CREDIT MANAGEMENT

ACCOUNTS RECEIVABLES

Money which is owed to a company by a customer for products and services provided on credit. This is treated as a current asset on a balance sheet. A specific sale is generally only treated as an accounts receivable after the customer is sent an invoice.

OBJECTI ES

 Maximizing the value of the firm: The main purpose of receivables management is to minimize the risk of bad debts and not maximization of order.  Optimum Investment in Sundry Debtors: credit sales helps to expand the company. But the funds get block which have an opportunity cost, which can be reduced by optimum investment in receivables.  Control and Dr.Bhatt the Cost of Trade Credit: no credit sales, no trade credit cost. But credit sales increases profit. It can be possible if the firm is able to keep the cost at minimum.

COSTS I VOLVED OLVED

 Opportunity Cost: The increased level of accounts receivables is an investment in current assets. If receIvables are financed by shareholders fund then opportunity cost of shareholders get missed and if involved by borrowed funds then payment of interest is extra which is also a cost.  Collection Cost: Collection of receivable is one of the tasks of receivables management. Collection costs are those cost that are increased in collecting the debt from the customers.  Bad Debts: sometimes customers may not be able to honor the dues to the firm because of the inability to pay. This cost are said as bad debt.

CREDIT POLICY

CREDIT POLICY VARIABLES

CREDIT STANDARDS

The term credit standards refer to the criteria for extending credit to customers. The bases for setting credit standards are:  Credit rating  References  Average payment period  Ratio analysis The firm may have light credit standards. It may sell on cash basis and extend credit only to financially strong customers. Such strict credit standards will bring down bad-debt losses and reduce the cost of credit administration. But the firm may not be able to increase its sales. The profit on lost sales may be more than the costs saved by the firm. The firm should evaluate the trade-off between cost and benefit of any credit standards. The effect of relaxing the credit standards on residual income may be estimated as follows: RI = {[ S(1-V) S*bn] * (1-t)} k I Where, I = ( S/360) * ACP * V RI = change in residual income S = increase in sales V = ratio of variable cost to sales bn = bad debt loss ratio on new sales t = corporate tax rate k = post-tax cost of capital ACP = average collection period

CREDIT PERIOD

Credit period refers to the length of time allowed to its customers by a firm to make payment for the purchases made by customers of the firm. It is generally expressed in days like 15 days or 20 days. Generally, firms give cash discount if payments are made within the specified period. If a firm follows a credit period of net 20 it means that it allows to its customers 20 days of credit with no inducement for early payments. Increasing the credit period will bring in additional sales from existing customers and new sales from new customers. Reducing the credit period will lower sales, decrease investments in receivables and reduce the bad debt loss. Increasing the credit period increases sales, increases investment in receivables and increases the incidence of bad debt loss. The effect of changing the credit period on residual income may be estimated as follows: RI = {[ S(1-V) S*bn] * (1-t)} k I Where, I = [ACPn ACPo]*(S/360) + V* ACPn*( S/360) RI = change in residual income S = increase in sales V = ratio of variable cost to sales bn = bad debt loss ratio on new sales t = corporate tax rate k = post-tax cost of capital ACPn = new average collection period ACPo = old average collection period

CASH DISCOUNT

Firms offer cash discounts to induce their customers to make prompt payments. Cash discounts have implications on sales volume, average collection period, investment in receivables, incidence of bad debts and profits. A cash discount of 2/10, net 20 means that a cash discount of 2% is offered if the payment is made by the 10th day; otherwise full payment will have to be made by the 20th day. The effect of such an action on residual income may be estimated as follows: RI = {[ S(1-V) DIS] * (1-t)} + k I Where, I = [ACPo ACPn]*(So/360) V* ACPn*( S/360) DIS = Pn*(So+ S)*dn Po*So*do RI = change in residual income S = increase in sales So = sales before liberalizing the discount terms V = ratio of variable cost to sales t = corporate tax rate k = post-tax cost of capital dn = new discount percentage do = old discount percentage ACPn = average collection period after liberalizing the discount terms ACPo = average collection period before liberalizing the discount terms Pn = proportion of discount sales after liberalizing the discount terms Po = proportion of discount sales before liberalizing the discount terms

COLLECTION EFFORT
The success of a collection programme depends on the collection policy pursued by the firm. The objective of a collection policy is to achieve timely collection of receivables, there by releasing funds locked in receivables and minimizing the incidence of bad debts. The collection programmes consists of the following:  Monitoring the receivables  Reminding customers about due date of payment  On line interaction through electronic media to customers about the payments due around the due date  Initiating legal action to recover the amount from overdue customers as the last resort to recover the dues from defaulted customers The effect of such an action on residual income may be estimated as follows: RI = {[ S(1-V) BD] * (1-t)} k* I Where, I = [ACPn ACPo]*(So/360) + V* ACPn*( S/360) BD = bn*(So+ S) bo*So RI = change in residual income So = old sales S = increase in sales V = ratio of variable cost to sales BD = increase in bad debt cost bn = percentage of new bad debts bo = percentage of old bad debts t = corporate tax rate k = post-tax cost of capital ACPn = new average collection period ACPo = old average collection period

CREDIT EVALUATION

Proper assessment of credit risks is important in establishing credit limits. In assessing credit risks, there can be 2 types of errors: Type I error: Type II error: A good customers is misclassified as a poor credit risk. A bad customer is misclassified as a good credit risk.

Type I error leads to the loss of profit on sales to good customers who are denied credit. Type II error results in bad debt losses on credit sales made to risky customers. The misclassification of errors cannot be eliminated totally, but it can be mitigated by doing proper credit evaluation. The credit evaluation can be done through 3 broad categories: 1. Traditional credit analysis 2. Numerical credit scoring 3. Discriminant analysis

Traditional credit analysis:

In this approach a prospective customer is analyzed in terms of 5 Cs of credit To get information on the 5 Cs, a firm may rely on the following:

Character Strong Strong Strong Strong Weak Weak Weak Weak

Capacity Strong Strong Weak Weak Strong Strong Weak Weak

Capital Strong Weak Strong Weak Strong Weak Strong Weak

Risk Excellent risk Fair risk Fair risk Doubtful risk Fair risk Doubtful risk Doubtful risk Dangerous risk

Discriminant analysis:
It can be explained with an example. ABC company manufactures gensets for industrial customers. It considers 2 ratios (current ratio and return on equity) of its customers to determine their creditworthiness. + = customers who have + + + 0 + + 0 + + + + 0 + 0 0 0 0 0 + 0 + 0 0 0 + 0 0 0 0 0 Return on equity Since this is the line which discriminates between the good and the bad customers, a customer with a Z score of more than 3 is deemed creditworthy and the customer with Z score less than 3 is considered not creditworthy. Of course, the higher the Z score, stronger the credit rating. paid their dues 0 = customers who have defaulted Z line= divided the 2 segments of customers (Z = 1 current ratio+ 0.1 return on equity)

Current ratio

CREDIT GRANTING DECISION

Once the credit worthiness of a customer has been assessed, the question which follows is whether to grant the credit. If there is no possibility of repeat order, the situation may be represented by the decision tree below.

Here, p is the probability that the customer pays his dues, (1-p) is the probability that the customer defaults, R is the revenue from sales, C is the cost of goods sold. The expected profit for the action offer credit is: [p*(R-C)] [(1-p)*C] The expected profit for the action refuse credit is 0. Obviously, if the expected profit of the course of action offer credit is positive, it is desirable to extend credit, otherwise not. But, in case of a repeat order, the expected profit would be calculated as follows: [p1*(R1 C1) (1-p1)*C1] + p1 [p2*(R2 C2) (1-p2)*C2]

CONTROL OF ACCOUNTS RECEIVABLES

The actual AS of the firm is compared with some standard AS to determine whether accounts receivables are in control. A problem is indicated if the actual AS shows a greater proportion of receivables, compared with the standard AS, in the higher age groups.

From the collection pattern, one can judge whether the collection is improving, stable or deteriorating. A secondary benefit of such an analysis is that it provides a historical record of collection percentages that can be useful in projecting monthly receipts for each budgeting period.

Credit management in India:

Credit management in India can be categorized into 3 broad areas:  Credit policy  Credit analysis  Control of accounts receivables

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Credit policy Very few companies have attempted a systematic articulation and formalisation of their credit policy. Generally credit policies have emerged as unstated conventions. Their underlying credit philosophy is sometimes stated in terms of too general to be of much relevance in guiding credit decisions. (e.g. our credit policy seeks to maximize sales growth consistent with an acceptable degree of risk ) The credit policy offered by firms varies from 0 to 60 days. Firms manufacturing consumers products (with some notable exceptions such as textile and garment units) seem to offer no credit or very limited credit, whereas firms manufacturing capital goods offer longer credit. The practice of offering cash discount is not very common.

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Credit analysis Prospective customers are generally required to furnish two or three trade references. However the follow up of these trade references is not very common. The financial statements of these prospective customers are, in general, not analysed in details. Creditors often do not bother to look into mortgages. Independent credit rating agencies are conspicuous by their absence. This represents a striking contrast to the U.S., where there are several nationally known independent credit rating agencies. Creditors obtain fairly reliable information about the credit standing of prospective customers from these agencies. Sometimes customers are requested to advice their bankers to provide credit information. However the assessments provided by the banks are often couched in every general terms and are not very useful. The larger business firms usually classify their customers into several credit categories. E.g. a large pharmaceutical concern uses the following classification: A. Completely reliable customers B. Highly reliable customers C. Slightly reliable customers D. Doubtful customers

Control of receivables 1. Monitoring and controlling of accounts receivable is often neither very thorough nor systematic. Very few firms have well defined systems for monitoring and controlling of accounts receivables. 2. The measures commonly employed judging whether the accounts receivables are in control are: A. Bad debt losses B. Average collection period C. Ageing schedule

1. 2. 3. 4. 5. 6.

Room for improvements Management of receivables must be accorded the importance it deserves. This responsibility should be shouldered by a senior executive. Credit policies need to be articulated in explicit terms and revised periodically in the light of internal and external changes. There should be better coordination between sales, production and finance departments. Firms granting credit should examine the published statements of prospective customers with great rigour. References provided by the prospective customers should be consulted and necessary follow-up actions should be taken. A well developed collection programme must be developed.