CREDIT MANAGEMENT
INTRODUCTION
 Which account is created when credit is granted?
 Account receivables
 What are the costs associated with granting a credit?
 The chance that the customer will not pay (Bad debts)
 Cost of Carrying the receivables (Financing receivables)
 Credit management examines the trade-off between increased sales and the cost of granting credit.
COMPONENTS OF CREDIT POLICY
Components of Credit Policy
Term of sale – cash or credit
Credit period
Cash discount and discount
period
Credit Analysis of the customers –
to whom we grant credit (good
customers) and to whom we don’t
extend our credit (Bad customers)
Collection Policy
Monitoring Receivables
When Should credit be
granted?
Collection Efforts
One time sale
Repeated sale
THE CASH FLOWS OF GRANTING CREDIT
Credit Sale
Check Mailed
Check Deposited
Cash Available
Cash Collection
Accounts Receivable
The distance between
each point would
differ across
companies
THE INVESTMENT IN RECEIVABLES
 What are the factors that decide the amount of investment in receivables
 Amount of credit sales
 Average collection period (ACP)
Account receivables = Average daily sales * Average collection period
TERM OF SALE
 As discussed term of sale are made up three elements:
 Credit Period (Period for which credit is granted)
 Cash Discount and discount period
 Type of Credit instrument – Basic evidence of indebtedness like promissory note, Commercial draft, sight
draft, time draft etc
 Basic Form: 2/10 net 60 (what does this mean?)
 This means that the customer has 60 days from the invoice date to pay the full amount; however, if
payment is made within 10 days, a 2 per cent discount can be taken.
CONTD..
 Total amount due in 60 days if discount not taken
 Buy $500 worth of merchandise with the credit terms given above.
 Pay $500(1 − .02) = $490 if you pay in 10 days
 Pay $500 if you pay in 60 days
 Credit Period – Length of time for which credit is granted – it varies widely from industry to industry
– if a cash discount is offered, then the credit period has two components:
 net credit period and
 cash discount period (in the above case, it is 60 days and 10 days, respectively).
 Finding the implied interest rate
 Credit terms of 2/10 net 45
 Period rate = Discount rate/(1- discount rate) = 0.02/(1-0.02) = 2.0408%
 The discount percentage is 2%, meaning if the buyer pays early, they only need to pay 98% of the
total invoice.
 The denominator (1 - Discount%) = 1 - 0.02 = 0.98 represents the amount paid if the discount is
taken.
 Period = (45 − 10) = 35 days
 365/35 = 10.4286 periods per year
 EAR = (1+Periodic rate)m - 1
 EAR = (1+.020408)365/35 − 1 = 23.45%
QUESTION
 Allice Corporation sells earnings forecast for Delhi trading corporation. Its credit terms are 2/10 net 30.
Based on corporation experience 70 percent of all its customers take the discount. Assume 365 days a
year. You are required to calculate the average collection period for the corporation? And if the
company sells 1080 earning forecasts every month at a price of ₹ 2040 each. What is its average
balance sheet amount in accounts receivables?
QUESTON
 Information provided
 Credit Terms – 2/10 net 30
Average collection period
 % customers take discount – 70%
.70(10)+.30(30)
 Number of forecast company sells every month-
7+ 9 = 16 days
1080
 Cost of each forecast - 2040
Average balance sheet account in receivable
1080(2040)(16)(12/365)
35,251,200(12/365)
 What is the average collection period?
423,014,400/365
 What is the average balance sheet accounts in
1,158,943.5616
receivables?
QUESTION
 ABC Incorporation sells 5,750 units of its perfume collection each year at a price per unit ₹ 445. All
sales are on credit with terms of 1/10 net 40. The discount is taken by 35 percent of the customers.
 What is the total amount of company receivables?
 As company faces competition from its peers, ABC Incorporation is considering a change in its credit
policy to terms of 2/10, net 30 to preserve its market share.
 How will this change in policy affects account receivables?
 Total credit sales = 5750*445 = ₹ 2,558,750
 Information Provided
 Yearly sales = 5,750 units
 Price per unit = ₹ 445
 Terms of credit sales = 1/10 net 40
 % customer avail discount = 35%
 If change in policy due to peer competition
 New term of sale = 2/10 net 30
 Average collection period = .35*(10) + .65(40)
= 29.50 days
 Receivable turnover = 365/average collection
period
= 365/29.50
=12.37 times
 Average Receivables = Credit sales/Average
receivables turnover
= 2,558,750/12.37
=
206,803.08
PART B IF CREDIT TERM CHANGES
 Total credit sales = 5750*445 = ₹ 2,558,750
 Average collection period = .35*(10) + .65(30) = 23 days
 Receivable turnover = 365/average collection period
= 365/23
=15.86 times
 Average Receivables = Credit sales/Average receivables turnover
= 2,558,750/15.86
=
161,333.54
Part C - If the corporation increases the cash discount, many people will take the discount and pay sooner,
which leads to lower in the average collection period and when the average collection period declines,
receivable turnover increases, which leads to a decrease in average receivables
CREDIT POLICY EFFECT
 Granting credit makes sense only if the NPV from doing so is positive
 Revenue Effects
 Delay in receiving cash from sales
 May be able to increase the price
 May increase total sales
 Cost Effects
 The cost of the sale is still incurred even though the cash from the sale has not been received.
 Cost of debt – must finance receivables
 Probability of nonpayment – some percentage of customers will not pay for products purchased
 Cash discount – some customers will pay early and pay less than the full sales price
SOME FORMULA'S
 Incremental Cash Flows
= (P – V) (Q`-Q)
 PV of Incremental Cash Flows = [(P – V) (Q`-Q)]/R
 Cost of Switching = PQ +V (Q`-Q)
 NPV of Switching = - [PQ +V (Q`-Q)] +[(P – V) (Q`-Q)]/R
EXAMPLE: EVALUATING A PROPOSED POLICY PART - I
 Your company is evaluating a switch from a cash only policy to a net 30 policy. The price per unit is
$100, and the variable cost per unit is $40. The company currently sells 1,000 units per month. Under
the proposed policy, the company expects to sell 1,050 units per month. The required monthly return is
1.5%.
 What is the NPV of the switch?
 Should the company offer credit terms of net 30?
EVALUATING A PROPOSED POLICY PART –II (NPV OF SWITCHING)
 Incremental cash inflow

(P-V) (Q`-Q)
 (100 − 40)(1,050 − 1,000) = 3,000
 Information Provided
 Present value of incremental cash inflow
 P= ₹100

 V= ₹ 40
 3,000/.015 = 200,000
 Q= 1000 units
C/r
 Cost of switching
 Q` = 1050 units

 R = 1.5 percent
 100(1,000) + 40(1,050 − 1,000) = 102,000
PQ +V(Q`-Q)
 NPV of switching

NPV of Switching = PV of Incremental Cash flows – Cost of switching or

-[PQ+V(Q`-Q)] + [(P-V)(Q`-Q)]/R
 200,000 − 102,000 = 98,000
 Yes, the company should switch.
BREAK EVEN ANALYSIS
 Q.14
 The Key variable in the previous question is the Q`-Q, the increase in the sale. The projected increase of 10 units is
only an estimate, so there is some forecasting risk. Under these circumstances, it is important to find out what
increase in unit sales is necessary to break even.
 In the previous question, the NPV of the switch was defined as
 NPV = -[PQ+V(Q`-Q)] + [(P-V)(Q`-Q)]/R
 From this, we can explicitly calculate the Break-even point by setting the NPV = 0 and solving for (Q`-Q)
NPV =0 = -[PQ+V(Q`-Q)] + [(P-V)(Q`-Q)]/R
PQ = -V(Q`-Q) +[(P-V)(Q`-Q)]/R
PQ = (Q`-Q) * [((P-V)/R)-V]
(Q`-Q) = PQ/[((P-V)/R)-V]
OPTIMAL CREDIT POLICY
 The optimal amount of credit is determined by the point at which the incremental cash flows from
increased sales are exactly equal to the incremental cost of carrying the increase in investment in
account receivables.
 The total credit cost curve
 The trade-off between granting credit and not granting credit is not hard to identify, but it is difficult to
quantify precisely.
TOTAL COST OF GRANTING CREDIT
 To begin, the carrying cost associated with granting credit comes in three forms
 Required return on receivables
 Losses from bad debts
 Costs of managing credit and collections
 Shortage costs (opportunity cost)
 Lost sales due to a restrictive credit policy
 Total cost curve
 Sum of carrying costs and shortage costs
 Optimal credit policy is where the total cost curve is minimized.
CREDIT ANALYSIS
 It refers to the process of deciding whether or not to extend credit to a particular customer. It usually
involves two steps :
 Gathering relevant information and
 Determning creditworthiness
ONE TIME SALE
NPV = −v + (1 − )P/(1 + R)
P = Price Per Unit
V = Variable Cost
R = Required return on receivables
The probability of customer default is . So (1- ) is the probability of the customers that pay
 Your company is considering granting credit to a new customer. The variable cost per unit is $50; the
current price is $110; the probability of default is 15%; and the monthly required return is 1%.
NPV = −50 + (1 − .15)(110)/(1.01) = ₹42.57
 What is the break-even probability?
NPV = 0 = −50 + (1 − )(110)/(1.01)
 = .5409 or 54.09%
REPEAT CUSTOMER
 NPV = −v + (1 − )(P − v)/R
 In the previous example, what is the NPV if we are looking at repeat business?
 NPV = −50 + (1 − .15)(110 − 50)/.01 = 5,050
 Repeat customers can be very valuable (hence the importance of good customer service).
 It may make sense to grant credit to almost everyone once, as long as the variable cost is low relative to
the price.
 If a customer defaults once, you don’t grant credit again.
 XYZ Ltd. is a wholesaler that stocks the hardware components of computers and tests software for
testing the performance of the computer. A new customer has placed an order for eight hardware
components for increasing the performance of their computers The variable cost is ₹1568 per unit, and
the credit price is ₹1840 each. Credit is extended for one period, and based on historical experience,
payment for about 1 out of every 200 such orders is never collected. The required return is a 2 percent
period.
 A Assuming that this is a one-time order, should it be filled? The customer will not buy if credit is not
extended
 What is the break-even probability of default in part (a)
 Suppose that customers who don’t default become repeat customers and place the same order every
period forever. Further, assume that repeat customers never default. Should the offer be filled? What is
the break-even probability of default?
a. If it is a one-time customer
NPV = −v + (1 − )P/(1 + R)
b. Break even default probability
NPV = 0 = –1,568 + (1 – )(1,840)/1.02
NPV = –1568 + (1 – .005)(1840)/1.02
-1,568 * (1.02) = (1 – )(1,840)
NPV = -1568 +(0.995)(1840)/1.02
-1,599.36 = (1 – )(1,840)
NPV = -1568 +1,830/1.02
(1 – ) = -1599.36/ 1,840
NPV = -1568 + 1,803.92
(1 – ) = 0.8692
NPV = 226.9019
 = 1-0.8692
(The company should fill the order)
 = 0.1307
The company should not accept the orders if the
default probability is higher than 13.07%
 D: what is the break even default probability
 C. If the customer is a repeat customer
 NPV = −v + (1 − )(P − v)/R
 NPV = –1,568 + (1 – .005)($1840 – 1568)/.02
 NPV = –1,568 +(0.995)(272)/.02
 NPV = - 1,568 +270.64/.02
 NPV = 0 = –1,568 + (1 – )(1,840 – 1,568)/.02
 -1,568 = (1 – )(272)
 -1,568*.02
= (1 – ) (272)
 -31.36 = (1 – ) (272)
 NPV = -1,568 + 13,532
 (1 – ) = 31.36/ 272
 NPV = 11,964

 The company should fill the order
  = 0.8847
 = 1- 0.1152
The company would not accept the order if the default
probability is higher than 88.47 percent
CREDIT INFORMATION
 Financial statements – Firm can ask a customer to supply its financial statements
 Credit reports with customer’s payment history to other firms
 Banks – banks provide some assistance to their business customers
 Payment history with the company
FIVE C’S OF CREDIT
1.
Character – willingness to meet financial obligations
2.
Capacity – ability to meet financial obligations out of operating cash flows
3.
Capital – financial reserves
4.
Collateral – assets pledged as security
5.
Conditions – general economic conditions related to customer’s business
Credit scoring is the process of calculating a numerical rating for a customer based on information
collected, credit is then granted or refused based on the results
Credit card issuers have developed statistical models for credit scoring
CREDIT PERIOD
 Factors influence length of credit period – Several factors influence the length of the credit period,
but two important ones are the buyer inventory period and operating cycle – Cetris peribus, the
shorter these, the shorter the credit period.
COLLECTION POLICY – MONITORING RECEIVABLES
 To keep track of payments by customers, most firms will monitor outstanding accounts
 1. a firm normally keeps track of its average collection period through time. For seasonal business,
ACP fluctuates over time, but unexpected ACP is a cause of concern.
 2. The ageing schedule is a second basic tool for monitoring receivables
Age of Accounts
Amount
% of Total value of
Account Receivables
0-15 days
70,000
40%
16- 65 days
30,000
35%
66-80 days
25,000
20%
80 days and above
10,000
5%
COLLECTION EFFORTS
 A firm usually goes through the following sequence of procedures for customers whose payments are
overdue
 It sends out a delinquency letter informing the customer of the past due status of the account
 It makes a telephone call to the customer
 It employs a collection agency
 It takes a legal action against the customer