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The decision to extend credit to customers has significant cash flow and credit risk implications for the firm.
Firms often don’t have a choice, if the availability of credit is an important factor in the customer’s purchase decision process (if competitors offer credit, then the firm must at least match those credit terms, and then choose to compete on another basis.)
The second decision (once the firm has decided to extend credit) is to determine which customers will be granted credit.
The process designed to assess the risk of non-payment by potential customers, which involves collecting information about potential customers with respect to their credit history, their ability to make payments as reflected in their expected cash flows, and their overall financial stability.
From the firm’s point of view:
Often willing to extend credit on terms better than a bank because:
The potential for the firm developing a good customer into the future, and
Losses are limited to production costs in the case of default.
It may not be cost-effective for a firm to manage the collection process itself.
Factoring arrangements are the sale of a firm’s receivables, at a discount, to a financial company called a factor, which specializes in collections, or the out-sourcing of the collections to a factor.
Measures the sales generated by every dollar of receivables.
Evaluating Receivables Management Average Collection Period
Estimates the number of days it takes a firm to collect on its accounts receivable.
If ACP is 40 days, and the firm’s credit policy is net 30, clearly, customers are not paying in keeping with the firm’s policy, and there may be concerns about the quality of the firm’s customers, and what might happen if economic conditions deteriorate.
Inventory Working Capital Management Current Assets and Current Liabilities
Estimates the number of times, ending inventory was ‘turned over’ (sold) in the year.
A ratio that involves both ‘stock’ and ‘flow’ values
Is strongly a function of ending inventory value…managers often try to improve this ratio as they approach year end through inventory reduction strategies (cash and carry sales/inventory clearance, etc.)
Special purpose vehicles (SPVs) are conduits for packaging portfolios of receivables and selling them to investors in the money market; a recent innovation in financing trade credit.
Credit enhancements are actions taken to reduce credit risk, such as requiring collateral, insurance or other agreements.
Asset-backed commercial paper (ABCP) is an example.
The sub-prime mortgage problems in the U.S. has exposed the problems with ABCP where investors have become concerned about the underlying asset values (packages of receivables) and the market is actively repricing these money market instruments
In some cases the market has disappeared for some of these money market instruments.