Credit Management. Why Credit Exists

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1 Credit Management (Text reference: Chapter 29) why credit exists terms of sale optimal credit policy credit analysis collection policy factoring AFM Credit Management Slide 1 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 there can be information asymmetry: between customer and seller one way to reduce problems is to give credit to allow for returns if the customer is unhappy with the product between seller and other potential lenders seller deals with the same customers regularly, so can have better information than a bank about bad credit risks seller has better knowledge about the value of collateral AFM Credit Management Slide 2

2 Terms of Sale terms of sale refers to the period for which credit is granted, the cash discount, and the type of credit instrument (invoice, promissory note, etc. see text pp ) typical credit terms for accounts receivable are 2/10, net 30; 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 opportunity cost of capital is 6%, should credit be granted? AFM Credit Management Slide 3 Cont d in general, we must also consider probability of non-payment, e.g. what 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 AFM Credit Management Slide 4

3 Cont d e.g. BB Inc. currently provides no credit to its customers. Daily sales, variable costs (at the present level of output), and fixed costs are $35,000, $24,500, and $8,000 respectively. The appropriate money market rate for an investment in short term securities is 4% (compounded annually). BB is considering offering credit terms of 2/15, net 45. The firm expects that under this policy sales volume would increase by 10%. It is expected that 70% of sales would be collected 15 days after the sale. Some of the remaining 30% of sales would be collected 45 days after the sale, and any remaining uncollected sales would be written off as bad debts. What is the highest value of bad debts as a percentage of total sales that would make it worthwhile for BB to adopt this credit policy? (Assume that all sales will be made on a credit basis if the new policy is adopted.) AFM Credit Management Slide 5 Optimal Credit Policy a decision to grant credit is a trade-off between carrying costs (delays in receiving cash, bad debts, costs of managing credit) opportunity costs (lost sales from reducing credit) cost in $ level of credit extended AFM Credit Management Slide 6

4 Cont d in perfect markets, credit policy is inconsequential: customers can borrow from any lender at the same rate, so the credit policy of the firm has no impact on sales no bad debts 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? AFM Credit Management Slide 7 Credit Analysis firms gather information to evaluate likelihood of payment: financial statements credit reports on customer payment history with other firms banks customer s payment history with the firm typical credit worthiness evaluation criteria (the five Cs): 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) credit scoring systems use these and similar criteria AFM Credit Management Slide 8

5 Collection Policy collection refers to obtaining payment of past due accounts; it 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. AFM Credit Management Slide 9 Cont d 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 , , ,000 > 90 5,000 total 40,000 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 these type of statistics can also be useful in bad debt analysis AFM Credit Management Slide 10

6 Factoring 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 and so assumes the risk of bad debts factoring is a form of insurance for bad debts since factors do business with many firms, they can attain scale economies such as diversification of credit risks, more expertise in collection AFM Credit Management Slide 11

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