CHAPTER 6
Credit
Management
Chapter Outline
 Credit and Receivables
 Components of Credit Policy
 Investment in Receivables
 Credit Policy Evaluation
 Optimal Credit Policy
Credit
 What is “credit sale”?
 Why do firms have “credit sales”?
 Are there any risks to “credit sales”?
 What is the trade-off of “credit sales”?
 Accounts receivable & trade credit
Components of Credit Policy
 Terms of sale
(credit periods, cash discounts & period)
 Credit analysis
(probability of payment and default)
 Collection policy
(how to collect)
Cash Flow from Granting Credit
Speed up the collection float!
Investment in Receivables
 What would the investment depend on?
 Kıyılar Balıkçılık:
Average collection period = 30 days
Credit sales per day = 1,000,000 TL
Accounts Receivable balance?
Terms of Sale
 Credit period
 Cash discount
 Discount period
 Type of credit instrument
 Within industry & accross industries
The Basic Form
 2/10 net 60
 Purchase of 1,000,000 TL by Uşak Tarım
What are the options?
 5/10 net 45
The Credit Period
 Credit Period: length of time for which credit
is granted
 Industry variation
30-120 days
 Cash discount:
- net credit period
- cash discount period
The Credit Period
 Invoice: A bill for goods or sevices provided by
the seller to the purchaser
 Invoice date: beginning of the credit period
- Billing or shipping date
- Receipt of goods
- End of month (constant purchases)
Length of Credit Period
 Affecting Factors:
-buyer’s inventory period
-operating cycle of the buyer
-perishability: more perishable=>shorter
-consumer demand:
established products => shorter
new products=> longer
Length of Credit Period
-cost: lower => shorter
-credit risk: higher=>shorter
-size of the acocunt: smaller=>shorter
-competition: higher=>longer
-customer type: customer differentiation
Cost of the Credit
 2/10 net 30?
Is the 2 % high enough to pay early?
 Çelik Üretim:
Buys worth 1,000,000 on credit
If not paid early?
Cost?
 Credit Instrument: Evidence of Indebtedness
Evaluating a Credit Policy
 Local Producer:
-currently sells for cash only
-considering net 30 sales
-Price = 49 TL Variable cost = 20 TL
-Current quantity sold (Q) = 100 units/month
-Future quantity to sell (Q*) = 110 u/month
-No discounts/no taxes/no default risk
-Should they switch?
Evaluating a Credit Policy
 Current monthly sales =
Variable cost =
Total cash flow =
Fixed costs?
Future monthly sales =
Total cash flow =
Monthly change =
Evaluating a Credit Policy
 Interest rate = 2 % monthly
 PV of monthly 290 =
 Costs?
 Extra variable cost =
Uncollected amount =
Total cost of this month =
Why only this month?
SWITCH or NOT?
Optimal Credit Policy
 Cashflow of increased sale
=
Carrying costs of credit
 Carrying costs:
* required return on receivables
* losses from bad debt
* costs of credit management & collection
 Opportunity costs (forgone sales)
Optimal Credit Policy
 Credit cost curve =
(carrying costs, opp. costs of forgone sales)
 Below optimal => ???
Over optimal => ???
Optimal Credit Policy
Customer Credit Analysis
 ONE TIME SALE:
Customer wants to buy 1 unit on credit at P.
No credit => no sale
Credit => pay in 1 month or default
Default probability => π
One time sale
Required return on acc. rec. => R
Variable cost => v
GRANT CREDIT?
Customer Credit Analysis
 ONE TIME SALE:
If credit granted:
Cash outflow? When?
Cash inflow? When?
v=20 P=49 R=%2 π=20 %
NPV?
GRANT CREDIT?
BREAK EVEN DEFUALT PROBABILITY?
Customer Credit Analysis
 REPEAT BUSINESS:
If new customer does not default at first
=> never defaults (assumption)
cost v this month
if no default=> P next month
If customer pays=>cycle goes on forever
Customer Credit Analysis
 REPEAT BUSINESS:
PV of every month’s sale?
First month’s cost?
NPV of extending credit?
GRANT CREDIT?
Customer’s 5 C’s
 Character
 Capacity
 Capital
 Collateral
 Conditions
Policy Change Example
 EGE Chemicals:
Annual Sales
Receivable Turnover
Doubtful Rec.
Current Policy
5,000,000
4
450,000
 R=25 %
 Varible cost=70 % of sales
 All sales are on credit
 ADOPT A NEW POLICY???
Policy I
6,000,000
3
600,000
Policy II
6,750,000
2.4
750,000
Policy Change Example
 EGE Chemicals:
Annual Sales
Receivable Turnover
Doubtful Rec.
Average Receivables
Current Policy
5,000,000
4
450,000
?
Policy I
6,000,000
3
600,000
?
 Compare marginal costs vs. benefits
 Ignore fixed costs?
Policy II
6,750,000
2.4
750,000
?
Policy Change Example
 Policy I
Marginal Benefit
Sales increase
Profit increase
Doubtful sale inc.
Net profit increase
Marginal Cost
Acc. rec. increase
Invest. in acc. rec.
Cost of marginal inc.
 NET BENEFIT???
Policy Change Example
 Policy II
Marginal Benefit
Sales increase
Profit increase
Doubtful sale inc.
Net profit increase
Marginal Cost
Acc. rec. increase
Invest. in acc. rec.
Cost of marginal inc.
 NET BENEFIT??? ANY POLICY CHANGES???
END OF CHAPTER