#9 credit management

8/2/2019 #9 Credit Management

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SESSION

#9 Credit Management

CF-II (Term III) 2012

Faculty: Prof. Kulbir Singh (IMT-Nagpur)


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Slide 2

Key Concepts and Skills

Understand typical credit terms

Understand the process used for deciding

whether or not to grant credit

PROF. KULBIR SINGH (IMT-NAGPUR)

n ers an ow o eva ua e ou s an ngreceivables


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Slide 3

Chapter Outline

1. Terms of the Sale2. The Decision to Grant Credit: Risk

and Information

3. Optimal Credit Polic


4. Credit Analysis5. Collection Policy

6. How to Finance Trade Credit


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Slide 4

1. Terms of the Sale

The terms of sale are composed of Credit Period Cash Discounts

Credit Instruments


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


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Slide 5

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 generallyincreases sales


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Slide 6

The Cash Flows of Granting Credit

Credit sale

is made

Customer

mails check

Firm

deposits

check

Bank credits

firms

account

Lengthening the credit period effectively reduces theprice paid by the customer..but it increases sales


Accounts receivable

Cash collection

Time


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Slide 7

Cash Discounts

Often part of the terms of saleto speedup the collection of receivables.

There is a tradeoff between the size of thediscount 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.


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Slide 8

The Interest Rate Implicit in 3/10,

net 30A 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.


Other customers will pay on day 30 and forgo the discount.

0 10 30

0 10 30

$1,000


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Slide 9

+$970 $1,000

A customer that forgoes the 3% discount to pay on day 30 is

borrowing $970 for 20 days and paying $30 interest:

The Interest Rate Implicit in 3/10,

net 30


36520)1(

000,1$970$

R+=

970$

000,1$)1( 36520 =+ R

%35.747435.01970$

000,1$ 20365

==

=R


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Slide 10

Credit Instruments

Most credit is offered on open accounttheinvoice 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


sen o e cus omer s an . en ecustomer signs the draft, the goods are sent.

Bankers acceptances allow a bank tosubstitute its creditworthiness for that of thecustomer, for a fee.

Conditional sales contracts let the seller retainlegal ownership of the goods until thecustomer has completed payment.


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Slide 11

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

)


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Slide 12

The Decision to Grant Credit:

Risk and InformationThe expectedcash flows of the creditstrategy are:

h Q0 P0

C0 Q0


0 1

and get paid in 1 period

by h% of our customers.

We incur costs up

front


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Slide 13

The Decision to Grant Credit:Risk and Information

NPVcash = Q0 (P0C0)

h Q0 P0

C +NPV =

The NPV of the cash only strategy is:

The NPV of the credit strategy is:


B

1. The delayed revenues from granting credit:

2. The immediate costs of granting credit:

3. The probability of repayment: h

4. The discount rate:RB

P0 Q0

C0 Q0

The decision to grant credit depends on fourfactors:


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Slide 14

Example of the Decision to Grant

Credit

A firm currently sells 1,000 items permonth on a cash basis for $500 each.

If the offered terms net 30 the marketin


department believes that they could sell1,300 items per month.

The collections department estimates that5% of credit customers will default.

The cost of capital is 10% per annum.


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Slide 15


Credit

No Credit Net 30

Quantity sold 1,000 1,300

Selling price $500 $500


Unit cost $400 $425

Probability of payment 100% 95%

Credit period (days) 0 30Discount rateperannum 10%


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Slide 16


Credit

The NPV of cash only = 1,000($500 $400)


= ,

The NPV of Net 30:1,300$5000.95

1,300$425 + (1.10)30/365 = $60,181.58


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Slide 17


Credit

How high must the credit price be to makeit worthwhile for the firm to extend credit?

The NPV of Net 30 must be at least as big as

the NPV of cash only:


365/30

'

0

)10.1(

95.0300,1425$300,1000,100$

+=

P

95.0300,1)10.1()425$300,1000,100($'

0

365/30

=+ P

50.532$95.0300,1

)10.1()425$300,1000,100($ 365/30'0 =

+=P


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Slide 18

The Value of New Information aboutCredit Risk

The most that we should be willing to pay fornewinformation about credit risk is the presentvalue of the expected cost of defaults:

$0

(1 +RB)C0 Q0 +NPVdefault= (1 h)


C0 Q0NPVdefault= (1 h)

C0 Q0 (1 h) = $4251,300(1 0.95) = $27,625

In our earlier example, with a credit price of$500, we would be willing to pay $27,625 for aperfectcredit screen.


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Slide 19

Future Sales and the Credit Decision

Customer pays

h = 100%

Customer pays

Information is

revealed at the

We face a more certain credit

decision with ourpaying

customers: Givecredit


ro a ty =

Customerdefaults

(Probability = 1h)Our first decision:

We refuse further

sales to deadbeats.

end of the first

period:

Give

credit

Do not

give credit

Do not

give credit


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Slide 20

3. Optimal Credit Policy

Carrying

Costs

Total (Credit) costs (curve)Costs in

dollars


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.

Opportunity costs


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Slide 21

Optimal Credit Policy

Trade Credit is more likely to be granted if:

1. The selling firm has a cost advantage over otherlenders.

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 forquality products or services.

5. The selling firm perceives a long-term strategicrelationship.

The optimal credit policy depends on thecharacteristics of particular firms.


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Slide 22

4. Credit Analysis

Credit Information Financial Statements Credit Reports on Customers Payment

History with Other Firms


Customers Payment History with the

Firm


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Slide 23

Credit Analysis

Credit Scoring: The traditional 5 Cs of credit

Character

Capacity


Collateral Conditions

Some firms employ sophisticatedstatistical models


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Slide 24

5. Collection Policy

Collection refers to obtaining paymenton past-due accounts.

Collection Policy is composed of:

The firms willingness to extend credit as


reflected in the firms investment inreceivables

Collection effort


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Slide 25

Average Collection Period

Measures the average amount of timerequired to collect an account receivable:

Average Collection Period =Accounts receivable


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

7.5 days =$150,000

$20,000/day


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Slide 26

Accounts Receivable AgingSchedule

Shows receivables by age of account

The longer an account has been unpaid,

the less likely it is to be paid.



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Slide 27

Collection Effort

Most firms follow a protocol for customersthat are past due:

1. Send a delinquency letter


.

3. Employ a collection agency

4. Take legal action against the customer


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Slide 28

Collection Effort

There is a potential for a conflict ofinterest between the collectionsdepartment and the sales department.


antagonizing a customer and being takenadvantage of by a deadbeat.


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Slide 29

Factoring

The sale of a firms accounts receivable toa financial institution (known as a factor)

The firm and the factor agree on the basiccredit terms for each customer.

The factor a s an a reed-


Firm

Factor

Customer

Customers send

payment to the

factor.

upon percentage of the

accounts receivable to the

firm. The factor bears the

risk of nonpaying

customers.

Goods


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Slide 30

6. How to Finance Trade Credit

There are three general ways of financingaccounting 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 accountsreceivable to a financial institution, which then poolsthe receivables and sells securities backed by theseassets.


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Slide 31

Quick Quiz

Explain a credit term quoted 2/10, net 30.

Discuss the process used for evaluating

the creditworthiness of potential


.

Identify the optimal credit policy.

#9 credit management

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