Financial Analysis, Planning and
Forecasting
Theory and Application
Chapter 19
Credit Management
By
Alice C. Lee
San Francisco State University
John C. Lee
J.P. Morgan Chase
Cheng F. Lee
Rutgers University
Outline

19.1 Introduction

19.2 Trade credit

19.3 The cost of trade credit

19.4 Financial ratios and credit analysis

19.5 Credit decision and collection policies

19.6 Summary
19.1 Introduction
19.2 Trade credit
ARt  ARt 1  AR  AR
N
t
0
t
（19-1）
Table 19-1
Aging of Accounts Receivable
January
Accounts Receivable
February
﹪ of Total
Accounts Receivable
﹪ of Total
＄ 250,000
25.0﹪
＄ 250,000
22.7﹪
31-60 days
500,000
50.0﹪
525,000
47.8﹪
61-90 days
200,000
20.0﹪
250,000
22.7﹪
50,000
5.0﹪
75,000
6.8﹪
＄1,000,000
100.0﹪
＄1,100,000
100.0﹪
0-30 days
Over 90 days
Total accounts
receivable
19.3 The cost of trade credit
 The
seller’s perspective
 The buyer’s perspective
19.3 The cost of trade credit
S 0 = Current sales =＄1 million per year.
S = Incremental sales =＄250,000.
V = Variable costs as a percentage of sales = 70 percent. includes the cost of
administering the credit department and all other costs except bad-debt losses
and financing costs (interest charges) associated with carrying the investment in
receivables. Costs of carrying inventories are included in .
1-V = Contribution margin = 30 percent or equivalently, the percentage of each sales dollar that
goes toward covering overhead and increasing profits.
k = The cost of financing the investment in receivables = 12 percents. k is the
firm’s cost of new capital when the capital is used to finance receivables.
ACP0= Average collection period prior to a change in credit policy = 20 days.
ACPN = New average collection period after the credit policy change = 30 days. In
this example, we assume that customers pay on time, thus ACP = specified
collection period).
19.3 The cost of trade credit
I  (increased investment in receivables associated with original sales)
 (additional investment in receivables associated with new sales)
 (change in collection period)(old sales per day)  V ( ACPN )
 (incremental sales per day)
 S0  
 S 
  ACPN  ACP0  
 V  ACPN  


360
360



 
 1, 000, 000  
 250, 000  
  30  20  
  .7  30  

360
360

 


 42,361
(19-2)
19.3The cost of trade credit
P   new sales  contribution margin     cost of carrying new receivables 
 S 1  V   k  I 
 $ 250,000(.3)  .12(42,361)
 $ 69,917
（19-3）
P   new sales  contribution margin    cost of carrying new receivables   (bad-debt losses)
 S 1  V   k  I   B  S 
 $ 250,000(.3)  .12(42,361)  .05($ 1,250,000)
 $ 7.417
（19-4）
19.4 Financial ratios and credit analysis
 Financial
ratio analysis
 Numerical credit scoring
 Benefits of credit-scoring models
 Outside sources of credit information
19.4 Financial ratios and credit analysis
(19-5)
Y  AX  BX
i
1i
2i
Table 19-2
Status and Index Values of the Accounts
Yi
Account Number
Account Status
7
Bad
.81
10
Bad
.89
2
Bad
3
Bad
1.45
6
Bad
1.64
12
Good
1.77
11
Bad
1.83
4
Good
1.96
1
Good
2.25
8
Good
2.50
5
Good
2.61
9
Good
2.80
1.30
19.4
Financial ratios and credit analysis
Figure19-1 Distributions of Good and Bad Accounts
Probability of Occurrence
Bad
Good
12
1.64 1.83
1.77 1.96
Discriminate Function
Value
19.4 Financial ratios and credit analysis
Fi  b1Y1  b2Y2 
Credit Score
from Scoring Model
－.200
 b jY j  bpYp
Cumulative Frequencies
“Goods”
0﹪
“Bads”
0﹪
.208
0
35
.226
2
36
.245
3
40
.356
6
58
.543
16
76
.577
17
82
.596
20
85
.699
34
97
.763
49
99
.898
75
100
1.200
100
100
(19-6)
19.4 Financial
ratios and credit
analysis
Figure 19-2
Key to Dun and
Bradstreet Ratings
19.5 Credit decision and collection policies
 Collection
policy
 Factoring and credit insurance
19.6 Summary
The subject of Chapter 19 is the management of trade credit for both buyer and
seller. For the buyer, the essential issue is to determine the cost of using trade
credit as a form of financing, then compare this cost with the cost of alternative
sources of capital. While some argue that accounts payable have no cost, we
support the arguments against this view. That is, for the buyer, trade credit
involves opportunity costs in the form of foregone discounts, implicit bankruptcy
costs for taking on too much accounts payable, and costs associated with the
timing of taxes and the accounting procedure used.
The grantor of trade credit, the seller, has a large array of decisions to make. The
first of these we discussed was determining the cost of granting trade credit. Next,
we examined a numerical credit-scoring method via linear discriminant analysis to
make the credit-granting decision more effective in terms of risk and related
collection and bad-debt costs. Finally, we discussed the other aspects of the
firm’s credit policy, including the decision of how much credit to grant, on what
terms, and the collection policy procedures to be pursued for delinquent accounts.
We noted that the evaluation of various collection policies can be viewed and
even carried out in the framework of a capital budgeting problem. Chapter 13
offer a number of methods to deal with the capital budgeting problem with
uncertainty, including（1）the risk-adjusted discount rate method,（2）the
certainty equivalent method,（3）the statistical distribution method, and（4）
various simulation methods.