Credit management

1. 29-0
Chapter Twenty Nine
Credit Management
Corporate Finance
Ross  Westerfield  Jaffe Sixth Edition 29
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

2. 29-1
Executive Summary
• When a firm sells goods and services:
(1) it can be paid in cash immediately or
(2) it can wait for a time to be paid by extending
credit to its customers.
• Granting credit is investing in a customer, an
investment tied to the sale of a product or service.
• This chapter examines the firm’s decision to grant
credit.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

3. 29-2
Chapter Outline
29.1 Terms of the Sale
29.2 The Decision to Grant Credit:
Risk and Information
29.3 Optimal Credit Policy
29.4 Credit Analysis
29.5 Collection Policy
29.6 Other Aspects of Credit Policy
29.7 Summary & Conclusions
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

4. 29-3
Introduction
• A firm’s credit policy is composed of:
– Terms of the sale
– Credit analysis
– Collection policy
• This chapter discusses each of the components of
credit policy that makes up the decision to grant
credit.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

5. 29-4
The Cash Flows of Granting Credit
Credit sale
is made
Customer
mails
cheque
Firm
deposits
cheque
Bank credits
firm’s
account
Cash collection
Accounts receivable
Time
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

6. 29-5
29.1 Terms of the Sale
• The terms of sale of composed of
– Credit Period
– Cash Discounts
– Credit Instruments
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

7. 29-6
Credit Period
• Credit periods vary across industries.
• Generally a firm must consider three factors in
setting a credit period:
– The probability that the customer will not pay.
– The size of the account.
– The extent to which goods are perishable.
• Lengthening the credit period generally increases
sales
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

8. 29-7
Cash Discounts
• Often part of the terms of sale.
• Tradeoff between the size of the discount and the
increased speed and rate of collection of
receivables.
• An example would be “3/10 net 30”
– The customer can take a 3% discount if he pays within 10
days.
– In any event, he must pay within 30 days.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

9. 29-8
The Interest Rate Implicit in 3/10 net 30
A firm offering credit terms of 3/10 net 30 is essentially
offering their customers a 20-day loan.
To see this, consider a firm that makes a $1,000 sale on day 0
Some customers will pay on day 10 and take the discount.
$970
0 10 30
Other customers will pay on day 30 and forgo the discount.
$1,000
0 10 30
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

10. 29-9
The Interest Rate Implicit in 3/10 net 30
A customer that forgoes the 3% discount to pay on day 30 is
borrowing $970 for 20 days and paying $30 interest:
+$970 -$1,000
0 10 30
$1,000
20 365 (1 )
$970
 r

$1,000
$970
(1 ) 20 365  r 

   
1 0.7435 74.35%
365
$1,000 20
$970


r 
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

11. 29-10
Credit Instruments
• Most credit is offered on open account—the invoice is the
only credit instrument.
• Promissory notes are IOUs that are signed after the delivery
of goods
• Commercial drafts call for a customer to pay a specific
amount by a specific date. The draft is sent to the customer’s
bank, when the customer signs the draft, the goods are sent.
• Banker’s acceptances allow a bank to substitute its
creditworthiness for the customer, for a fee.
• Conditional sales contracts let the seller retain legal
ownership of the goods until the customer has completed
payment.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

12. 29-11
29.2 The Decision to Grant Credit: Risk
and Information
• Consider a firm that is choosing between two
alternative credit policies:
– “In God we trust—everybody else pays cash.”
– Offering their customers credit.
( ) 0 0 0 • The only cash flow of the first strategy isQ  P C
• The expected cash flows of the credit strategy are:
'
0hQ P
'
0
'
0C Q
'
0
0 1
We incur costs up
front…
…and get paid in 1 period
by h% of our customers.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

13. 29-12
29.2 The Decision to Grant Credit: Risk
and Information
•The NPV of the cash only strategy is
( ) 0 0 0 NPV Q P C cash   
'
0
'
•The NPV of the credit strategy is
h 
Q P
' 0
0
NPV C Q
  
credit r
(1 )
'
0
B

The decision to grant credit depends on four factors:
1. The delayed revenues from granting credit,
2. The immediate costs of granting credit,
3. The probability of repayment, h
4. The discount rate, rB
'
0PQ
'
0
'
0
'
0C Q
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

14. 29-13
Example of the Decision to Grant Credit
• A firm currently sells 1,000 items per month on a
cash basis for $500 each.
• If they offered terms net 30, the marketing
department believes that they could sell 1,300 items
per month.
• The collections department estimates that 5% of
credit customers will default.
• The cost of capital is 10% per annum.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

15. 29-14
Example of the Decision to Grant Credit
No Credit Net 45
Quantity sold 1,000 1,300
Selling price $500 $500
Unit cost $400 $425
Probability of payment 100% 95%
Credit period (days) 0 30
Discount rate p.a. 10%
The NPV of cash only: 1,000($500$400)  $100,000
The NPV of Net 30:
$60,181.58
1,300  $500 
0.95
   
1,300 $425 30/365 
(1.10)
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

16. 29-15
Example of the Decision to Grant Credit
• How high must the credit price be to make it
worthwhile for the firm to extend credit?
The NPV of Net 30 must be at least as big as
the NPV of cash only:
'
0
P
1,300  
0.95
30/365
(1.10)
$100,000 1,300 $425
   
($100,000  1,300  $425)  (1.10) 30/365  1,300 P '

0.95 0
$532.50
($100,000  1,300  $425) 
(1.10) 30/365
'
0 
1,300 
0.95
P 
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

17. 29-16
The Value of New Information about
Credit Risk
• The most that we should be willing to pay for new
information about credit risk is the present value of
the expected cost of defaults:
NPV C Q h
    (1  )

C Q h
    
(1 )
$0
r
(1 )
'
0
'
0
'
0
'
0
B
default

In our earlier example, with a credit price of $500, we would
be willing to pay $26,000 for a perfect credit screen.
'
0 C Q   h     
(1 ) $400 1,300 (1 0.95) $26,000 '
0
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

18. 29-17
Future Sales and the Credit Decision
Customer pays
Give
credit
h = 100%
Do not
give credit
We face a more certain credit
decision with our paying
customers:
Information is
revealed at the
end of the first
period:
Customer pays
(Probability = h)
Customer
defaults
(Probability = 1– h)
Give
credit
Our first decision:
Do not
give credit
We refuse further
sales to deadbeats.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

19. 29-18
29.3 Optimal Credit Policy
Carrying
Costs
Total costs
C*
Costs in
dollars
Opportunity costs
Level of credit extended
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.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

20. 29-19
29.3 Optimal Credit Policy
• Trade Credit is more likely to be granted if:
1. The selling firm has a cost advantage over other lenders.
2. The selling firm can engage in price discrimination.
3. The selling firm can obtain favourable tax treatment.
4. The selling firm has no established reputation for
quality products or services.
5. The selling firm perceives a long-term strategic
relationship.
• The optimal credit policy depends on the
characteristics of particular firms.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

21. 29-20
Organizing the Credit Function
• Firms that run strictly internal credit operations are self-insured
against default risk.
• An alternative is to buy credit insurance through an
insurance company.
• In Canada, exporters may qualify for credit insurance
through the Export Development Corporation (EDC).
• Large corporations commonly extend credit through a
wholly owned subsidiary called a captive finance company.
• Securitization occurs when the selling firm sells its accounts
receivable to a financial institution.
• During 1991--92 recession, some Canadian companies
tightened their credit-granting rules to offset the higher
probability of customer bankruptcy.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

22. 29-21
29.4 Credit Analysis
• Credit Information
– Financial Statements
– Credit Reports on Customer’s Payment History with Other Firms
– Banks
– Customer’s Payment History with the Firm
• Credit Scoring:
– The traditional 5 C’s of credit
• Character
• Capacity
• Capital
• Collateral
• Conditions
– Some firms employ sophisticated statistical models
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

23. 29-22
Credit Scoring
• Credit scoring refers to the process of:
(1) calculating a numerical rating for a customer based on
information collected,
(2) granting or refusing credit based on the result.
• Financial Institutions have developed elaborate statistical
models for credit scoring. This approach has the advantage
of being objective as compared to scoring based on
judgments on the 5 C’s.
• Credit scoring is used for business customers by Canadian
chartered banks. Scoring for small business loans is a
particularly attractive application because the technique
offers the advantages of objective analysis.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

24. 29-23
29.5 Collection Policy
• Collection refers to obtaining payment on past-due
accounts.
• Collection Policy is composed of
– The firm’s willingness to extend credit as reflected in the
firm’s investment in receivables.
– Collection Effort
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25. 29-24
Average Collection Period
• Measures the average amount of time required to
collect an account receivable.
Accounts receivable
Average daily sales
Average collection period 
• For example, a firm with average daily sales of
$20,000 and an investment in accounts receivable
of $150,000 has an average collection period of
7.5 days
$150,000
$20,000 day

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

26. 29-25
Accounts Receivable Aging Schedule
• Shows receivables by age of account.
• The aging schedule is often augmented by the
payments pattern.
• The payments pattern describes the lagged
collection pattern of receivables.
• The longer an account has been unpaid, the less
likely it is to be paid.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

27. 29-26
Collection Effort
• 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.
• There is a potential for a conflict of interest
between the collections department and the sales
department.
• You need to strike a balance between antagonizing
a customer and being taken advantage of by a
deadbeat.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

28. 29-27
29.6 Other Aspects of Credit Policy/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 credit
terms for each customer.
The factor pays an agreed-upon
percentage of the
accounts receivable to the
firm. The factor bears the
risk of nonpaying
customers
Firm
Factor
Customers send
payment to the
factor
Customer
Goods
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

29. 29-28
Factoring
• Factoring in Canada is conducted by independent
firms where main customers are small businesses.
• What factoring does is remove receivables from
the balance sheet and so, indirectly, it reduces the
need for financing.
• Firms financing their receivables through a
chartered bank may also use the services of a
factor to improve the receivables’ collateral value.
This is called maturity factoring with assignment
of equity.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

30. 29-29
Credit Management in Practice
• To make monitoring easy, treasury credit staff call
up customer information from a central database.
• The system also provides collections staff with a
daily list of accounts due for a telephone call with a
complete history of each account.
• Credit analysis uses an early warning system that
examines the solvency risk of existing and new
commercial accounts. The software scores the
accounts based on financial ratios.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

31. 29-30
29.7 Summary & Conclusions
1. The components of a firm’s credit policy are the terms of
sale, the credit analysis, and the collection policy.
2. The decision to grant credit is a straightforward NPV
problem.
3. Additional information about the probability of customer
default has value, but must be weighed against the cost of
the information.
4. The optimal amount of credit is a function of the conditions
in which a firm finds itself.
5. The collection policy is the firm’s method for dealing with
past-due accounts—it is an integral part of the decision to
extend credit.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited