CREDIT MANAGEMENT
The Cash Flows of Granting Credit
Credit sale
is made
Customer
mails check
Firm
deposits
check
Bank credits
firm’s
account
Time
Cash collection
Accounts receivable
COSTS & BENEFITS OF
CREDIT MANAGEMENT
 OPPORTUNITY COST
 COLLECTION COST
 BAD DEBTS
 INCREASED SALES
 INCREASE IN MARKET SHARE
 INCREASE IN PROFITS
TERMS OF PAYMENT
• Cash Mode
• Bill of Exchange
• Letter of Credit
• Consignment
CREDIT POLICY VARIABLES
The important dimensions of a firm’s credit policy are:
• Credit standards
• Credit period
• Cash discount
• Collection effort
CREDIT STANDARDS
Liberal
Stiff
• Sales
Higher
Lower
• Bad debt loss
Higher
Lower
• Investment
Larger
Smaller
Higher
Lower
in receivables
• Collection costs
IMPACT ON RESIDUAL INCOME
OF RELAXATION
P = [S(1 – V) - Sbn] (1 – t ) – k  I
where P = change in Profit
S = increase in sales
V = ratio if variable costs to sales
bn = bad debt loss ratio on new sales
t
= corporate tax rate
I = increase in receivables investment
Q.PSD Ltd. is considering relaxing its credit standards.
S = Rs.15 million, bn = 0.10, V = 0.80,
ACP = 40 days, k = 0.10, t = 0.4
P = [15,000,000 (1 – 0.80) – 15,000,000 x 0.10] (1 – 0.4)
15,000,000
– 0.10 x
x 40 x 0.80
360
= Rs.766,667
CREDIT PERIOD
Longer
Shorter
• Sales
Higher
Lower
• Investment in
Larger
Smaller
Higher
Lower
receivables
• Bad debts
IMPACT ON RESIDUAL
INCOME OF LONGER CREDIT PERIOD
P = [S(1 – V) - Sbn] (1 – t ) – k  I
INCREASE IN RECEIVABLES INVESTMENT
I = (ACPn – ACP0)
S
S0
+ V (ACPn)
360
where:
I
360
= increase in receivables investment
ACPn = new average collection period (after lengthening
the credit period)
ACP0 = old average collection period
V
S
= ratio of variable cost to sales
= increase in sales
Q. X Limited is considering extending its credit period from
30 to 60 days.
S = Rs.50 million, S = Rs.5 million, V = 0.85, bn = 0.08,
k = 0.10, t = 0.40
P = [5,000,000 x 0.15 – 5,000,000 x 0.08] (0.6)
50,000,000
5,000,000
– 0.10 (60 – 30) x
+ 0.85 x 60 x
360
360
= [750,000 – 400,000] (0.6) – 0.10 [4,166,667 + 708,333]
= – 277,500
LIBERALISING THE CASH DISCOUNT POLICY
P = [S(1 – V) - DIS] (1 – t ) + k  I
DECREASING THE RIGOUR OF COLLECTION PROGRAMME
RI = [S(1 – V) - BD] (1 – t ) – k  I
Cash Discounts
• Often part of the terms of sale
• There is a tradeoff between the size of the
discount and the increased speed and rate of
collection of receivables.
• An example would be “3/10, net 30”
– The customer can take a 3% discount if s/he pays
within 10 days.
– In any event, s/he must pay within 30 days.
The Interest Rate Implicit in 3/10,
net 30
A firm offering credit terms of 3/10, net 30 is essentially offering their
customers a 20-day loan.
To see this, consider a firm that makes a $1,000 sale on day 0.
Some customers will pay on day 10 and take the discount.
$970
0
10
30
Other customers will pay on day 30 and forgo the discount.
$1,000
0
10
30
Calculation of Cost of Cash Discount
Rate of discount x No. of days in a year
1- Rate of discount (Credit period-Discount
period)
Credit terms
2/10 Net 30
2/10 Net 45
1/10 Net 60
2/15 Net 30
Cost of trade credit(%)
36.72
20.99
18.18
48.98
28.3 Optimal Credit Policy
Costs in
dollars
Total costs
Carrying
Costs
Opportunity costs
C*
Level of credit extended
At the optimal amount of credit, the incremental cash
flows from increased sales are exactly equal to the
carrying costs from the increase in accounts receivable.
TRADITIONAL CREDIT ANALYSIS
Five Cs of Credit
Character : The willingness of the customer to honour
his obligations
Capacity
: The operating cash flows of the customer
Capital
: The financial reserves of the customer
Collateral
: The security offered by the customer
Conditions : The general economic conditions that
affect the customer
Case History : Checking customers past transaction to extend credit to
the customer
MONITORING OF ACCOUNTS RECEIVABLES
• RECEIVABLES TURNOVER
• AVERAGE COLLECTION PERIOD (ACP)
• AGEING SCHEDULE
• COLLECTION MATRIX
RECEIVABLES TURNOVER
• How quickly RECEIVABLES are CONVERTED in
to CASH
Receivables Turnover Rate
= Total Net Sales
Avg. Debtors*
(*including Bills Receivables)
AVERAGE COLLECTION PERIOD (ACP)
•
•
•
•
Time (no. of Days)
the Credit Sales
are converted
In to Cash
ACP= 365/ Receivables Turnover
AGEING SCHEDULE
• Statement showing
• AGE WISE GROUPING OF DEBTORS
OR
• Breaking up of Debtors
• according to the LENGTH OF TIME
• for which they have been OUTSTANDING
Age Group
(in Days)
Amount Outstanding
(Rs.)
Percentage of Debtors
to Total Debtors
Less Than 30
40,00,000
40
31-45
20,00,000
20
46-60
30,00,000
30
Above 60
10,00,000
10
Total
1,00,00,000
100
COLLECTION MATRIX
•
•
•
•
Shows
the collection pattern (in months)
for the CREDIT SALES
made in a month
Percentage of Receivables
Collected During the
Month of sales
First following month
Second following month
Third following month
Fourth following month
January
Sales
13
42
33
12
-
February
Sales
14
35
40
11
-
March
Sales
April
Sales
May
Sales
June
Sales
15
40
21
24
-
12
40
24
19
5
10
36
26
24
4
9
35
26
25
5
Factoring
• The sale of a firm’s accounts receivable to a
financial institution (known as a factor)
• The firm and the factor agree on the basic
credit terms for each customer.
Customers send
payment to the
factor.
Customer
The factor pays an agreedupon percentage of the
accounts receivable to the
firm. The factor bears the
risk of nonpaying
Factor
customers.
Goods
Firm
TYPES OF FACTORING
TYPES/ Service
Short term finance
Sales Ledger
Administration
Credit Protection
Recourse
Yes
Yes
No
Non Recourse
Yes
Yes
Yes
Maturity
No
Yes
No
Invoice Discounting
Yes
No
No