SINGH (IMT-NAGPUR)

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Example of the Decision to Grant Credit

A firm currently sells 1,000 items per month on a cash basis for $500 each. If they offered terms net 30, the marketing department believes that they could sell 1,300 items per month. The collections department estimates that 5% of credit customers will default. The cost of capital is 10% per annum.
PROF. KULBIR SINGH (IMT-NAGPUR)

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Example of the Decision to Grant Credit

No Credit
Quantity sold Selling price Unit cost Probability of payment Credit period (days) Discount rate per annum 1,000 $500 $400 100% 0

Net 30
1,300 $500 $425 95% 30 10%

PROF. KULBIR SINGH (IMT-NAGPUR)

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Example of the Decision to Grant Credit

The NPV of cash only = 1,000($500 $400) = $100,000 The NPV of Net 30: 1,300$5000.95 1,300$425 + = $60,181.58 30/365 (1.10)

PROF. KULBIR SINGH (IMT-NAGPUR)

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Example of the Decision to Grant Credit

How high must the credit price be to make it worthwhile for the firm to extend credit?
The NPV of Net 30 must be at least as big as the NPV of cash only:

1,300 P0' 0.95 $100,000 = 1,300 $425 + (1.10)30 / 365

($100,000 + 1,300 $425) (1.10) 30 / 365 = 1,300 P0' 0.95

($100,000 + 1,300 $425) (1.10) 30 / 365 P0' = = $532.50 1,300 0.95
PROF. KULBIR SINGH (IMT-NAGPUR)

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The Value of New Information about Credit Risk

The most that we should be willing to pay for new information about credit risk is the present value of the expected cost of defaults: $0 NPV default = C0 Q0 (1 h) + (1 + RB) NPV default = C0 Q0 (1 h) In our earlier example, with a credit price of $500, we would be willing to pay $27,625 for a perfect credit screen. C0 Q0 (1 h) = $4251,300(1 0.95) = $27,625
PROF. KULBIR SINGH (IMT-NAGPUR)

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Future Sales and the Credit Decision

We face a more certain credit decision with our paying customers: Information is revealed at the end of the first period:
Customer pays (Probability = h) Do not give credit Give credit Customer defaults (Probability = 1 h) Customer pays h = 100% Give credit

Our first decision:

Do not give credit

We refuse further sales to deadbeats.

PROF. KULBIR SINGH (IMT-NAGPUR)

3. Optimal Credit Policy

Costs in dollars Total (Credit) costs (curve) Carrying Costs

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Opportunity costs C* Level of credit extended

At the optimal amount of credit, the incremental cash flows from increased sales are exactly equal to the carrying costs from the increase in accounts receivable.
PROF. KULBIR SINGH (IMT-NAGPUR)

Optimal Credit Policy

Trade Credit is more likely to be granted if:

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1. The selling firm has a cost advantage over other lenders. 2. The selling firm can engage in price discrimination. 3. The selling firm can obtain favorable tax treatment. 4. The selling firm has no established reputation for quality products or services. 5. The selling firm perceives a long-term strategic relationship.

The optimal credit policy depends on the characteristics of particular firms.

PROF. KULBIR SINGH (IMT-NAGPUR)

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4. Credit Analysis
Credit Information Financial Statements Credit Reports on Customers Payment History with Other Firms Banks Customers Payment History with the Firm

PROF. KULBIR SINGH (IMT-NAGPUR)

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Credit Analysis
Credit Scoring: The traditional 5 Cs of credit
Character Capacity Capital Collateral Conditions

Some firms employ sophisticated statistical models

PROF. KULBIR SINGH (IMT-NAGPUR)

5. Collection Policy
Collection refers to obtaining payment on past-due accounts. Collection Policy is composed of:
The firms willingness to extend credit as reflected in the firms investment in receivables Collection effort

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PROF. KULBIR SINGH (IMT-NAGPUR)

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Average Collection Period

Measures the average amount of time required to collect an account receivable:
Average Collection Period

Accounts receivable Average daily sales

For example, a firm with average daily sales of $20,000 and an investment in accounts receivable of $150,000 has an average collection period of

$150,000 7.5 days = $20,000/day

PROF. KULBIR SINGH (IMT-NAGPUR)

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Accounts Receivable Aging Schedule

Shows receivables by age of account The longer an account has been unpaid, the less likely it is to be paid.

PROF. KULBIR SINGH (IMT-NAGPUR)

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Collection Effort
Most firms follow a protocol for customers that are past due:
1. 2. 3. 4. Send a delinquency letter Make a telephone call to the customer Employ a collection agency Take legal action against the customer

PROF. KULBIR SINGH (IMT-NAGPUR)

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Collection Effort
There is a potential for a conflict of interest between the collections department and the sales department. You need to strike a balance between antagonizing a customer and being taken advantage of by a deadbeat.

PROF. KULBIR SINGH (IMT-NAGPUR)

Factoring

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The sale of a firms accounts receivable to a financial institution (known as a factor) The firm and the factor agree on the basic credit terms for each customer.
The factor pays an agreedupon percentage of the accounts receivable to the firm. The factor bears the risk of nonpaying Factor customers.

Customers send payment to the factor.

Customer

Goods

Firm

PROF. KULBIR SINGH (IMT-NAGPUR)

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6. How to Finance Trade Credit

There are three general ways of financing accounting receivables:
1. Secured Debt
Referred to as asset-based receivables financing. The predominant form of receivables financing.

2. Captive Finance Company

Large companies with good credit ratings often form a finance company as a subsidiary of the firm.

3. Securitization
Occurs when the selling firm sells its accounts receivable to a financial institution, which then pools the receivables and sells securities backed by these assets.
PROF. KULBIR SINGH (IMT-NAGPUR)

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Quick Quiz
Explain a credit term quoted 2/10, net 30. Discuss the process used for evaluating the creditworthiness of potential customers. Identify the optimal credit policy.

PROF. KULBIR SINGH (IMT-NAGPUR)