Credit Management. Chapter. PART Seven Terms of the Sale. Credit Period KEY NOTATIONS

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1 _ Chapter Credit Management 28 PART Seven C P Q R B KEY NOTATIONS Cost per unit Price received per unit Quantity sold Discount rate In any sale, one of the most important decisions made by the seller is whether to grant credit and, if credit is granted, the terms of the credit sale. As with many other decisions, there is variation from company to company, but credit policies tend to be similar within industries. One way to examine a company s credit policy is to look at the days sales in receivables, or the length of time from the sale until the company is paid. In 2009 the receivables period for a typical firm in Europe was about 35 days, or a little over a month. For some firms the period is much shorter. For example, British retailer Sainsbury s was about five days and Tesco s was about nine days. Although both firms have operations in several industries, neither routinely grants credit to its customers, and so these numbers come as no surprise. In contrast, in the pharmaceutical business, credit periods are longer. Sanofi-Aventis, for example, had a credit period of about 65 days in 2007 (see Chapter 26). In this chapter we examine how a firm sets its credit policy, including when to grant credit and for how long Terms of the Sale The terms of sale refer to the period for which credit is granted, the cash discount, and the type of credit instrument. For example, suppose a customer is granted credit with terms of 2/10, net 30. This means that the customer has 30 days from the invoice date within which to pay. 1 In addition, a cash discount of 2 per cent from the stated sales price is to be given if payment is made in 10 days. If the stated terms are net 60, the customer has 60 days from the invoice date to pay, and no discount is offered for early payment. When sales are seasonal, a firm might use seasonal dating. O.M. Scott and Sons is a manufacturer of lawn and garden products with a seasonal dating policy that is tied to the growing season. Payments for winter shipments of fertilizer might be due in the spring or summer. A firm offering 3/10, net 60, 1 May dating, is making the effective invoice date 1 May. The stated amount must be paid on 30 June, regardless of when the sale is made. The cash discount of 3 per cent can be taken until 10 May. A trade or account receivable is created when credit is granted; a trade or account payable is created when a firm receives credit. These accounts are illustrated in Fig The term trade credit refers to credit granted to other firms. _ Credit Period Credit periods vary between different industries. For example, a jewellery store may sell diamond engagement rings for 5/30, net 4 months. A food wholesaler, selling fresh fruit and produce, might use net 7. Generally, a firm must consider three factors in setting a credit period:

2 Terms of the Sale 767 FIGURE 28.1 Firm s customer Trade receivable Trade payable Trade credit extended to a customer by a firm appears as a trade receivable. Trade credit extended by the firm s supplier to the firm appears as a trade payable. Figure 28.1 Trade credit Firm Firm s supplier FIGURE 28.2 Credit sale is made. Customer mails cheque. Firm deposits cheque in bank. Bank credits firm s account. Time Cash collection Trade receivables Figure 28.2 The cash flows of granting credit 1 The probability that the customer will not pay: A firm whose customers are in high-risk businesses may find itself offering restrictive credit terms. 2 The size of the account: If the account is small, the credit period will be shorter. Small accounts are more costly to manage, and small customers are less important. 3 The extent to which the goods are perishable: If the collateral values of the goods are low and cannot be sustained for long periods, less credit will be granted. Lengthening the credit period effectively reduces the price paid by the customer. Generally, this increases sales. Figure 28.2 illustrates the cash flows from granting credit. Cash Discounts Cash discounts are often part of the terms of sale. One reason for offering them is to speed up the collection of receivables. The firm must trade this off against the cost of the discount. Credit Policy EXAMPLE Edward Manalt, the chief financial officer of Ruptbank, is considering the request of the 28.1 company s largest customer, who wants to take a 3 per cent discount for payment within 20 days on a 10,000 purchase. In other words, he intends to pay 9,700 [= 10,000 (1 0.03)]. Normally, this customer pays in 30 days with no discount. The cost of debt capital for Ruptbank is 10 per cent. Edward has worked out the cash flow implications illustrated in Fig He assumes that the time required to cash the cheque when the customer receives it is the same under both credit arrangements. He has calculated the present value of the two proposals:

3 _ 768 Chapter 28 Credit Management Current policy: 10, 000 PV = 1+ ( ) = 9, Proposed policy: 9, 700 PV = 1+ ( ) = 9, His calculation shows that granting the discount would cost Ruptbank (= 9, ,647.14) in present value. Consequently, Ruptbank is better off with the current credit arrangement. FIGURE 28.3 Current credit terms (net 30) 10,000 Proposed credit terms (3/20, net 30) Days Sale date 9,700 Receive cheque Current situation: Customers usually pay 30 days from the sale date and receive no discount. Proposed situation: Customer will pay 20 days from the sale date at a 3 per cent discount from the 10,000 purchase price. Days Sale date Receive cheque Figure 28.3 Cash flows for different credit terms In the previous example we implicitly assumed that granting credit had no side effects. However, the decision to grant credit may generate higher sales and involve a different cost structure. The next example illustrates the impact of changes in the level of sales and costs in the credit decision. More Credit Policy EXAMPLE Suppose that Ruptbank has variable costs of 0.50 per 1 of sales. If offered a discount of per cent, customers will increase their order size by 10 per cent. This new information is shown in Fig That is, the customer will increase the order size to 11,000 and, with the 3 per cent discount, will remit 10,670 [= 11,000 (1 0.03)] to Ruptbank in 20 days. It will cost more to fill the larger order because variable costs are 5,500. The net present values are worked out here: Current policy: _ 10, 000 NPV = 5, ( / 365) = 4,

4 Terms of the Sale 769 Proposed policy: 10, 670 NPV = 5, ( ) = 5, Now it is clear that the firm is better off with the proposed credit policy. This increase is the net effect of several different factors, including the larger initial costs, the earlier receipt of the cash inflows, the increased sales level, and the discount. FIGURE 28.4 Current credit terms (net 30) Sale date 10,000 Days ,000 (variable order costs) Cheque received Proposed credit terms (3/20, net 30) Sale date 10,670 Days ,500 (variable order costs) Cheque received Figure 28.4 Cash flows for different credit terms: the impact of new sales and costs Credit Instruments Most credit is offered on open account. This means that the only formal credit instrument is the invoice, which is sent with the shipment of goods, and which the customer signs as evidence that the goods have been received. Afterwards, the firm and its customers record the exchange on their accounting books. At times, the firm may require that the customer sign a promissory note or IOU. This is used when the order is large and when the firm anticipates a problem in collections. Promissory notes can eliminate controversies later about the existence of a credit agreement. One problem with promissory notes is that they are signed after delivery of the goods. One way to obtain a credit commitment from a customer before the goods are delivered is through the use of a commercial draft. The selling firm typically writes a commercial draft calling for the customer to pay a specific amount by a specified date. The draft is then sent to the customer s bank with the shipping invoices. The bank has the buyer sign the draft before turning over the invoices. The goods can then be shipped to the buyer. If immediate payment is required, it is called a sight draft. Here, funds must be turned over to the bank before the goods are shipped. Frequently, even a signed draft is not enough for the seller. In this case she might demand that the banker pay for the goods and collect the money from the customer. When the banker agrees to do so in writing, the document is called a banker s acceptance. That is, the banker

5 _ 770 Chapter 28 Credit Management accepts responsibility for payment. Because banks generally are well-known and well-respected institutions, the banker s acceptance becomes a liquid instrument. In other words, the seller can then sell (discount) the banker s acceptance in the secondary market. A firm can also use a conditional sales contract as a credit instrument. This is an arrangement where the firm retains legal ownership of the goods until the customer has completed payment. Conditional sales contracts are usually paid off in instalments and have interest costs built into them The Decision to Grant Credit: Risk and Information Locust Industries has been in existence for two years. It is one of several successful firms that develop computer programs. The present financial managers have set out two alternative credit strategies: the firm can offer credit, or the firm can refuse credit. Suppose Locust has determined that if it offers no credit to its customers, it can sell its existing computer software for $50 per program. It estimates that the costs to produce a typical computer program are $20 per program. The alternative is to offer credit. In this case customers of Locust will pay one period later. With some probability, Locust has determined that if it offers credit, it can charge higher prices and expect higher sales. Strategy 1: Refuse Credit If Locust refuses to grant credit, cash flows will not be delayed, and period 0 net cash flows, NCF, will be P 0 Q 0 C 0 Q 0 = NCF The subscripts denote the time when the cash flows are incurred, where P 0 is the price per unit received at time 0, C 0 is the cost per unit paid at time 0, and Q 0 is the quantity sold at time 0. The net cash flows at period 1 are zero, and the net present value to Locust of refusing credit will simply be the period 0 net cash flow: NPV = NCF For example, if credit is not granted and Q 0 = 100, the NPV can be calculated as ($50 100) ($20 100) = $3,000 Strategy 2: Offer Credit Alternatively, let us assume that Locust grants credit to all customers for one period. The factors that influence the decision are listed here: Strategy 1: Refuse credit Strategy 2: Offer credit Price per unit P 0 = 50 P 0 = 50 Quantity sold Q 0 = 100 Q 0 = 200 Cost per unit C 0 = 20 C 0 = 25 Probability of payment h = 1 h = 0.90 Credit period 0 1 period Discount rate 0 R B = 0.01 _ The prime ( ) denotes the variables under the second strategy. If the firm offers credit and the new customers pay, the firm will receive revenues of P 0 Q 0 one period hence, but its costs, C 0 Q 0, are incurred in period 0. If new customers do not pay, the firm incurs costs C 0 Q 0 and receives no revenues. The probability that customers will pay, h, is 0.90 in the example. Quantity sold is higher with credit because new customers are attracted. The cost per unit is also higher with credit because of the costs of operating a credit policy.

6 The Decision to Grant Credit: Risk and Information 771 The expected cash flows for each policy are set out as follows: Expected Cash Flows Time 0 Time 1 Refuse credit P 0 Q 0 C 0 Q 0 0 Offer credit C 0 Q 0 h P 0 Q 0 Note that granting credit produces delayed expected cash inflows equal to h P 0 Q 0. The costs are incurred immediately and require no discounting. The net present value if credit is offered is h PQ 0 0 NPV(offer) = CQ R B 09. $ = $ 5, = $ 3, Locust s decision should be to adopt the proposed credit policy. The NPV of granting credit is higher than that of refusing credit. This decision is very sensitive to the probability of payment. If it turns out that the probability of payment is 81 per cent, Locust Software is indifferent to whether it grants credit or not. In this case the NPV of granting credit is $3,000, which we previously found to be the NPV of not granting credit: $ $ 3, 000 = h $ 5, $ $ 8, 000 = h h = 80. 8% The decision to grant credit depends on four factors: 1 The delayed revenues from granting credit, P 0 Q 0. 2 The immediate costs of granting credit, C 0 Q 0. 3 The probability of payment, h. 4 The appropriate required rate of return for delayed cash flows, R B. The Value of New Information about Credit Risk Obtaining a better estimate of the probability that a customer will default can lead to a better decision. How can a firm determine when to acquire new information about the creditworthiness of its customers? It may be sensible for Locust to determine which of its customers are most likely not to pay. The overall probability of non-payment is 10 per cent. But credit checks by an independent firm show that 90 per cent of Locust s customers (computer stores) have been profitable over the last five years, and that these customers have never defaulted on payments. The less profitable customers are much more likely to default. In fact, 100 per cent of the less profitable customers have defaulted on previous obligations. Locust would like to avoid offering credit to the deadbeats. Consider its projected number of customers per year of Q 0 = 200 if credit is granted. Of these customers, 180 have been profitable over the last five years and have never defaulted on past obligations. The remaining 20 have not been profitable. Locust Software expects that all of these less profitable customers will default. This information is set out here:

7 _ 772 Chapter 28 Credit Management Type of Customer Number Probability of non-payment (%) Expected number of defaults Profitable Less profitable Total customers The NPV of granting credit to the customers who default is hp0 Q0 1 + R B 0 $ CQ 0 0 = $ = $ 500 This is the cost of providing them with the software. If Locust can identify these customers without cost, it would certainly deny them credit. In fact, it actually costs Locust $3 per customer to figure out whether a customer has been profitable over the last five years. The expected pay-off of the credit check on its 200 customers is then Gain from not Cost of extending credit credit checks $500 $3 200 = $100 For Locust, credit is not worth checking. It would need to pay $600 to avoid a $500 loss. Future Sales Up to this point Locust has not considered the possibility that offering credit will permanently increase the level of sales in future periods (beyond next month). In addition, payment and non-payment patterns in the current period will provide credit information that is useful for the next period. These two factors should be analysed. In the case of Locust, there is a 90 per cent probability that the customer will pay in period 1. But, if payment is made, there will be another sale in period 2. The probability that the customer will pay in period 2, if the customer has paid in period 1, is 100 per cent. Locust can refuse to offer credit in period 2 to customers that have refused to pay in period 1. This is diagrammed in Fig FIGURE 28.5 Give credit. Do not give credit. Customer pays (h = 0.9). Customer does not pay. Give credit. Do not give credit. Customer pays (h = 1). There is a 90 per cent probability that a customer will pay in period 1. However, if payment is made, there will be another sale in period 2. The probability that the customer will pay in period 2 is 100 per cent if the customer has paid in period 1. _ Figure 28.5 Future sales and the credit decision

8 28.3 Optimal Credit Policy Optimal Credit Policy 773 So far, we have discussed how to compute net present value for two alternative credit policies. However, we have not discussed the optimal amount of credit. 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. Consider a firm that does not currently grant credit. This firm has no bad debts, no credit department, and relatively few customers. Now consider another firm that grants credit. This firm has lots of customers, a credit department, and a bad debt expense account. It is useful to think of the decision to grant credit in terms of carrying costs and opportunity costs: 1 Carrying costs are the costs associated with granting credit and making an investment in receivables. Carrying costs include the delay in receiving cash, the losses from bad debts, and the costs of managing credit. 2 Opportunity costs are the lost sales from refusing to offer credit. These costs drop as credit is granted. We represent these costs in Fig The sum of the carrying costs and the opportunity costs of a particular credit policy is called the total credit cost curve. A point is identified as the minimum of the total credit cost curve. If the firm extends more credit than the minimum, the additional net cash flow from new customers will not cover the carrying costs of this investment in receivables. The concept of optimal credit policy in the context of modern principles of finance should be somewhat analogous to the concept of the optimal capital structure discussed earlier in the text. In perfect financial markets there should be no optimal credit policy. Alternative amounts of credit for a firm should not affect the value of the firm. Thus the decision to grant credit would be a matter of indifference to financial managers. Just as with optimal capital structure, we could expect taxes, monopoly power, bankruptcy costs and agency costs to be important in determining an optimal credit policy in a world of imperfect financial markets. For example, customers in high tax brackets would be better off borrowing and taking advantage of cash discounts offered by firms than would customers in low tax brackets. Corporations in low tax brackets would be less able to offer credit, because borrowing would be relatively more expensive than for firms in high tax brackets. In general, a firm will extend trade credit if it has a comparative advantage in doing so. Trade credit is likely to be advantageous if the selling firm has a cost advantage over other FIGURE 28.6 Cost Optimal amount of credit Total costs Level of credit extended Carrying costs Opportunity costs Carrying costs are the costs that must be incurred when credit is granted. They are positively related to the amount of credit extended. Opportunity costs are the lost sales from refusing credit. These costs drop when credit is granted. Figure 28.6 The costs of granting credit

9 _ 774 Chapter 28 Credit Management potential lenders, if the selling firm has monopoly power it can exploit, if the selling firm can reduce taxes by extending credit, and if the product quality of the selling firm is difficult to determine. Firm size may be important if there are size economies in managing credit. The Decision to Grant Credit Trade credit is more likely to be granted by the selling firm if 1. The selling firm has a cost advantage over other lenders. Example: York Manufacturing Ltd produces widgets. In a default, it is easier for York Manufacturing Ltd to repossess widgets and resell them than for a finance company to arrange for it with no experience in selling widgets. 2. The selling firm can engage in price discrimination. Example: National Motors can offer below-market interest rates to lower-income customers who must finance a large portion of the purchase price of cars. Higher-income customers pay the list price and do not generally finance a large part of the purchase. 3. The selling firm can obtain favourable tax treatment. Example: AB Production offers long-term credit to its best customers. This form of financing may qualify as an instalment plan and allow AB Production to book profits of the sale over the life of the loan. This may save taxes, because the present value of the tax payments will be lower if spread over time. 4. The selling firm has no established reputation for quality products or services. Example: Advanced Micro Instruments (AMI) manufactures sophisticated measurement instruments for controlling electrical systems on commercial airplanes. The firm was founded by two engineering graduates from the University of Amsterdam in It became a public firm in To hedge their bets, aircraft manufacturers will ask for credit from AMI. It is very difficult for customers of AMI to assess the quality of its instruments until the instruments have been in place for some time. 5. The selling firm perceives a long-term strategic relationship. Example: Food.com is a fast-growing, cash-constrained Internet food distributor. It is currently not profitable. Fantastic Food will grant Food.com credit for food purchased because Food.com will generate profits in the future. Source: S.I. Mian and C.W. Smith, Extending trade credit and financing receivables, Journal of Applied Corporate Finance (Spring 1994); M. Deloof and M. Jegers, Trade credit, product quality, and intragroup trade: some European evidence, Financial Management (Autumn 1996); M. Long, I.B. Malitz and S.A. Ravid, Trade credit, quality guarantees, and product marketability, Financial Management (Winter 1993); and M.A. Petersen and R.G. Rajan, Trade credit: theories and evidence, The Review of Financial Studies, vol. 10 (1997). The optimal credit policy depends on the characteristics of particular firms. Assuming that the firm has more flexibility in its credit policy than in the prices it charges, firms with excess capacity, low variable operating costs, high tax brackets and repeat customers should extend credit more liberally than others Credit Analysis _ When granting credit, a firm tries to distinguish between customers that will pay and customers that will not pay. There are a number of sources of information for determining creditworthiness.

10 Collection Policy 775 Credit Information Information commonly used to assess creditworthiness includes the following: 1 Financial statements: A firm can ask a customer to supply financial statements. Rules of thumb based on calculated financial ratios can be used. 2 Credit reports on customer s payment history with other firms: Many organizations sell information on the credit strength of business firms. Firms such as Experian, Equifax and Dun & Bradstreet provide subscribers with credit reports on individual firms. 3 Banks: Banks will generally provide some assistance to their business customers in acquiring information on the creditworthiness of other firms. 4 The customer s payment history with the firm: The most obvious way to obtain an estimate of a customer s probability of non-payment is whether he or she has paid previous bills. Credit Scoring Once information has been gathered, the firm faces the hard choice of either granting or refusing credit. Many firms use the traditional and subjective guidelines referred to as the five Cs of credit : 1 Character: The customer s willingness to meet credit obligations. 2 Capacity: The customer s ability to meet credit obligations out of operating cash flows. 3 Capital: The customer s financial reserves. 4 Collateral: A pledged asset in the case of default. 5 Conditions: General economic conditions. Conversely, firms such as credit card issuers have developed elaborate statistical models (called credit scoring models) for determining the probability of default. Usually, all the relevant and observable characteristics of a large pool of customers are studied to find their historic relation to default. Because these models determine who is and who is not creditworthy, not surprisingly they have been the subject of government regulation. For example, if a statistical model were to find that women default more than men, it might be used to deny women credit. Regulation removes such models from the domain of the statistician and makes them the subject of politicians Collection Policy Collection refers to obtaining payment of past-due accounts. The credit manager keeps a record of payment experiences with each customer. Average Collection Period Paragon Blu-Ray Disc Players sells 100,000 Blu-Ray disc players a year at $300 each. All sales are for credit with terms of 2/20, net 60. Suppose that 80 per cent of Paragon s customers take the discounts and pay on day 20; the rest pay on day 60. The average collection period (ACP) measures the average amount of time required to collect a trade or account receivable. The ACP for Paragon is 28 days: days days = 28 days (The average collection period is frequently referred to as days sales outstanding or days in receivables.) Of course, this is an idealized example where customers pay on either one of two dates. In reality, payments arrive in a random fashion, so the average collection period must be calculated differently.

11 _ 776 Chapter 28 Credit Management To determine the ACP in the real world, firms first calculate average daily sales. The average daily sales (ADS) equal annual sales divided by 365. The ADS of Paragon are $ , 000 Average daily sales = 365 days = $ 82, 192 If receivables today are $2,301,376, the average collection period is Average collection period = Accounts receivable Average daily sales = $2,301,376 $82,192 = 28 days In practice, firms observe sales and receivables daily. Consequently, an average collection period can be computed and compared with the stated credit terms. For example, suppose Paragon had computed its ACP at 40 days for several weeks, versus its credit terms of 2/20, net 60. With a 40-day ACP, some customers are paying later than usual. Some accounts may be overdue. However, firms with seasonal sales will often find the calculated ACP changing during the year, making the ACP a somewhat flawed tool. This occurs because receivables are low before the selling season and high after the season. Thus firms may keep track of seasonal movement in the ACP over past years. In this way, they can compare the ACP for today s date with the average ACP for that date in previous years. To supplement the information in the ACP, the credit manager may make up an accounts receivable ageing schedule. Ageing Schedule The ageing schedule tabulates receivables by age of account. In the following schedule, 75 per cent of the accounts are on time, but a significant number are more than 60 days past due. This signifies that some customers are in arrears. Age of account Percentage of total value of accounts receivable 0 20 days days days 20 Over 80 days 5 The ageing schedule changes during the year. Comparatively, the ACP is a somewhat flawed tool because it gives only the yearly average. Some firms have refined it so that they can examine how it changes with peaks and valleys in their sales. Similarly, the ageing schedule is often augmented by the payments pattern. The payments pattern describes the lagged collection pattern of receivables. Like a mortality table that describes the probability that a 23-year-old will live to be 24, the payments pattern describes the probability that a 67-day-old account will still be unpaid when it is 68 days old. 100 Collection Effort The firm usually employs the following procedures for customers that are overdue: 1 2 Send a delinquency letter informing the customer of the past-due status of the account. Make a telephone call to the customer. _ 3 4 Employ a collection agency. Take legal action against the customer.

12 How to Finance Trade Credit 777 At times, a firm may refuse to grant additional credit to customers until arrears are paid. This may antagonize a normally good customer, and points to a potential conflict of interest between the collections department and the sales department. Factoring Factoring refers to the sale of a firm s trade receivables to a financial institution known as a factor. The firm and the factor agree on the basic credit terms for each customer. The customer sends payment directly to the factor, and the factor bears the risk of non-paying customers. The factor buys the receivables at a discount, which usually ranges from 0.35 to 4 per cent of the value of the invoice amount. The average discount throughout the economy is probably about 1 per cent. One point should be stressed. We have presented the elements of credit policy as though they were somewhat independent of each other. In fact, they are closely interrelated. For example, the optimal credit policy is not independent of collection and monitoring policies. A tighter collection policy can reduce the probability of default, and this in turn can raise the NPV of a more liberal credit policy How to Finance Trade Credit In addition to the unsecured debt instruments described earlier in this chapter, there are three general ways of financing accounting receivables: secured debt, a captive finance company, and securitization. Use of secured debt is usually referred to as asset-based receivables financing. This is the predominant form of receivables financing. Many lenders will not lend without security to firms with substantive uncertainty or little equity. With secured debt, if the borrower gets into financial difficulty, the lender can repossess the asset and sell it for its fair market value. Many large firms with good credit ratings use captive finance companies. The captive finance companies are subsidiaries of the parent firm. This is similar to the use of secured debt, because the creditors of the captive finance company have a claim on its assets and, as a consequence, the accounts receivable of the parent firm. A captive finance company is attractive if economies of scale are important, and if an independent subsidiary with limited liability is warranted. Securitization occurs when the selling firm sells its accounts receivable to a financial institution. The financial institution pools the receivables with other receivables and issues securities to finance items. Summary and Conclusions The components of a firm s credit policy are the terms of sale, the credit analysis, and the collection policy. The terms of sale describe the amount and period of time for which credit is granted, and the type of credit instrument. The decision to grant credit is a straightforward NPV decision that can be improved by additional information about customer payment characteristics. Additional information about the customer s probability of defaulting is valuable, but this value must be traded off against the expense of acquiring the information. The optimal amount of credit the firm offers is a function of the competitive conditions in which it finds itself. These conditions will determine the carrying costs associated with granting credit and the opportunity costs of the lost sales from refusing to offer credit. The optimal credit policy minimizes the sum of these two costs.

13 _ 778 Chapter 28 Credit Management 5 6 We have seen that knowledge of the probability that customers will default is valuable. To enhance its ability to assess customers default probability, a firm can score credit. This relates the default probability to observable characteristics of customers. The collection policy is the method of dealing with past-due accounts. The first step is to analyse the average collection period and to prepare an ageing schedule that relates the age of accounts to the proportion of the accounts receivable they represent. The next step is to decide on the collection method and to evaluate the possibility of factoring that is, selling the overdue accounts. _ CONCEPT 1 5 REGULAR 6 35 Questions and Problems 1 Terms of the Sale Explain what is meant by the credit terms of a sale. Provide an example of a typical trade credit agreement. 2 The Decision to Grant Credit Review the factors that are commonly considered when deciding to offer credit to a customer. 3 Optimal Credit Policy Is it possible to have an optimal credit policy? In this context, discuss what the total credit curve is, and its impact on a firm s approach to trade credit. 4 Credit Analysis What are the five C s of credit? Are there any other factors a firm 5 should consider? Collection Policy How can a firm use an ageing schedule of payments to maximize its total collection of outstanding debtors? 6 Credit Instruments Describe each of the following: (a) Sight draft. (b) Time draft. (c) Banker s acceptance. (d) Promissory note. (e) Trade acceptance. 7 Trade Credit Forms In what form is trade credit most commonly offered? What is the credit instrument in this case? 8 Receivables Costs What are the costs associated with carrying receivables? What are the costs associated with not granting credit? What do we call the sum of the costs for different levels of receivables? 9 Credit Period Length What are some factors that determine the length of the credit period? Why is the length of the buyer s operating cycle often considered an upper bound on the length of the credit period? 10 Credit Period Length In each of the following pairings, indicate which firm would probably have a longer credit period, and explain your reasoning. (a) Firm A sells a miracle cure for baldness; firm B sells toupees. (b) Firm A specializes in products for landlords; firm B specializes in products for renters. (c) Firm A sells to customers with an inventory turnover of 10 times; firm B sells to customers with an inventory turnover of 20 times. (d) Firm A sells fresh fruit; firm B sells canned fruit. (e) Firm A sells and installs carpeting; firm B sells rugs. 11 Credit Analysis When performing an NPV analysis for the decision to grant credit, what cost of debt should be used?

14 Questions and Problems Granting Credit Suppose we have a new customer who will buy from our company if we grant credit. In calculating the default rate, it is likely to be high. Why is this so? How does this compare with the decision to grant credit to a previous, cash-paying customer? 13 Granting Credit Suppose we are considering granting credit to a new customer who will make a one-time purchase. If we compare the default rate from this analysis with the default rate for a customer who will become a repeat customer, which default rate will be higher? Why? 14 Granting Credit What is the relationship between the decision to grant credit and the gross margin of the product? 15 Cash Discounts You place an order for 200 units of inventory at a unit price of 95. The supplier offers terms of 2/10, net 30. (a) (b) (c) How long do you have to pay before the account is overdue? If you take the full period, how much should you remit? What is the discount being offered? How quickly must you pay to get the discount? If you take the discount, how much should you remit? If you don t take the discount, how much interest are you paying implicitly? How many days credit are you receiving? 16 Size of Accounts Receivable Zidane SA has annual sales of $65 million. The average collection period is 48 days. What is Zidane s average investment in accounts receivable as shown on the balance sheet? 17 ACP and Accounts Receivable Dalglish plc sells earnings forecasts for British securities. Its credit terms are 2/10, net 30. Based on experience, 65 per cent of all customers will take the discount. (a) (b) What is the average collection period for Dalglish? If Dalglish sells 1,200 forecasts every month at a price of 2,200 each, what is its average balance sheet amount in accounts receivable? 18 Size of Accounts Receivable Vitale, Baby! Ltd has weekly credit sales of 18,000, and the average collection period is 29 days. The cost of production is 80 per cent of the selling price. What is Vitale s average accounts receivable figure? 19 Terms of Sale A firm offers terms of 2/9, net 40. What effective annual interest rate does the firm earn when a customer does not take the discount? Without doing any calculations, explain what will happen to this effective rate if: (a) (b) (c) The discount is changed to 3 per cent. The credit period is increased to 60 days. The discount period is increased to 15 days. 20 ACP and Receivables Turnover Muziek Stad NV has an average collection period of 52 days. Its average daily investment in receivables is $46,000. What are annual credit sales? What is the receivables turnover? 21 Size of Accounts Receivable Fragrances Ltd sells 4,000 units of its perfume collection each year at a price per unit of 400. All sales are on credit with terms of 2/15, net 40. The discount is taken by 60 per cent of the customers. What is the amount of the company s accounts receivable? In reaction to sales by its main competitor, Sentiment Spray plc, Fragrances is considering a change in its credit policy to terms of 4/10, net 30 to preserve its market share. How will this change in policy affect accounts receivable? 22 Size of Accounts Receivable Baker Ginger Ltd sells on credit terms of net 25. Its accounts are, on average, nine days past due. If annual credit sales are 8 million, what is the company s balance sheet amount in accounts receivable?

15 _ 780 Chapter 28 Credit Management 23 Evaluating Credit Policy Air Spares is a wholesaler that stocks engine components and test equipment for the commercial aircraft industry. A new customer has placed an order for eight high-bypass turbine engines, which increase fuel economy. The variable cost is $1.5 million per unit, and the credit price is $1.8 million 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 2.5 per cent per period. (a) (b) (c) (d) 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 for ever. Further assume that repeat customers never default. Should the order be filled? What is the break-even probability of default? Describe in general terms why credit terms will be more liberal when repeat orders are a possibility. 24 Credit Policy Evaluation Champions SA is considering a change in its cash-only sales policy. The new terms of sale would be net one month. Based on the following information, determine whether Champions should proceed. Describe the build-up of receivables in this case. The required return is 1.5 per cent per month. Current policy New policy Price per unit ( ) Cost per unit ( ) Unit sales per month 1,130 1, Evaluating Credit Policy Bruce Jacks plc is in the process of considering a change in its terms of sale. The current policy is cash only; the new policy will involve one period s credit. Sales are 70,000 units per period at a price of 530 per unit. If credit is offered, the new price will be 552. Unit sales are not expected to change, and all customers are expected to take the credit. Bruce Jacks estimates that 2 per cent of credit sales will be uncollectable. If the required return is 2 per cent per period, is the change a good idea? 26 Credit Policy Evaluation Clapton Erich GmbH sells 3,000 pairs of running shoes per month at a cash price of $90 per pair. The firm is considering a new policy that involves 30 days credit and an increase in price to $91.84 per pair on credit sales. The cash price will remain at $90, and the new policy is not expected to affect the quantity sold. The discount period will be 10 days. The required return is 1 per cent per month. (a) (b) (c) (d) How would the new credit terms be quoted? What is the investment in receivables required under the new policy? Explain why the variable cost of manufacturing the shoes is not relevant here. If the default rate is anticipated to be 10 per cent, should the switch be made? What is the break-even credit price? The break-even cash discount? 27 Factoring The factoring department of Inter Scandanavian Bank (ISB) is processing 100,000 invoices per year with an average invoice value of $1,500. ISB buys the accounts receivable at 3.5 per cent off the invoice value. Currently 2.5 per cent of the accounts receivable turns out to be bad debt. The annual operating expense of this department is $400,000. What are the EBIT for the factoring department of ISB? _ 28 Factoring Receivables Your firm has an average collection period of 34 days. Current practice is to factor all receivables immediately at a 2 per cent discount. What is the effective cost of borrowing in this case? Assume that default is extremely unlikely.

16 Questions and Problems Credit Analysis Silicon Wafers plc (SW) is debating whether to extend credit to a particular customer. SW s products, used primarily in the manufacture of semiconductors, currently sell for 1,850 per unit. The variable cost is 1,200 per unit. The order under consideration is for 12 units today; payment is promised in 30 days. (a) (b) (c) If there is a 20 per cent chance of default, should SW fill the order? The required return is 2 per cent per month. This is a one-time sale, and the customer will not buy if credit is not extended. What is the break-even probability in part (a)? This part is a little harder. In general terms, how do you think your answer to part (a) will be affected if the customer will purchase the merchandise for cash if the credit is refused? The cash price is 1,700 per unit. 30 Credit Analysis Consider the following information about two alternative credit strategies: Refuse credit Grant credit Price per unit ( ) Cost per unit ( ) Quantity sold per quarter 3,300 3,500 Probability of payment The higher cost per unit reflects the expense associated with credit orders, and the higher price per unit reflects the existence of a cash discount. The credit period will be 90 days, and the cost of debt is 0.75 per cent per month. (a) (b) (c) Based on this information, should credit be granted? In part (a), what does the credit price per unit have to be to break even? In part (a), suppose we can obtain a credit report for 2 per customer. Assuming that each customer buys one unit, and that the credit report correctly identifies all customers who will not pay, should credit be extended? 31 NPV of Credit Policy Switch Suppose a corporation currently sells Q units per month for a cash-only price of P. Under a new credit policy that allows one month s credit, the quantity sold will be Q and the price per unit will be P. Defaults will be p per cent of credit sales. The variable cost is n per unit and is not expected to change. The percentage of customers who will take the credit is a, and the required return is R per month. What is the NPV of the decision to switch? Interpret the various parts of your answer. 32 Credit Policy Walloon NV operates a mail-order running shoe business. Management is considering dropping its policy of no credit. The credit policy under consideration is this: Current policy New policy Price per unit ( ) Cost per unit ( ) Quantity sold 2,000 3,000 Probability of payment (%) 100% 85% Credit period 0 1 (a) If the interest rate is 3 per cent per period, should the company offer credit to its customers? (b) What must the probability of payment be before the company would adopt the policy?

17 _ 782 Chapter 28 Credit Management 33 Credit Policy The Silver Spokes Bicycle Shop has decided to offer credit to its customers during the spring selling season. Sales are expected to be 400 bicycles. The average cost to the shop of a bicycle is 280. The owner knows that only 97 per cent of the customers will be able to make their payments. To identify the remaining 3 per cent, she is considering subscribing to a credit agency. The initial charge for this service is 500, with an additional charge of 4 per individual report. Should she subscribe to the agency? 34 Credit Policy Evaluation Dschungel AG is considering a change in its cash-only policy. The new terms would be net one period. Based on the following information, determine whether Dschungel should proceed. The required return is 3 per cent per period. Current policy New policy Price per unit ( ) Cost per unit ( ) Unit sales per month 3,200 3, Credit Policy Evaluation Happiness Systems currently has an all-cash credit policy. It is considering making a change in the credit policy by going to terms of net 30 days. Based on the following information, what do you recommend? The required return is 2 per cent per month. Current policy New policy Price per unit ( ) Cost per unit ( ) Unit sales per month 1,800 1,850 CHALLENGE Break-Even Quantity In Problem 34, what is the break-even quantity for the new credit policy? 37 Credit Markup In Problem 34, what is the break-even price per unit that should be charged under the new credit policy? Assume that the sales figure under the new policy is 3,300 units and all other values remain the same. 38 Credit Markup In Problem 35, what is the break-even price per unit under the new credit policy? Assume all other values remain the same. 39 Credit Policy Netal Ltd has annual sales of 50 million rand, all of which are on credit. The current collection period is 45 days, and the credit terms are net 30. The company is considering offering terms of 2/10, net 30. It anticipates that 70 per cent of its customers will take advantage of the discount. The new policy will reduce the collection period to 28 days. The appropriate interest rate is 6 per cent. Should the new credit policy be adopted? How does the level of credit sales affect this decision? _ MINI CASE Credit Policy at Schwarzwald AG Dagmar Bamberger, the president of Schwarzwald AG, has been exploring ways of improving the company s financial performance. Schwarzwald manufactures and sells office equipment to retailers. The company s growth has been relatively slow in recent years, but with an expansion in the economy it appears that sales may increase more quickly in the future. Dagmar has asked Johann Rüstow, the company s treasurer, to examine Schwarzwald s credit policy to see whether a different credit policy can help increase profitability. The company currently has a policy of net 30. As with any credit sales, default rates are always of concern. Because of Schwarzwald s screening and collection process, the default rate on credit is currently only 1.5 per cent. Johann has examined the company s credit policy in relation to other vendors, and he has determined that three options are available.

18 Endnote 783 The first option is to relax the company s decision on when to grant credit. The second option is to increase the credit period to net 45, and the third option is a combination of the relaxed credit policy and the extension of the credit period to net 45. On the positive side, each of the three policies under consideration would increase sales. The three policies have the drawbacks that default rates would increase, the administrative costs of managing the firm s receivables would increase, and the receivables period would increase. The credit policy change would impact on all four of these variables in different degrees. Johann has prepared the following table outlining the effect on each of these variables: Annual sales ( millions) Default rate (% of sales) Administrative costs (% of sales) Receivables period (days) Current policy Option Option Option Schwarwald s variable costs of production are 45 per cent of sales, and the relevant interest rate is a 6 per cent effective annual rate. Which credit policy should the company use? Also, notice that in option 3 the default rate and administrative costs are below those in option 2. Is this plausible? Why or why not? Additional Reading In the aftermath of the global credit crunch in 2007, the study of trade credit, and credit in general, has taken on much more importance. See below for some relevant reading. Atanasova, C. (2007) Access to institutional finance and the use of trade credit, Financial Management, vol. 36, no. 1, pp UK. Cunat, V. (2007) Trade credit: suppliers as debt collectors and insurance providers, Review of Financial Studies, vol. 20, no. 2, UK. Garcia-Teruel, P.J. and P. Martinez-Solano (2009) A dynamic approach to accounts receivable: a study of Spanish SMEs, European Financial Management (forthcoming). Spain. Love, I., L.A. Preve and V. Sarria-Allende (2007) Trade credit and bank credit: evidence from recent financial crises, Journal of Financial Economics, vol. 83, no. 2, pp International. Howorth, C. and B. Reber (2003) Habitual late payment of trade credit: an empirical examination of UK small firms, Managerial and Decision Economics, vol. 24, nos 6/7, pp UK. Sufi, A. (2009) Bank lines of credit in corporate finance: an empirical analysis, Review of Financial Studies, vol. 22, no. 3, pp UK. Wilner, B.S. (2000) The exploitation of relationships in financial distress: the case of trade credit, Journal of Finance, vol. 55, no. 1, pp US. Endnote 1 An invoice is a bill written by a seller of goods or services and submitted to the buyer. The invoice date is usually the same as the shipping date. To help you grasp the key concepts of this chapter check out the extra resources posted on the Online Learning Centre at Among other helpful resources there are PowerPoint presentations, chapter outlines and mini-cases.

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