Credit Management
(Text reference: Chapter 29)
why credit exists
terms of sale
optimal credit policy
credit analysis
collection policy
factoring
AFM 271 - Credit Management
Slide 1
Why Credit Exists
clearly, businesses would prefer to receive cash
due to market imperfections, it is beneficial for firms to provide
credit to their customers
in a perfect market, customer should be able to borrow at the
same rate from anyone (bank, business selling the goods, etc.)
in an imperfect market there can be information asymmetry:
between customer and seller
one way to reduce problems is to give credit to allow for
returns if the customer is unhappy with the product
between seller and other potential lenders
seller deals with the same customers regularly, so can
have better information than a bank about bad credit risks
seller has better knowledge about the value of collateral
AFM 271 - Credit Management
Slide 2
Terms of Sale
“terms of sale” refers to the period for which credit is granted,
the cash discount, and the type of credit instrument (invoice,
promissory note, etc.—see text pp. 810-811)
typical credit terms for accounts receivable are 2/10, net 30;
this implies a significant cost to late payment
credit terms (and their effect on sales) determine the
profitability of extending credit
e.g. Home Carpet Inc. currently doesn’t extend credit to its
customers. If 2/10, net 30 terms were adopted, sales would
increase by 40%, with 40%, 30%, and 30% of customers paying
in 10, 30, and 50 days respectively. Revenues and expenses for
an average sale are $500 and $400. If the opportunity cost of
capital is 6%, should credit be granted?
AFM 271 - Credit Management
Slide 3
Cont’d
in general, we must also consider probability of
non-payment, e.g. what if the probability of
non-payment for overdue accounts is 75%?
clearly, as you gain information about customers (e.g.
previous payment history), you can make better credit
decisions
AFM 271 - Credit Management
Slide 4
Cont’d
e.g. BB Inc. currently provides no credit to its customers. Daily sales, variable costs (at
the present level of output), and fixed costs are $35,000, $24,500, and $8,000
respectively. The appropriate money market rate for an investment in short term
securities is 4% (compounded annually). BB is considering offering credit terms of
2/15, net 45. The firm expects that under this policy sales volume would increase by
10%. It is expected that 70% of sales would be collected 15 days after the sale. Some
of the remaining 30% of sales would be collected 45 days after the sale, and any
remaining uncollected sales would be written off as bad debts. What is the highest
value of bad debts as a percentage of total sales that would make it worthwhile for BB
to adopt this credit policy? (Assume that all sales will be made on a credit basis if the
new policy is adopted.)
AFM 271 - Credit Management
Slide 5
Optimal Credit Policy
a decision to grant credit is a trade-off between
carrying costs (delays in receiving cash, bad debts, costs of
managing credit)
opportunity costs (lost sales from reducing credit)
cost in $
level of credit extended
AFM 271 - Credit Management
Slide 6
Cont’d
in perfect markets, credit policy is inconsequential:
customers can borrow from any lender at the same rate, so
the credit policy of the firm has no impact on sales
no bad debts
in imperfect markets, the optimal policy depends on the
characteristics of the individual firm, e.g.:
does a firm have a cost advantage in extending credit?
is the firm lacking established reputation and trying to
attract customers?
does the firm have excess capacity, or low variable
operating costs?
does the firm have a stable, repeat customer base?
what is the nature of the firm’s product?
AFM 271 - Credit Management
Slide 7
Credit Analysis
firms gather information to evaluate likelihood of payment:
financial statements
credit reports on customer payment history with other firms
banks
customer’s payment history with the firm
typical credit worthiness evaluation criteria (the five Cs):
character (willingness to pay)
capacity (ability to pay from operating cash flow)
capital (ability to pay from capital reserves)
collateral (pledged asset in case of default)
conditions (economic conditions of customer’s line of
business)
“credit scoring” systems use these and similar criteria
AFM 271 - Credit Management
Slide 8
Collection Policy
“collection” refers to obtaining payment of past due accounts; it
may involve
sending past-due delinquency notices
calling the customer
employing a collection agency
taking legal action against the customer
collection analysis tools
day’s sales outstanding (a.k.a. day’s sales in receivables,
average collection period); e.g. ABC Corp. sells $3.2 million
of goods annually. Its accounts receivable balance is
$750,000. Calculate the average collection period.
AFM 271 - Credit Management
Slide 9
Cont’d
accounts receivable aging schedule, e.g. based on the
outstanding A/R data provided below, prepare the
company’s accounts receivable aging schedule
age (days)
amount o/s
0-30
17,000
30-60
10,000
60-90
8,000
> 90
5,000
total
40,000
% of total A/R
using average collection period and aging schedule
statistics:
statistics have limited use on their own
useful when compared to the firm’s own history and
similar companies and industries
these type of statistics can also be useful in bad debt
analysis
AFM 271 - Credit Management
Slide 10
Factoring
a factor is an independent firm which acts as a credit
department, handling aspects such as collection,
authorization, bookkeeping
the factor pays the firm the amount collected from
invoices less a discount as collections are made
late accounts must be paid by a specified date
legally, the factor purchases the accounts receivable
from the firm and so assumes the risk of bad debts
⇒ factoring is a form of insurance for bad debts
since factors do business with many firms, they can
attain scale economies such as diversification of credit
risks, more expertise in collection
AFM 271 - Credit Management
Slide 11