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Credit management

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Credit management

  1. 1. Credit Management1www.pace2race.com
  2. 2. Put your queries on www.financeclubb.comSession Outline• Receivables• Receivables Management• Factors Determining Credit Policy• Credit Evaluation• Financing of Receivables• Control of Receivables2
  3. 3. Put your queries on www.financeclubb.comReceivables3• It Involves an Element ofRisk• Cash Payment will bemade in future• Increase Sales• Strategy to facecompetition• Cost of Financing• Administrative Cost• Collection Costs• Cost of defaultCharacteristics Objectives Cost of Maintaining• It is amount/Debt which is receivable for the goods or Services provided on Credit• Also known as Trade, Debtors, Sundry Debtors, Trade, Receivables, Book Debts
  4. 4. Put your queries on www.financeclubb.comReceivables Management4Maintain Receivables at a level at which there is a trade-off between Profitability &Cost• Determining the Level ofCredit Sales• Determining of the CreditStandards• Determining of the CreditTerms• Rate of cash discountThis requires the financemanager to determine as tohow risky it is toadvance credit to a particularparty.This requires financemanager to follow updebtors and decideabout a suitable creditcollection policy. It involvesboth laying down of creditpoliciesand execution of suchpolicies.Credit Policy Credit Analysis Control of Receivables
  5. 5. Put your queries on www.financeclubb.comFactors Determining Credit Policy• The effect of credit on the volume of sales;• Credit terms;• Cash discount;• Policies and practices of the firm for selecting creditcustomers.• Paying practices and habits of the customers.• The firm’s policy and practice of collection.• The degree of operating efficiency in the billing, recordkeeping and adjustment function,• other costs such as interest, collection costs and bad debtsetc.5
  6. 6. Put your queries on www.financeclubb.comIllustrationXYZ Corporation is considering relaxing its present credit policy and is in the processof evaluating two proposed policies. Currently, the firm has annual credit sales of `50 lakhs and accounts receivable turnover ratio of 4 times a year. The current level ofloss due to bad debts is ` 1,50,000. The firm is required to give a return of 25% onthe investment in new accounts receivables. The company’s variable costs are 70% ofthe selling price. Given the following information, which is the better option?6
  7. 7. Put your queries on www.financeclubb.comIllustration7
  8. 8. Put your queries on www.financeclubb.comFive C’s of Credit Analysis8Character The willingness of the customer to honour hisobligationsCapacity The operating cash flows of the customerCapital The financial reserves of the customerCollateral The security offered by the customerConditions The general economic conditions that affect the customer
  9. 9. Put your queries on www.financeclubb.comNumerical Credit Rating Index9Factor Factor Rating Factorweight 5 4 3 2 1 scorePast payment 0.30 √ 1.20Net profit margin 0.20 √ 0.80Current ratio 0.20 √ 0.60Debt-equity ratio 0.10 √ 0.40Return on equity 0.20 √ 1.00Rating index 4.00
  10. 10. Put your queries on www.financeclubb.comRisk Classification Scheme10Risk Class Description1 Customers with no risk of default2 Customers with negligible risk of default (default rate lessthan 2 percent)3 Customers with little risk of default (default rate between 2percent and 5 percent)4 Customers with some risk of default (default rate between 5percent and 10 percent)5 Customers with significant risk of default (default rate inexcess of 10 percent)
  11. 11. Put your queries on www.financeclubb.comDecision Tree Analysis11Rev – Cost– Costp (Revenue – Cost) – (1 – p) Cost
  12. 12. Put your queries on www.financeclubb.comIllustrationABC Company is considering offering credit to acustomer. The probability that the customer wouldpay is 0.8 and the probability that the customerwould default is 0.2. The revenues from the salewould be Rs.1,200 and the cost of sale would beRs.800.The expected profit from offering credit, given theabove information, is:0.8 (1,200 – 800) – 0.2 (800) = Rs.16012
  13. 13. Put your queries on www.financeclubb.comErrors in Credit EvaluationType I errorA good customer is misclassified as a poorcredit riskType II errorA bad customer is misclassified as a good creditrisk13
  14. 14. Put your queries on www.financeclubb.comFinancing Receivables• Pledging: This refers to the use of a firm’s receivable to securea short term loan. A firm’s receivables can be termed as itsmost liquid assets and this serve as prime collateral for asecured loan.• Factoring: Factoring refers to out right sale of accountsreceivables to a factor or a financial agency.14
  15. 15. Put your queries on www.financeclubb.comControl of Receivables• Days’ Sales Outstanding• Ageing Schedule• Collection Matrix15
  16. 16. Put your queries on www.financeclubb.comCollection Matrix16% of Receivables January February March April May JuneCollected During the Sales Sales Sales Sales SalesMonth of sales 13 14 15 12 10 9First following month 42 35 40 40 36 35Second following month 33 40 21 24 26 26Third following month 12 11 24 19 24 25Fourth following month - - - 5 4 5
  17. 17. Put your queries on www.financeclubb.comIllustrationMosaic Limited has current sales of ` 15 lakh per year. Cost of sales is75 per cent of sales and bad debts are one per cent of sales. Cost ofsales comprises 80 per cent variable costs and 20 per cent fixed costs,while the company’s required rate of return is 12 per cent. MosaicLimited currently allows customers 30 days’ credit, but is consideringincreasing this to 60 days’ credit in order to increase sales.It has been estimated that this change in policy will increase sales by15 per cent, while bad debts will increase from one per cent to fourper cent. It is not expected that the policy change will result in anincrease in fixed costs and creditors and stock will be unchanged.Should Mosaic Limited introduce the proposed policy?17
  18. 18. Put your queries on www.financeclubb.comIllustration• New level of sales will be 15,00,000×1.15 = ` 17,25,000• Variable costs are 80% ×75% = 60% of sales• Contribution from sales is therefore 40% of salesx 60% (11,540)24,460
  19. 19. Put your queries on www.financeclubb.comSummary• The important dimensions of a firm’s credit policy are :credit standards, credit period, cash discount, andcollection effort• In general, liberal credit standards tend to push salesup by attracting more customers. However, this isaccompanied by a higher incidence of bad debt loss, alarger investment in receivables, and a higher cost ofcollection. Stiff credit standards have opposite effects.• Three broad approaches are used for credit evaluation: traditional credit analysis, numerical credit scoringrisk classification.
  20. 20. Put your queries on www.financeclubb.comSummary• The traditional approach to credit analysis calls forassessing a prospective customer in terms of the five Csof credit, viz. character, capacity, capital, collateral, andconditions.• Three methods are commonly employed for monitoringaccounts receivable : days’ sales outstanding, ageingschedule, and collection matrix.20

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