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OUTLINE
Terms of Payment
Credit Policy Variables Credit Evaluation
TERMS OF PAYMENT
Cash Terms
Open Account Consignment Bill of Exchange Letter of Credit
CREDIT POLICY VARIABLES The important dimensions of a firms credit policy are: Credit standards Credit period
Cash discount
Collection effort
CREDIT STANDARDS Liberal Sales Bad debt loss Investment in receivables Higher Higher Larger Stiff Lower Lower Smaller
Collection costs
Higher
Lower
EXAMPLE
is
considering
relaxing
its
credit
S = Rs.15 million, bn = 0.10, V = 0.80, ACP = 40 days, k = 0.10, t = 0.4 RI = [15,000,000 (1 0.80) 15,000,000 x 0.10] (1 0.4) 15,000,000 0.10 x 360 = Rs.766,667
Centre for Financial Management , Bangalore
x 40 x 0.80
Sales
Investment in
Higher
Larger
Lower
Smaller
receivables
Bad debts Higher Lower
RI = [S(1 V) - Sbn] (1 t ) k I
ACPn = new average collection period (after lengthening the credit period)
ACP0 = old average collection period
V
S
EXAMPLE
Zenith Limited is considering extending its credit period from 30 to 60 days. S = Rs.50 million, S = Rs.5 million, V = 0.85, bn = 0.08, k = 0.10, t = 0.40
RI = [S(1 V) - DIS] (1 t ) + k I
RI = [S(1 V) - BD] (1 t ) k I
ERRORS IN CREDIT EVALUATION In assessing credit risks, two types of errors occur :
Type I error A good customer is misclassified as a poor credit risk Type II error A bad customer is misclassified as a good credit risk
TRADITIONAL CREDIT ANALYSIS Five Cs of Credit Character : The willingness of the customer to honour his obligations Capacity : The operating cash flows of the customer
Capital
Collateral
Strong
Character
Weak
Capacity
Capacity
Strong
Capital
Strong
Weak
Capital Capital
Weak
Capital
Strong
Excellent risk
Weak
Strong Weak
Fair risk
Strong
Weak
Strong
Weak
Dangerous risk
Doubtful risk
Factor
Rating 3 2
Past payment Net profit margin Current ratio Debt-equity ratio Return on equity
Rating index
DISCRIMINANT ANALYSIS
Z = 1 Current ratio + 0.1 Return on equity
Current + ratio
+
+
+ + + + + + + +
+
+
Return on equity
Centre for Financial Management , Bangalore
Risk Class 1 2 3 4 5
Description Customers with no risk of default Customers with negligible risk of default (default rate less than 2 percent) Customers with little risk of default (default rate between 2 percent and 5 percent) Customers with some risk of default (default rate between 5 percent and 10 percent) Customers with significant risk of default (default rate in excess of 10 percent)
p Cost
0
Centre for Financial Management , Bangalore
EXAMPLE ABC Company is considering offering credit to a customer. The probability that the customer would pay is 0.8 and the probability that the customer would default is 0.2. The revenues from the sale would be Rs.1,200 and the cost of sale would be Rs.800.
The expected profit from offering credit, given the above information, is:
0.8 (1,200 800) 0.2 (800) = Rs.160
REPEAT ORDER
Expected profit on Probability of payment Expected profit on + and repeat order x repeat order initial order [ p1(REV1 COST1) (1-p1) COST1] + p1 x [ p2 (REV2 COST2) (1-p2) COST2] [0.9 (2000-1500) 0.1(1500)] + 0.9 [0.95 (2000-1500) 0.05 (1500)] = 660
CONTROL OF ACCOUNTS RECEIVABLES Days Sales Outstanding Ageing Schedule Collection Matrix
COLLECTION MATRIX
Percentage of Receivables Collected During the Month of sales First following month Second following month Third following month Fourth following month
January Sales 13 42 33 12 -
February Sales 14 35 40 11 -
March Sales 15 40 21 24 -
April Sales 12 40 24 19 5
May Sales 10 36 26 24 4
June Sales 9 35 26 25 5
SUMMING UP
The important dimensions of a firms credit policy are : credit standards, credit period, cash discount, and collection effort
In general, liberal credit standards tend to push sales up by attracting more customers. However, this is accompanied by a higher incidence of bad debt loss, a larger investment in receivables, and a higher cost of collection. Stiff credit standards have opposite effects. Three broad approaches are used for credit evaluation : traditional credit analysis, numerical credit scoring, and discriminant analysis. The traditional approach to credit analysis calls for assessing a prospective customer in terms of the five Cs of credit, viz. character, capacity, capital, collateral, and conditions. Three methods are commonly employed for monitoring accounts receivable : days sales outstanding, ageing schedule, and collection matrix.
Centre for Financial Management , Bangalore