Chapter 6 Credit Policy and Collections

Order Placed

Order Received < Inventory >

Payment Sent Cash Received Accounts Collection < Receivable > < Float >

Sale

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

Invoice Received

Payment Sent Cash Disbursed Copyright 2005 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.

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Evaluate Changes in Credit Policy

Credit term change decision variables

effect on dollar profits sales effect receivables effect return on investment effect default probability credit limits opportunity cost of funds invested in receivables companys overall cost of capital

84% can estimate:

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Incremental Profit vs NPV

Financial statement approach NPV approach

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Changing Credit Terms, EQ 6.1

ZN =

[(1+g)SE](1-dN)PN(1-bN) / (1 + iDPN)
+ [(1+g)SE](1-PN)(1-bN) / (1 + iCPN)

PV discount pmts
PV non-discount pmts

- VCR [(1+g)SE]
- EXPN[(1+g)SE] / (1 + iCPN)

PV variable cost pmts

PV credit expense pmts
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Changing Credit Terms, EQ 6.2

ZE =

SE(1-dE)PE(1-bE) / (1 + iDPE)
+ SE(1-PE)(1-bE) / (1 + iCPE)

PV discount pmts
PV non-discount pmts

- VCR (SE)
- EXPE SE / (1 + iCPE)

PV variable cost pmts

PV credit expense pmts
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Changing Credit Terms, EQ 6.3, 6.4

EQ 6.3 Z = ZN - ZE Decision Rule: IF Z > 0 then Accept policy change IF Z < 0 then Reject policy change EQ 6.4 NPV = Z / i
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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

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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

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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
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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

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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.