Professional Documents
Culture Documents
Introduction
Liquid asset after Cash Credit sales Sundry Debtors Why to manage?
Year End Y2010 Y2009 Y2008 Y2007 Y2006 Y2005 Y2004 Y2003 Y2002
Sundry Debtors 14990.62 42801.28 38503.85 31153.93 29279.25 24104.23 18811.56 16326.07 12615.32
Year End Y2010 Y2009 Y2008 Y2007 Y2006 Y2005 Y2004 Y2003 Y2002
Rs. In million
Competition Operating cycle Type of good (raw materials vs finished goods, perishables, etc.) Seasonality of demand Consumer acceptance Cost and pricing Customer type Product profit margin
Goals of Mktg.:
Meeting Demands Choice of Distribution system
Distribution Channel
Direct Impact of Receivables and Inventory Direct Marketing Vs Traditional Chain Direct Marketing:
Best from Receivables Management point of view
Mfg. has direct control over distribution system Close monitoring
Competitive Market
From Sellers Market to Buyers Market There is an inherent conflict between a manufacturer who typically produce a large quantity of a limited variety of goods and the customer who usually desire to buy only a limited quantity of a wide variety of goods Requires Dedicated Marketing and Distribution System
Operating Motive
Allow receivables to absorb shocks of demand fluctuations Meet deficit in demand by relaxing credit terms or standards Respond to variable and uncertain demand
Marketing Motive
Attract Customers, New Market, Increase in Market share,
Financial Motive
Exploitation of opportunities thrown up by market
Financial Motive
Trade credit: Lending through receivables This is an alternative lending opportunity beyond the money market Recovering Financial Market Tariff
Difference in lending and borrowing rates Go to Page No. 52 Example
Price Discrimination
Pushing the Product Motivating Distribution Channel Member
Limitations
The time period at which marginal cost of fund of a seller equals the market borrowing rate of the customer, is the maximum period for which trade credit can be extended. Tax Consideration: Full profit is booked at the time of sales under accrual system and quarterly advance tax is paid on that. Go to Page No. 57 for example The constraints discussed above limit the Maximum Length of Trade Credit that a firm can allow on its receivables.
Credit Terms
Credit Standards
TERMS OF PAYMENT
Cash Terms
Open Account Consignment Bill of Exchange Letter of Credit
Investment in receivable
volume of credit sales collection period
Credit policy
credit standards credit terms collection efforts
Estimation of incremental profit Estimation of incremental investment in receivable Estimation of incremental rate of return (IRR) Comparison of incre-mental rate of return with required rate of return (RRR) Optimum credit policy: IRR = RRR
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
The current sales of pioneer are 100 ml. The company classifies its customers into four categories. Company presently extends unlimited credit to customers in category 1 and 2, limited credit to 3 and no credit to 4. As a result it forgoing sales of Rs. 10 ml in category 3&4 each. Company is planning to adopt more liberal standards and to give unlimited credit to 3rd and limited to 4th category Such relaxation would increase sales by 15 ml on which 10% would be bad debt. The contribution margin is 20%. The Average collection period is 40 days. The cost of fund is 10% and tax rate is 40%
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 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
Quiz Time
Rakesh Enterprises currently provides 30 days credit to its customers. Its present sales are Rs. 200 million .Its cost of capital is 12 percent and the ratio of variable costs to sales is 0.80 Rakesh Enterprises are considering extending the credit period to 45 days which is likely to push sales up by Rs.60 million. The bad debt proportion on additional sales would be 15 percent. The tax rate is 33 percent. What will be the effect of lengthening the credit period on the residual income of the firm?
Solution
RI = [ S(1-V) Sbn](1-t) kI I = (ACPN ACP0){ S0/360} + V(ACPN) S/360 = (45-30) x (200,000,000/360) + 0.80 x 45 x ( 60,000,000/360) = 14,333,333 RI = (60,000,000 x 0.20 - 60,000,000 x 0.15)(0.67) -0.12 x 14,333,333 = 290,000
RI = [S(1 V) - DIS] (1 t ) + k I
Example
The present credit terms of Indus Industries are 3/15, net 30. Its sales are Rs.470 million, its average collection period is 45 days, its variable costs to sales ratio, V, is 0.85, and its cost of capital is 12 percent. The proportion of sales on which customers currently take discount, is 0.4. Indus is considering relaxing its credit terms to 5/15, net 30. Such a relaxation is expected to increase sales by Rs.20 million, increase the proportion of discount sales to 0.6, and reduce the ACP to 40 days. Induss tax rate is 30 percent. What will be the effect of liberalising the cash discount on residual income?
Solution
RI = [ DIS S(IV)DIS ] (1 - t ) + R I
pn (S0 + S) dn - p0S0do
= 0.6 [470,000,000 + 20,000,000 ] x 0.05 - 0.4 x = 470,000,000 x 0.03 = 9,060,000 I = 470,000,000 (45 40) - 0.85 x
-------------------------------------------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -----
----------------------------------------------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -
20,000,000 x 40
360
Quiz Time
The present credit terms of Globus Corporation are 2/10, net 40. It sales are Rs.650 million, its average collection period is 30 days, its variable costs to sales ratio, V, is 0.75, and its cost of capital is 10 percent. The proportion of sales on which customers currently take discount, is 0.3. Globus is considering relaxing its credit terms to 3/10, net 40. Such a relaxation is expected to increase sales by Rs.30 million, increase the proportion of discount sales to 0.5, and reduce the ACP to 20 days. Globuss tax rate is 35 percent. What will be the effect of liberalising the cash discount on residual income?
Solution
RI = [S (1 V) DIS] (1 t) + R I DIS = pn (So + S)dn poso do
= 0.5 [650,000,000 + 30,000,000] .03 0.30 [650,000,000] .02 = 10,200,000 3,900,000 = 6,300,000 650,000,000 30,000,000 I = ------------- (30 20) 0.75 x ------------- x 20 360 360 = 18,055,556 1,250,000 = 16,805,556
RI = [S(1 V) - BD] (1 t ) k I
Credit investigation
Time
Financial analysis
Credit terms
credit period cash discount
Credit limit
maximum dollar level of credit balances
Collection procedures
how long to wait past due date to initiate collection efforts
methods of contact
whether and at what point to refer account to collection agency
Credit information
financial statements bank references trade references
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
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)
Credit-Granting Sequence
Order and credit request received New/increased credit limit Yes Size of proposed credit limit Large Indepth credit invest. Medium Moderate credit invest. Small No Yes Material change in customer status No
No
Minimal credit invest. Extend Credit Yes Set up,post A/R, ship
p Cost
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.