21-1
Fundamentals
of Corporate
Finance
Second Canadian Edition
prepared by:
Carol Edwards
BA, MBA, CFA
Instructor, Finance
British Columbia Institute of Technology
copyright © 2003 McGraw Hill Ryerson Limited
21-2
Chapter 21
Credit Management and Collection
Chapter Outline
Terms of Sale
 Credit Agreements
 Credit Analysis
 The Credit Decision
 Collection Policy
 Bankruptcy

copyright © 2003 McGraw Hill Ryerson Limited
21-3
Introduction
• A/R
– A Valuable Asset
A few companies ask for cash on delivery
when they sell their goods.
 However, the majority allow a delay in
payment.
 The customers’ promises to pay for their
purchases constitute a valuable asset.

 It
appears on the balance sheet as
Accounts Receivable (A/R).
copyright © 2003 McGraw Hill Ryerson Limited
21-4
Introduction
• A/R



– A Valuable Asset
Additional customers will be attracted to firms
that offer the opportunity to buy on credit.
However, there is a cost to the seller who
provides this credit.
Good credit management involves balancing
the costs and benefits of giving the firm’s
customers credit.
 There
are a number of steps a financial
manager can follow, each of which will be
discussed in this chapter.
copyright © 2003 McGraw Hill Ryerson Limited
21-5
Terms of Sale
• The

Payment Terms
The terms of sale are the terms under which
your firm will sell its products.
 Does
it offer credit, or does it expect cash on
delivery (COD)?
 If the firm gives credit, how long will customers
have to pay their bills?
 Is the firm prepared to offer a cash discount for
prompt payment?
copyright © 2003 McGraw Hill Ryerson Limited
21-6
Terms of Sale
• The


Payment Terms
Terms of sale will vary from industry to industry,
but share similarities within industries.
The terms of sale include the following:
 The
seller must supply the buyer with a final
payment date.
 To encourage payment before that date, the
seller may offer a discount to the buyer for
prompt settlement.
 If a discount is offered, the seller must indicate
how long that discount will be available.
copyright © 2003 McGraw Hill Ryerson Limited
21-7
Terms of Sale
• The


Payment Terms
For example, a manufacturer may require
payment within 30 days, but offer a 5%
discount to customers who pay in 10 days.
These terms would be called 5/10, net 30:
5
percent discount
for early
payment
/
10,
Number of days
discount is
available
net 30
Number of days
before payment
is due
copyright © 2003 McGraw Hill Ryerson Limited
21-8
Terms of Sale
• A/R

as a Loan to Customers
A firm that buys on credit is in effect borrowing
from its supplier.
 It
will pay later for the products it receives.
 This is an implicit loan from the supplier.


We can calculate the implicit cost of this loan.
For example: a supplier offers your firm terms
of 3/10, net 30.
 If
your company forgoes the discount and pays
for a $100 order on the 30th day, what is the
effective interest rate for taking the extra days of
credit?
copyright © 2003 McGraw Hill Ryerson Limited
21-9
Terms of Sale
• A/R

as a Loan to Customers
The effective annual rate to the firm of
foregoing the discount is calculated as:
(
Discount
Effective Rate = 1+
Discounted Price
365
extra days credit
)
-1
copyright © 2003 McGraw Hill Ryerson Limited
21-10
Terms of Sale
• A/R



as a Loan to Customers
With terms of 3/10, net 30, if your company
forgoes the discount and pays on the 30th day,
the effective cost will be 74.3%!
That is, you obtain an extra 20 days of credit
by delaying payment from the 10th to the 30th
day.
If you had paid within 10 days, the cost of the
order would have been $97.
 By
delaying, you will pay $100, or $3 extra.
 Thus, the extra 20 days of credit costs $3/$97 or
3.09%, which must be compounded to get the
annual rate.
copyright © 2003 McGraw Hill Ryerson Limited
21-11
Terms of Sale
• A/R

as a Loan to Customers
The effective annual rate to the firm of
foregoing the discount is calculated as:
(
Discount
Effective Rate = 1+
Discounted Price
( )
$3
= 1+
$97
365
extra days credit
)
-1
365
20
-1
=
0.743 or 74.3%
copyright © 2003 McGraw Hill Ryerson Limited
21-12
Credit Agreements
• Creating

the Contract
When your firm gives credit to a customer,
what should it request as evidence that the
customer owes it money?
 Open
Account means that sales are made on
credit with no formal debt contract.
 A promissory note is a simple IOU from the
customer.
 A commercial draft is a an order to pay.
A cheque is an example of a commercial draft.
 It is your order to your bank to make a payment.

copyright © 2003 McGraw Hill Ryerson Limited
21-13
Credit Agreements
• Creating the Contract
 A sight draft is a draft which orders the
customer’s bank to make immediate payment.
 A time draft is a draft which orders the
customer’s bank to make payment in the future.
 When a bank receives a draft, it either pays up
or acknowledges the debt by adding the word
“accepted” and a signature.
 Once accepted, a draft is like a postdated
cheque and is called a trade acceptance.

A trade acceptance is forwarded to the seller who
holds it until the due date.
copyright © 2003 McGraw Hill Ryerson Limited
21-14
Credit Agreements
• Creating the Contract
 The seller can ask the customer to
arrange for his/her bank to accept the
time draft.
 In this case, the bank guarantees the
customer’s debt and the draft becomes
known as a banker’s acceptance.
 Banker’s acceptances are often used in
overseas trade.
 They are actively bought and sold in the
money market for short-term, high quality
debt.
copyright © 2003 McGraw Hill Ryerson Limited
21-15
Credit Analysis
• Measuring


Customer Reliability
Credit analysis is a procedure to determine
the likelihood a customer will pay its bills.
There are a number of ways to find out
whether customers are likely to pay their debts.
 Your
firm could look at the customer’s past credit
history with it.
 For new clients, your firm could use the services
of a credit agency, such as Dun & Bradstreet, to
provide reports on the potential customer’s
creditworthiness.
copyright © 2003 McGraw Hill Ryerson Limited
21-16
Credit Analysis
• Measuring Customer Reliability
 Your firm could ask its bank to perform a credit
check on the customer.

It would call the customer’s bank and ask for
information on their credit history.
 The
firm could check with the financial
community.

For a public firm, for example, your firm could
check its bond rating.
 For
corporate customers, your firm could
perform a financial ratio analysis on their
financial statements.
copyright © 2003 McGraw Hill Ryerson Limited
21-17
Credit Analysis
• Measuring

Customer Reliability
Credit management involves making a
judgment about what are often termed
the five C’s of credit:
 Customer’s
character.
 Customer’s capacity to pay.
 Customer’s capital.
 Collateral provided by the customer.
 Condition of the customer’s business.
copyright © 2003 McGraw Hill Ryerson Limited
21-18
Credit Analysis
• Measuring


Customer Reliability
Firms will try to streamline the process of
dealing with large volumes of credit data by
creating a scoring system for prescreening
credit applicants.
For example, if you apply for a credit card or a
bank loan, you will be asked about your job,
home, and financial position.
 The
information is used to calculate an overall
score.
 Applicants who do not make a minimum grade
may be refused credit or subjected to more
detailed analysis.
copyright © 2003 McGraw Hill Ryerson Limited
21-19
Credit Analysis
• Multiple


Discriminant Analysis
Multiple discriminant analysis is a technique
used to develop a measure of solvency known
at the Z Score.
The Z-Score is a formula that is able to identify
bankrupt firms with a high degree of accuracy:
Z= 3.3
EBIT
Total Assets
+1.4
Sales
+1.0
+0.6
Total Assets
Retained Earnings
Total Assets
+1.2
MV of Equity
Total Book Debt
Working Capital
Total Assets
copyright © 2003 McGraw Hill Ryerson Limited
21-20
Credit Analysis
• Measuring

Customer Reliability
Credit analysis is worthwhile only if the
expected savings exceed the costs.
 Don’t
undertake a full credit analysis unless the
order is big enough to justify it.

Don’t spend $200 to do a credit check for an order
with a maximum profit of $100.
 Undertake
a full credit analysis for the doubtful
orders only.
Only borderline applicants should be subject to a
full-blown credit check.
 Other applicants should be quickly accepted or
rejected.

copyright © 2003 McGraw Hill Ryerson Limited
21-21
The Credit Decision
• Setting


a Credit Policy
A credit policy is a set of standards for
determining the amount and nature of credit to
extend to customers.
If there is no probability of a repeat order, the
credit decision is very simple:
 The

firm can refuse credit and pass on the sale.
Thus, profit = 0.
 The
firm can offer credit.
If the customer pays, the firm benefits by the profit
margin.
 If the customer defaults, the firm loses the cost of
the goods delivered.

copyright © 2003 McGraw Hill Ryerson Limited
21-22
The Credit Decision
• Setting


a Credit Policy
You can see the decision tree for this problem
in Figure 21.1 on page 637 of your text.
The expected profit from the two sources of
action are as follows:
Refuse Credit: 0
Grant Credit: p x PV(Rev – Cost) – (1-p) x PV(Cost)

The firm should grant credit if the expected
profit from doing so is positive.
copyright © 2003 McGraw Hill Ryerson Limited
21-23
The Credit Decision
• Setting

a Credit Policy
If you set the “grant credit” equation to zero, then
the breakeven probability of collection is:
p=

PV(Cost)
PV(Revenue)
For example:


Cast Iron Company (CIC) earns revenues with a
present value of $1,200. The present value of its
costs are $1,000 on each non-delinquent sale.
Under what circumstances should CIC grant
credit?
copyright © 2003 McGraw Hill Ryerson Limited
21-24
The Credit Decision
• Setting

a Credit Policy
For CIC, the expected profit from the two
sources of action are as follows:
Refuse Credit: 0
Grant Credit: p x PV(Rev – Cost) – (1-p) x PV(Cost)
= p x PV(1,200-1,000) – (1-p) x PV(1,000)


Setting this equation equal to zero, means that
p = 5/6.
In other words, CIC should grant credit
whenever the chances of collection are better
than 5 out of 6.
copyright © 2003 McGraw Hill Ryerson Limited
21-25
The Credit Decision
• Setting

a Credit Policy
The above analysis assumes that the client
gives the firm only one order.
 What
happens to the credit decision if there is
the possibility of profitable repeat orders?

Under these circumstances, the PV(Rev-Cost)
increases substantially.
 Thus,
the firm can afford to accept a customer
who would have been unacceptable had there
been the potential for only one order.

Try Example 21.4 on page 638 of your text.
copyright © 2003 McGraw Hill Ryerson Limited
21-26
The Credit Decision
• Some

General Principles
Maximize profits
 As
a credit manager, you wish to maximize
profits, not minimize the number of bad
accounts.
 You must weigh the benefits of gaining an
additional sale against the losses from a
defaulting customer.
 If the expected margin of profit is high, then you
are justified in a liberal credit policy.
 If the margin of profit is low, you cannot afford
many bad debts.
copyright © 2003 McGraw Hill Ryerson Limited
21-27
The Credit Decision
• Some

General Principles
Concentrate on the Dangerous Accounts
 Do
not waste time analyzing every credit
decision.
 Most decisions will be a routine accept-reject.
Only the large and/or dubious decisions will
require a detailed credit analysis.
 Many companies set a credit limit for each
customer.
 The sales rep refers the order for approval only
if the customer exceeds this limit.
copyright © 2003 McGraw Hill Ryerson Limited
21-28
The Credit Decision
• Some

General Principles
Look beyond the immediate order
 Sometimes
it is worth accepting a marginal
customer if there is a likelihood that they will
become a regular and reliable buyer.
 Incurring bad debts is part of the cost of building
a good customer list.
copyright © 2003 McGraw Hill Ryerson Limited
21-29
Collection Policy
• The

Problem of Collecting
If credit is granted, the next problem is setting
a collection policy.
A
collection policy is the firm’s procedures to
collect and monitor its receivables.

Recognize that some clients are going to fail to
pay their bills on time.
 How

will you deal with them?
This question requires tact and judgment.
 You
need to be firm with delinquent customers,
but you do not wish to offend a client whose
cheque has merely been delayed in the mail.
copyright © 2003 McGraw Hill Ryerson Limited
21-30
Collection Policy
• The

Problem of Collecting
You will find it easier to spot troublesome
accounts if you keep a careful aging schedule
of outstanding accounts.
 An
aging schedule involves classifying the firm’s
accounts receivable by the time outstanding.
 An example of an aging schedule can be seen
in Table 21.1 on page 640 of your text.
copyright © 2003 McGraw Hill Ryerson Limited
21-31
Bankruptcy
• When


things go wrong …
What happens when a firm cannot pay its
creditors?
A firm that cannot meet its obligations can try
to arrange a workout with its creditors to
enable it to settle its debts.
A
workout is an agreement between a company
and its creditors establishing the steps the
company must take to avoid bankruptcy.

If the workout is unsuccessful, the firm may
have to declare bankruptcy.
copyright © 2003 McGraw Hill Ryerson Limited
21-32
Bankruptcy
• When

things go wrong …
Bankruptcy is the reorganization or
liquidation of a firm that cannot pay its
debts.
 Liquidation
involves the sale of the bankrupt
firm’s assets.
 The alternative to liquidation is
reorganization.
Reorganization is a restructuring of the financial
claims of the firm to allow it to keep operating.
 It involves keeping the firm as a going concern
and compensating the creditors with new
securities, including equity.

copyright © 2003 McGraw Hill Ryerson Limited
21-33
Bankruptcy
• When
things go wrong …
Restructurings are often successful and the
company re-emerges fit and healthy.
 However, other times it fails and the
company ends-up being liquidated.

 Ideally,
a firm should be worth more as a
going concern than it would be in liquidation.
 However, conflicts between the objectives of
keeping the company alive and protecting
the lenders can lead to the process failing.
copyright © 2003 McGraw Hill Ryerson Limited
21-34
Summary of Chapter 21

The first step in the credit management process
is to set the terms of sale.
 This
means you decide the length of the
payment period, the size of any discounts and
how long the discount will be available.
 Such terms are usually standardized by industry.

Your next step is to decide the form of the
contract with your customer.
 Most
domestic sales are on open account,
meaning there is no formal written contract of
the customer’s debt for the goods.
copyright © 2003 McGraw Hill Ryerson Limited
21-35
Summary of Chapter 21


The third step is to establish a procedure for
determining each client’s creditworthiness.
The fourth step is to establish a collection policy
to identify and pursue slow payers.
 This
requires tact and judgment: being firm with
delinquent clients without offending a client
whose cheque has been delayed in the mail.

Credit analysis is the process of deciding which
clients will pay their bills.
 There
are various sources of such client
information, including the firm’s own records,
credit agencies, banks and analyzing the
customer’s financial statements.
copyright © 2003 McGraw Hill Ryerson Limited
21-36
Summary of Chapter 21

The job of the credit manager is to maximize
profits, not to minimize the number of bad debts.
 You
must weigh the odds of payment, and making
a profit, against the odds of default and losses.
 It is often worthwhile accepting a marginal client if
there is a chance they will become a reliable and
regular customer.

When a customer fails to pay, solutions range
from a workout to bankruptcy.
 Bankruptcy
may involve reorganization or
liquidation.

Conflicts between parties, can lead to the usually
less desirable option of liquidation.
copyright © 2003 McGraw Hill Ryerson Limited