Managing debtors

One of the key advantages of offering credit to customers is an increase in sales.

Credit is often used as a competitive marketing device to attract new customers.

Against the increased sales must be set the cost of offering credit:-

• Increased investment in debtors and reduced cash-flow to the firm.

• Increase in bad debt losses.

Managing debtors

The main issues which have to be considered by a firm in setting credit policy are:

• Establish payment terms• analyze credit risk• Decide when and whom to offer credit• How to collect the debt

Payment terms

Payment term refers to when customers have to pay the invoice and what discounts are available for prompt payment.

Payment terms can include:-• cash term• Credit termCash termsThis offers the greatest protection to the seller.The buyers pays either in advance (CASH IN

ADVANCE) or upon taking delivery of the goods (CASH ON DELIVERY).

Payment termsCredit termsThe seller delivers the goods and the buyer pays later,

but the buyers does not sign a formal debt contract.Credit terms (i.e. credit period and the cash discount for

prompt payment) are usually stated on the invoice.3/15 net 45 implies 3% discount if payment is within 15

days otherwise full payment required within 45 days.The implicit interest rate in the above credit term is

about 45%. A buyer should forego the discount only if alternative finance cannot be obtained.

Setting credit terms

If a buyer is willing to borrow at this rate, then it is highly likely that they are desperate for cash.

The interest rate implicit in the credit term is found from the following formula:-

365Interest rate = [ 1 + D ] N - 1 100 – D D is the cash discount percentage and N is the

number of days that payment can be delayed by foregoing the discount.

Setting credit terms: ExampleCredit terms usually follow industry norms however a firm can

vary its credit terms to suit its purpose. In setting credit terms, you have to balance the trade off between increase in sales, reduced cash flow and the cost of the discount.

ExampleMistral Plc currently offers credit terms to its customers of 2/10

net 30, but is thinking of changing the policy to 1/15 net 45. Average collection period is expected to increase from 10 days to 40 days. Credit sales are expected to rise from £ 10 to 15m per annum. The firm estimates that the percentage of customers taking advantage of the discount will drop from 80% to 20%. The company makes a profit margin on cost of 5%. If a return of 20% is required on investment in debtors should it switch policy?

Setting credit terms: ExampleCurrent average debtor balance 10,000,000 * 10 = 273,973 365Net average debtor balance 15,000,000 * 40 = 1,643,836 365Interest cost of increase in debtors 20% * ( 1%*1,643,836 – 273,973) =

(273,973)

Present cost pf cash discount 80% * (2% * 10,000,000) = 160,000Net cost of cash discount 20% * (1% * 15,000,000) = 30,000Saving on cash discount 160,000 – 30,000 = 130,000

Profit from increased sales 5 *(15,000,000 – 10,000,000) 105

= 238,095

Net change in profit = 94,122

Managing credit risk

In order to decide whether to grant credit the company must evaluate the risk of default by classifying customers into good and bad risk.

There are two types of errors involved:-Type I error implies classifying a good buyer as a bad

riskType II error implies classifying a bad customer as a

good risk.

Managing credit riskDetermining a particular customer’s credit risk is not

easy, however useful information sources include:-bank referencesReferences from existing suppliersTrade association reportsCredit rating agencies (e.g. Dun & Bradstreet)Published accountsSalespeople’s reportsCompany’s own sales ledgerDirect interviewIn the US the exercise is more scientific because of the

provisions of the every lender take same decision under same facts.

Statistical techniques for determining credit risk

The main scientific techniques include:-Credit scoring:- a numerical index of various

measures used to predict the probability that the buyer will default. Usually information provided by the credit applicant in a questionnaire is used to calculate the credit score.

Multiple discount Analysis (MDA):- this uses statistical techniques to develop a model which assigns weights to difference factors so that the model discriminates between good and bad credit risk.

Statistical techniques for determining credit risk

MDA was first used in the prediction of corporate bankruptcy (Altman, 1968).

The composite index developed in bankruptcy prediction is called a Z score.

The main UK work on Z-scores in Taffler (1963).

Most Z score models are proprietary and only available commercially.

Making the credit decisionThis implies deciding the point on your credit

risk index below which a customer is refused credit.

Grant credit if the expected profit from granting credit is greater than the expected loss from refusing credit.

Since the granting of credit is equivalent to making an investment in debtors, the firm should grant credit so long as the NPV of the credit decision is greater than zero.

Making the credit decision

Customer pays _______ PV Revenue – cost Probability (P)

OfferCredit

CreditDecision Customer default

Probability (1-P) --- - PV costNPV of offering credit

Refuse 0Credit

P * PV Rev – PV Cost – ( 1 – P) * PV Cost > 0

Making credit decision: Example

Vents Ltd sells on credit with average collection period of 45 days

The selling price of each item is $500 with a profit margin on cost of 10%

If the company required return on debtors is 15% per annum, what probability of collection is required for the company to extend credit to a customer

Making credit decision: Example

Interest rate for 45 days 15 % * 45 = 1.85 % 365

Present value of a credit sale 500 = 491 (1 + 1.85%)Present value of cost 455 = 447 (1 + 1.85%)

The expected profit from offering credit is set equal to zero when

P * (491 – 447) = (1 – P) * 447P = 91.04% Offer credit if the probability of collection of greater than 91.04%.

Incentive problems in making credit decisions

There are potentially some incentive problems in making credit decisions.

If sales managers are judged solely on the basis of sales targets, then they are more willing to grant credit in order to increase sales, irrespective of the bad debt losses incurred or the resources tied up in debtors.

A possible approach is to base compensation for sales people on the profitability of credit sales, including the cost of funds tied up in debtors.

Collection policy

Collecting debts can be arduous.Once an account is overdue the seller has two

choices:-• Collect the debt yourself. Send statements, write

insistent letters and make phone calls.• Hire a professional debt collector or lawyer. They

are expensive and can cost between 15% and 40% of the amount collected.

• Factoring.• Another way of spending up cash-flow from sales is

factoring.• A factor buys a company’s debt on a non-recourse

basis.

Factoring

The factor pays the seller based on the agreed average collection period irrespective of when the buyer paid the debt. This is called maturity factoring.

For this service the factor can charge fees of about 1% to 2% of the invoice value.

The advantages of factoring include:-• The seller is guaranteed payment on time.• The seller does not risk the business relationship with the

buyer, by chasing the buyer for the debt. Let the factor be the bad guy.

• The factor guarantees implicit claims made by the seller