A firm s credit policy is composed of: Terms of the sale Credit analysis Collection policy
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1 Chapter 28 Credit Management Introduction Terms of the Sale The Decision to Grant Credit: Risk and Information Optimal Credit Policy Credit Analysis Collection Policy How to Finance Trade Credit Summary & Conclusions A firm s policy is composed of: Terms of the sale Credit analysis Collection policy 1 The Cash Flows of Granting Credit Terms of the Sale Credit sale is made Customer mails check Firm deposits check Bank s firm s account The terms of sale of composed of Credit Period Cash Discounts Credit Instruments Time Cash collection Accounts receivable 2 3 Credit Period Cash Discounts Credit periods vary across industries. Generally a firm must consider three factors: Probability that the customer will not pay. Size of the account. Extent goods are perishable. Lengthening the period generally increases sales Often part of the terms of sale. Tradeoff between the size of discount and increased rate of collection of receivables. Example - 3/1 net percent discount for early payment 1 - number of days that the discount is available net 3 - number of days before payment is due 4 5 1
2 The Interest Rate Implicit in 3/1 net 3 A firm offering terms of 3/1 net 3 is essentially offering their customers a 2-day loan. To see this, consider a firm that makes a $1, sale on day Some customers will pay on day 1 and take the discount Goods shipped $97 The Interest Rate Implicit in 3/1 net 3 A customer that forgoes the 3% discount to pay on day 3 is borrowing $97 for 2 days and paying $3 interest: $97 -$1, Other customers will pay on day 3 and forgo the discount. $1, Effective annual rate of cash discount Alternative method Effective annualrate = discount ( 1 ) 365/extra days - 1 discountedprice The Decision to Grant Credit: Timing of CF s Consider a firm that is choosing between two alternative policies: In God we trust everybody else pays cash. Offering their customers. The only cash flow of the first strategy is The expected cash flows of the strategy are: C Q Q ( P - ) C Q P 8 1 We incur costs up front and get paid in 1 period by all of our customers. 9 The Decision to Grant Credit: Timing of CF s The NPV of the cash only strategy is NPV cash = Q ( P - ) C The NPV of the strategy is Q P NPV = -CQ ( 1 t rb) The decision to grant depends on four factors: 1. The delayed revenues from granting, 2. The immediate costs of granting, C Q P Q Example: NPV of Cash Discount Current policy no cash discount, no Proposed policy(1) no discount, net 3, sales increase 5% Proposed policy(2) 3/1 net 3, sales increase by 1%, 12% cost of debt Current sales -$1,,, variable costs 4% of sales Answer: 3. The discount rate, r B
3 Credit Instruments The Decision to Grant Credit: Risk and Information Most is offered on open account. Promissory notes Commercial drafts Banker s acceptances Conditional sales contracts Now consider the same two policies, but only h% of our customers pay In God we trust everybody else pays cash. Offering their customers. The only cash flow of the first strategy is The expected cash flows of the strategy are: C Q Q - ( P C h Q P ) 12 1 We incur costs up front and get paid in 1 period by h% of our customers. 13 The Decision to Grant Credit: Risk and Information Example of the Decision to Grant Credit The NPV of the cash only strategy is NPV cash = Q ( P - ) C The NPV of the strategy is h Q P NPV = CQ (1 r t B) The decision to grant depends on four factors: 1. The delayed revenues from granting, 2. The immediate costs of granting, C Q 3. The probability of repayment, h 4. The discount rate, r B P Q 14 A firm currently sells 1, items per month on a cash basis for $5 each, cost is $4. If they offered terms net 3, the marketing department believes that they could sell 1,3 items per month, price is $5, cost is $425. The collections department estimates that 5% of customers will default. The cost of capital is 1% per annum. 15 Example of the Decision to Grant Credit No Credit Net 3 Quantity sold 1, 1,3 Selling price $5 $5 Unit cost $4 $425 Probability of payment 1% 95% Credit period (days) 3 Discount rate p.a. 1% ( ) h Q P NPV cash = Q P C NPV = CQ t 1( rb ) Example of the Decision to Grant Credit How high must the price be to make it worthwhile for the firm to extend? The NPV of Net 3 must be at least as big as the NPV of cash only:
4 The Value of New Information about Credit Risk Future Sales and the Credit Decision The most that we should be willing to pay for new information about risk is the present value of the expected cost of defaults: NPV default $ ( 1 - h)( Q = -C Q ( 1-h) ( 1 r ) = -C Q ( 1-h) B P ) 18 We face a more certain decision with our paying customers: Information is revealed at the end of the first period: Our first decision: Customer pays (Probability = h) Give Do not give Customer pays h = 1% Give Do not give Customer defaults (Probability = 1 h) We refuse further sales to deadbeats. 19 Optimal Credit Policy Optimal Credit Policy Costs in dollars Total costs C * Carrying Costs Opportunity costs Level of extended Trade Credit is more likely to be granted if: 1. Selling firm has a cost advantage over other lenders. 2. Selling firm can engage in price discrimination. 3. Selling firm can obtain favorable tax treatment. 4. Selling firm has no established reputation for quality products or services. 5. Selling firm perceives a long-term strategic relationship Credit Analysis Credit Information Financial Statements Credit Reports Banks Customer s Payment History Credit Scoring: The traditional 5 C s of Character Capacity Capital Collateral Conditions Some firms employ sophisticated statistical models Credit Analysis Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time
5 Credit Analysis Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time. A score above 2.7 indicates good. Altman Z Score formula Z =3.3 EBIT total 1. assets sales total retained earnings 1.4 market valueofequity.6 assets totalbookdebt 1.2 working capital Example -If the Altman Z score cut off for a worthy business is 2.7 or higher, would we accept the following client? EBIT =.12 sales = 1.4 market equity =.9 book debt retained earnings total assets working capital total assets AltmanZ Scoreformula Z =3.3 EBIT sales.6 retainedearnings 1.2 =. 4 =. 12 market valueof workingcapital totalbookdebt equity Credit Analysis Collection Policy Credit analysis only worthwhile if expected savings exceed the cost. Don t undertake full analysis unless order is big enough to justify it. Undertake full analysis for doubtful orders only. Collection refers to obtaining payment on past-due accounts. Collection Policy is composed of: Firm s willingness to extend --- reflected in the firm s investment in receivables. Collection Effort Average Collection Period Accounts Receivable Aging Schedule Measures the average amount of time required to collect an account receivable. Accounts receivable Average collection period = Average daily sales Shows receivables by age of account. The longer an account has been unpaid, the less likely it is to be paid. For example, a firm with average daily sales of $2, and an investment in accounts receivable of $75, has an average collection period of
6 Collection Effort Age of Account 3 days 31 6 days 61 9 days Aging Schedule Percent of Total Value of Accounts Receivable 55% 1% 15% Most firms follow a protocol for customers that are past due: 1. Send a delinquency letter. 2. Make a telephone call to the customer. 3. Employ a collection agency. 4. Take legal action against the customer. Potential for a conflict of interest. Strike a balance. Over 9 days 2% 3 31 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 terms for each customer. Customers send payment to the factor Factor The factor pays an agreedupon percentage of the accounts receivable to the firm. The factor bears the risk of nonpaying customers How to Finance Trade Credit There are three general ways of financing account receivables: 1. Secured Debt 2. Captive Finance Company 3. Securitization Customer Goods Firm
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