Chapter Fourteen

Credit Management

Chapter Organisation

14.1 Credit and Receivables14.2 Terms of the Sale14.3 Analysing Credit Policy14.4 More on Credit Policy Analysis14.5 Optimal Credit Policy14.6 Credit Analysis14.7 Collection Policy14.8 Summary and Conclusions

Chapter ObjectivesUnderstand the components of credit policy and the cash flows associated with granting credit.Identify the factors that influence the length of the credit period.Calculate the cost of forgoing discounts in credit periods.Outline the various credit policy effects.Calculate the cost and NPV of switching policies.Determine the optimal credit policy.Discuss the five Cs of credit.

Components of Credit PolicyTerms of saleThe conditions on which a firm sells its goods and services for cash or credit.Credit analysisThe process of determining the probability that customers will not pay.Collection policyProcedures that are followed by a firm in collecting accounts receivable.

Accounts receivable = Average daily sales average collection period

Cash Flows from Granting CreditCreditsale ismadeCustomermailschequeFirm depositscheque inbankBank creditsfirmsaccountCash collectionAccounts receivableTime

Terms of the SaleCredit periodThe length of time that credit is granted, usually between 30 and 120 days.

Cash discountA discount that is given for a cash purchase to speed up the collection of receivables.

Credit instrumentEvidence of indebtedness such as an invoice or promissory note.

Length of the Credit PeriodFactors that influence the length of the credit period include:

buyers inventory period and operating cycleperishability and collateral value of goodsconsumer demand for the productcost, profitability and standardisationcredit risk of the buyerthe size of the accountcompetition in the product marketcustomer type.

Cost of the Credit2/10, net 30 = buyer pays in 10 days to get a 2 per cent discount, or within 30 days for no discount.Buyer has an order for $1500 and ignores the credit period gives up $30 discount.

The benefit obviously lies in paying early.

Credit Policy EffectsRevenue effectsPayment is received later, but price and quantity sold may increase.Cost effectsCost of sale is still incurred even though the cash from the sale has not been received.The cost of debtThe firm must finance receivables and, therefore, incur financing costs.The probability of non-paymentThe firm always gets paid if it sells for cash, but risks losses due to customer default if it sells on credit.The cash discountDiscounts induce buyers to pay early; the size of the discount affects payment patterns and amounts.

Evaluating a Proposed Credit PolicyP = price per unitQ = new quantity expected to be soldv = variable cost per unitQ = current quantity sold per periodR = periodic required return

The benefit of switching is the change in cash flow:

Evaluating a Proposed Credit PolicyThe present value of switching is: PV = [(P v) (Q Q)]/R

The cost of switching is the amount uncollected for the period plus the additional variable costs of production: Cost = PQ + v(Q Q)

And the NPV of the switch is:NPV = [PQ + v(Q Q)] + [(P v)(Q Q)]/R

ExampleEvaluating a Proposed Credit PolicyABC Co. is thinking of changing from a cash-only policy to a net 30 days on sales policy. The company has estimated the following:

P = $55v = $32Q = 160

Q = 175R = 2%

SolutionEvaluating a Proposed Credit Policy

SolutionEvaluating a Proposed Credit Policy

SolutionEvaluating a Proposed Credit PolicyTherefore, the switch is very profitable.

Break-even PointThe switch is a good idea as long as the company can sell an additional 7.87 units.

Discounts and Default RiskABC Co. currently has a cash price of $55 per unit. If the company extends the 30 day credit policy, the price will increase to $56 per unit on credit sales. ABC Co. expects 0.5 per cent of credit to go uncollected (). All other information remains unchanged. Should the company switch to the credit policy?

Discounts and Default RiskNPV of changing credit terms:As the NPV of the change is negative, ABC Co. should not switch.

The Costs of Granting CreditOpportunity costs are lost sales from refusing credit. These costs go down when credit is granted.Carrying costs are the cash flows that must be incurred when credit is granted. They are positively related to the amount of credit extended.The required return on receivables.The losses from bad debts.The costs of managing credit and credit collections.

Optimal Credit Policy

Credit AnalysisProcess of deciding which customers receive credit.One-time salerisk is variable cost only.Repeat customersbenefit is gained from one- time sale in perpetuity.Grant credit to almost all customers once as long as variable cost is low relative to price (high markup).

The Five Cs of CreditCharacterCustomers willingness to pay.CapacityCustomers ability to pay.CapitalFinancial reserves/borrowing capacity.CollateralPledged assets.ConditionsRelevant economic conditions.

Collection PolicyMonitoring receivables:- Keep an eye on average collection period relative to your credit terms.Ageing schedulecompilation of accounts receivable by the age of each account; used to determine the percentage of payments that are being made late.Collection procedures include:delinquency letterstelephone callsemployment of collection agencylegal action.