Credit Management

Credit Management
(Text reference: Chapter 29)
why credit exists
terms of sale
optimal credit policy
credit analysis
collection policy
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, information asymmetry exists:
between customer and seller
between seller and other potential lenders
Terms of Sale
“terms of sale” refers to the period for which credit is granted, the cash
discount, and the type of credit instrument
typical credit terms for accounts receivable are 2/10, net 30. Note that 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 OCC is
6%, should credit be granted?
in general, we must also consider probability of non-payment, e.g.
does your answer change 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
Optimal Credit Policy
a decision to grant credit is a trade-off between
– carrying costs
– opportunity costs
cost in $
level of credit extended
in perfect markets, credit policy is inconsequential (i.e. there is no optimal
credit policy):
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?
– etc.
Credit Analysis
firms gather information to evaluate likelihood of payment:
– financial statements
– credit reports on customer payment history with other firms (e.g. Dun &
Bradstreet Canada)
– banks
– customer’s payment history with the firm
typical credit worthiness evaluation criteria (the 5 C’s)
– 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)
systems have been developed based on these and similar criteria
Collection Policy
“collection” refers to obtaining payment of past due accounts
collection 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.
– 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
% 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
– note that these type of statistics can also be of use in bad debt
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
since factors do business with many firms, can attain scale economies