short-term financial management chapter 6 – credit policy & collections

SHORT-TERMFINANCIAL MANAGEMENT

Chapter 6 – Credit Policy & Collections

2

CREDIT POLICY & COLLECTIONS

Chapter 6 Agenda

Calculate the net present value of proposed and existing credit policies, identify and utilize techniques used to assess collection patterns, and describe present corporate credit policy practices.

3

Cash Flow Timeline

The cash conversion period is the time between when cash is received versus paid.

The shorter the cash conversion period, the more efficient the firm’s working capital.

The firm is a system of cash flows. These cash flows are unsynchronized and

uncertain.

4

Credit Policy & Collections

Before, we developed strategies for extending

credit to individual customers.

Since a significant amount of cash can be tied up in A/R, in this chapter, we look at the:

Credit Policy decisions (portfolio management) that affect all customers, as well as

Collections practices and account receivable portfolio monitoring techniques.

5


Strategic changes to Credit Policy are considered when: Sales volume and/or profits can be

enhanced. Receivables performance is unsatisfactory. Competitors change credit terms.

6


Financial Managers consider the following variables:

1. Loosening or tightening credit standards.

2. Lengthening or shortening credit period.

3. Offering, reducing, or discontinuing cash discounts.

4. Imposing and/or enforcing late fees.

7


Credit Managers can predict the impact from credit policy changes on Sales Default probabilities Delinquency

8

Value Maximizing Decisioning

Net Present Value (NPV) is the difference between the present value of the cash inflows and the present value of the cash outflows.

Credit managers select the credit policy that combines mutually-exclusive alternatives such that NPV is maximized.

9

Changing Credit Terms

Before we said our goal is to design a credit policy that maximizes NPV.

There are a variety of decision variables that can be combined and/or altered to impact Z (NPV from one day’s average sales).

If the credit policy is changed, most variables will change.

Terms (all sales are credit sales)

Sales Growth Rate (g)

Annual Credit Sales

Daily Credit Sales (S)

Cash Discount Offered - % (d)

Customers Taking Discount - % (p)

DSO - Discount Takers (DP )

DSO - Non-Discount Takers (CP )

Variable Cost Ratio (VCR)

Collection/Credit Exp (EXP) at CP

Bad Debt Expense Ratio (b) at CP

Annual Cost of Capital (i)

Variables

10


If we offer a cash discount, not all customers will take it.

The cash flow amounts for discount takers versus non-discount takers will vary, as will the timing of the cash flows.

Further, the bad debt experience for each could vary.

Z = PV of Sales To Discount Takers

+ PV of Sales to Non-Discount Takers

– Variable Operating Costs

– PV of Credit/Collection Costs



Annual Credit Sales










Variables

11

Modeling Z

The model assumes: All sales are sold on trade credit. All variables can be estimated with accuracy. The bad debt loss rate applies, evenly, to:

New and existing customers. Customers taking and customers not taking the cash

discounts, if offered. Other than the change in receivables, no new fixed

assets or inventory is required. The VCR does not change.

If the Credit Manager prefers, adjustments to these model decisions can be incorporated.

12

Modeling Z

Before, we calculated the NPV from a single sale, using the following formula.

Now, we will model the NPV of a single average day’s sales (Z):

)1(

)()(

)1(

)1)(1(

)1(

)1()1(

iCP

SEXPSVCR

iCP

bpS

iDP

bpdSZ

SVCRiCP

SEXPSNPV

1

13

Modeling Credit Terms

Z = S(1-d)p(1-b) / (1 + iDP) PV of Sales To Discount

Takers

+ S(1-p)(1-b) / (1 + iCP) PV of Sales To Non-Discount

Takers

‐ VCR(S) Variable Operating Costs1

‐ EXP(S) / (1 + iCP) PV of Credit/Collection Costs

1 Assume that the firm has excess capacity and will have no increase in fixed costs or fixed assets as a result of the policy change.



Annual Credit Sales










Variables

14

Modeling Credit Terms Illustrative

Z = S(1-d)p(1-b) / (1 + iDP) + S(1-p)(1-b) / (1 + iCP) ‐ VCR(S) ‐ EXP(S) / (1 + iCP)

($13,699)(1-.02)(.75)(1-.05)/[1+(.14/365)(12)]+ ($13,699)(1-.75)(1-.05) / [1+(.14/365)(45)] ‐ (.70)($13,699) ‐ (.02)($13,699) / [1+(.14/365)(45)]

= $9,521 + $3,198 - $9,589 - $269 = $2,861

Can compare to other options. Note: rounding impacts results on this slide.

Terms (all sales are credit sales) 2/10, Net 30


Annual Credit Sales $5,000,000

Daily Credit Sales (S) $13,698.63

Cash Discount Offered - % (d) 2%

Customers Taking Discount - % (p) 75%

DSO - Discount Takers (DP ) 12

DSO - Non-Discount Takers (CP ) 45

Variable Cost Ratio (VCR) 70.00%

Collection/Credit Exp (EXP) at CP 2.00%

Bad Debt Expense Ratio (b) at CP 5.00%

Annual Cost of Capital (i) 14.00%

Variables Terms

15


If credit terms are already offered, the NPV of the

existing terms ( ZE ) can be compared to

combinations of new terms ( ZN ):

Z = ZN – ZE

The aggregate NPV is calculated from the daily NPV (Z):

NPV = Z / i

Decision Rule:If Delta Z > 0 Accept policy changeIf Delta Z = 0 Indifferent about policy changeIf Delta Z < 0 Reject policy change

16

ZN = [(1+g)SE](1-dN)pN(1-bN) / (1 + iDPN) + [(1+g)SE](1-pN)(1-bN) / (1 + iCPN) ‐ VCR [(1+g)SE] ‐ EXPN[(1+g)SE] / (1 + iCPN)

ZN = New Policy

Modeling Changes to Credit Terms

ZE = SE(1-dE)pE(1-bE) / (1 + iDPE) PV of Discounted

Invoices

+ SE(1-pE)(1-bE) / (1 + iCPE) PV of Non-Discounted

Invs

‐ VCR (SE) Variable Cost Pmts

‐ EXPE (SE) / (1 + iCPE) PV of Credit Expense

Pmts

This analysis assumes policy changes will increase (or decrease) sales and incorporates (g) sales growth, where SN = (1+g)(SE). Note you would include a decrease in sales with (1-g)(SE).

ZE = Existing Policy

17

Credit Policy Modeling Example

Lengthening Credit Period (no cash discount) Offer net-60 rather than net-30 terms.

Terms (all sales are credit sales) Net 30 Net 60

Sales Growth Rate (g) 16.66667%

Annual Credit Sales $30,000,000 $35,000,000

Daily Credit Sales (S) $82,191.78 $95,890.41

Cash Discount Offered - % (d) Not Offered Not Offered

Customers Taking Discount - % (p) N/A N/A

DSO - Discount Takers (DP ) N/A N/A

DSO - Non-Discount Takers (CP ) 50 75

Variable Cost Ratio (VCR) 70.00% No Change

Collection/Credit Exp (EXP) at CP 2.00% 2.50%

Bad Debt Expense Ratio (b) at CP 5.00% 6.00%

Annual Cost of Capital (i) 14.00% No Change

VariablesProposed Terms

(N)Current Terms (E)

18



First, calculate ZE.

ZE = SE(1-dE)pE(1-bE) / (1 + iDPE)+ SE(1-pE)(1-bE) / (1 + iCPE)‐ VCR (SE) ‐ EXPE (SE) / (1 + iCPE)

($82,192)(1-0)(1-.05) / [1 + (.14/365)(50)]‐ (0.70)($82,192)‐ (0.02)($82,192) / [1 + (.14/365)(50)]

= $76,613 - $57,534 - $1,613= $17,466















19


ZN = [(1+g)SE](1-dN)pN(1-bN) / (1 + iDPN)+ [(1+g)SE](1-pN)(1-bN) / (1 + iCPN) ‐ VCR [(1+g)SE] ‐ EXPN[(1+g)SE] / (1 + iCPN)

($95,890)(1-0)(1-.06) / [1 + (.14/365)(75)] ‐ (0.70)($95,890) ‐ (0.025)($95,890) / [1 + (.14/365)(75)]

= $87,616 - $67,123 - $2,330= $18,163


Now, calculate ZN.















20

Lengthening Credit Period (no cash discount) Offer net-60 rather than net-30 terms

Compare results:

Z = ZN – ZE

Z = $18,163 – $17,466 = $697

∆Z > 0, so accept policy change

Calculate the aggregate NPV:

NPV = Z / i

NPV = $697 / (0.14/365) = $1,816,997


21

Another Modeling Example

Introduce Cash Discount Offer 2/10, net-30 rather than net-30 terms.

Terms (all sales are credit sales) Net 30 2/10, Net 30

Sales Growth Rate (g) 3%



Cash Discount Offered - % (d) Not Offered 2%

Customers Taking Discount - % (p) N/A 40%

DSO - Discount Takers (DP ) N/A 10

DSO - Non-Discount Takers (CP ) 35 No Change


Collection/Credit Exp (EXP) at CP 4.00% No Change



Proposed Terms (N)

Variables Current Terms (E)

22













Proposed Terms (N)




First, calculate ZE.

ZE = SE(1-dE)pE(1-bE) / (1 + iDPE)+ SE(1-pE)(1-bE) / (1 + iCPE)‐ VCR (SE) ‐ EXPE (SE) / (1 + iCPE)

($54,795)(1-.03) / [1+(.12/365)(35)]‐ (0.60)($54,795)‐ (0.04)($54,795) / [1 + (.12/365)(35)]

= $52,546 - $32,877 - $2,167= $17,502

23



Now, calculate ZN.

ZN = [(1+g)SE](1-dN)pN(1-bN) / (1 + iDPN)+ [(1+g)SE](1-pN)(1-bN) / (1 + iCPN) ‐ VCR [(1+g)SE] ‐ EXPN[(1+g)SE] / (1 + iCPN)

($56,438)(1-.02)(.4)(1-.025)/[1+(.12/365)(10)]+ ($56,438)(1-.4)(1-.025) / [1+(.12/365)(35)] ‐ (0.60) ($56,438) ‐ (0.04)($56,438) / [1 + (.12/365)(35)]

= $21,500 + $32,641 - $33,863 - $2,231= $18,046













Proposed Terms (N)


24

Cash Discount Offer 2/10, net-30 rather than net-30 terms.

Compare results:

Z = ZN – ZE

Z = $18,046 - $17,502 = $544

∆Z > 0, so accept policy change

Calculate the aggregate NPV:

NPV = Z / i

NPV = $544 / (0.12/365) = $1,654,501


25

Sometimes, a firm has no competitive threat, regardless of terms offered.

Otherwise, competitors are likely to react to unilateral changes to credit policy by matching the terms.

This can be incorporated into the analysis.

A revised sales estimate would be made (quantity of pricing).

Competitor Reaction

26

Monitoring Receivables

Nothing is more important than getting paid!

The diligent management of A/R is crucial to:

Accelerate collection of cash.

Reduce collection costs.

Increase likelihood of payment.

Credit Managers watch trends for:

Days Sales Outstanding (DSO).

Accounts Receivable Turnover.

Aging Schedules (organizes A/R into categories-next slide).

)365/( salescreditAnnual

receivableAccountsDSO

27


Last time we said the Credit Policy includes:

1. Credit Standards Create a profile of the minimally acceptable credit-worthy

customer.

2. Credit Terms Define how long the customer has to pay and/or the offering

of Cash Discounts.

3. Credit Limits Determine the amount of cumulative credit offered to a

single customer and/or group of customers.

4. Collection Process (Chapter 6) Determine how and when past-due accounts are handled.

28

Collection Procedures

Firms try to strike the balance between collection activities and protecting the relationship with the customer. The typical collection effort includes:

Contact past due customer (letter or phone call) within 10 days of delinquency.

Notify the sales force of the delinquency.

As a last resort, refer the account to a collection agency, which can include legal action.

29

Trends in Receivables

short-term financial management chapter 6 – credit policy & collections

Documents

credit managers

credit period

credit policy changes

trade credit

credit standards

changing credit terms

existing credit policies

cash discounts