#9 credit management
TRANSCRIPT
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SESSION
#9 Credit Management
CF-II (Term III) 2012
Faculty: Prof. Kulbir Singh (IMT-Nagpur)
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Slide 2
Key Concepts and Skills
Understand typical credit terms
Understand the process used for deciding
whether or not to grant credit
PROF. KULBIR SINGH (IMT-NAGPUR)
n ers an ow o eva ua e ou s an ngreceivables
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Slide 3
Chapter Outline
1. Terms of the Sale2. The Decision to Grant Credit: Risk
and Information
3. Optimal Credit Polic
PROF. KULBIR SINGH (IMT-NAGPUR)
4. Credit Analysis5. Collection Policy
6. How to Finance Trade Credit
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Slide 4
1. Terms of the Sale
The terms of sale are composed of Credit Period Cash Discounts
Credit Instruments
PROF. KULBIR SINGH (IMT-NAGPUR)
Example: 2/10, net 30 Net 60 Seasonal Sales.3/10,net 60,May 01 dating
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Slide 5
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
PROF. KULBIR SINGH (IMT-NAGPUR)
The size of the account The extent to which goods are perishable
Lengthening the credit period generallyincreases sales
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Slide 6
The Cash Flows of Granting Credit
Credit sale
is made
Customer
mails check
Firm
deposits
check
Bank credits
firms
account
Lengthening the credit period effectively reduces theprice paid by the customer..but it increases sales
PROF. KULBIR SINGH (IMT-NAGPUR)
Accounts receivable
Cash collection
Time
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Slide 7
Cash Discounts
Often part of the terms of saleto speedup the collection of receivables.
There is a tradeoff between the size of thediscount and the increased speed and rate
of collection of receivables.
PROF. KULBIR SINGH (IMT-NAGPUR)
An example would be 3/10, net 30 The customer can take a 3% discount if s/he
pays within 10 days.
In any event, s/he must pay within 30 days.
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Slide 8
The Interest Rate Implicit in 3/10,
net 30A 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.
PROF. KULBIR SINGH (IMT-NAGPUR)
Other customers will pay on day 30 and forgo the discount.
0 10 30
0 10 30
$1,000
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Slide 9
+$970 $1,000
A customer that forgoes the 3% discount to pay on day 30 is
borrowing $970 for 20 days and paying $30 interest:
The Interest Rate Implicit in 3/10,
net 30
PROF. KULBIR SINGH (IMT-NAGPUR)
36520)1(
000,1$970$
R+=
970$
000,1$)1( 36520 =+ R
%35.747435.01970$
000,1$ 20365
==
=R
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Slide 10
Credit Instruments
Most credit is offered on open accounttheinvoice 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
PROF. KULBIR SINGH (IMT-NAGPUR)
sen o e cus omer s an . en ecustomer signs the draft, the goods are sent.
Bankers acceptances allow a bank tosubstitute its creditworthiness for that of thecustomer, for a fee.
Conditional sales contracts let the seller retainlegal ownership of the goods until thecustomer has completed payment.
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Slide 11
2. The Decision to Grant Credit:
Risk and Information Consider a firm that is choosing between
two alternative credit policies: In God we trusteverybody else pays cash.
Offering their customers credit.
PROF. KULBIR SINGH (IMT-NAGPUR)
The only cash flow of the first strategy is:
Q0
(P0
C0
)
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Slide 12
The Decision to Grant Credit:
Risk and InformationThe expectedcash flows of the creditstrategy are:
h Q0 P0
C0 Q0
PROF. KULBIR SINGH (IMT-NAGPUR)
0 1
and get paid in 1 period
by h% of our customers.
We incur costs up
front
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Slide 13
The Decision to Grant Credit:Risk and Information
NPVcash = Q0 (P0C0)
h Q0 P0
C +NPV =
The NPV of the cash only strategy is:
The NPV of the credit strategy is:
PROF. KULBIR SINGH (IMT-NAGPUR)
B
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
P0 Q0
C0 Q0
The decision to grant credit depends on fourfactors:
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Slide 14
Example of the Decision to Grant
Credit
A firm currently sells 1,000 items permonth on a cash basis for $500 each.
If the offered terms net 30 the marketin
PROF. KULBIR SINGH (IMT-NAGPUR)
department believes that they could sell1,300 items per month.
The collections department estimates that5% of credit customers will default.
The cost of capital is 10% per annum.
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Slide 15
Example of the Decision to Grant
Credit
No Credit Net 30
Quantity sold 1,000 1,300
Selling price $500 $500
PROF. KULBIR SINGH (IMT-NAGPUR)
Unit cost $400 $425
Probability of payment 100% 95%
Credit period (days) 0 30Discount rateperannum 10%
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Slide 16
Example of the Decision to Grant
Credit
The NPV of cash only = 1,000($500 $400)
PROF. KULBIR SINGH (IMT-NAGPUR)
= ,
The NPV of Net 30:1,300$5000.95
1,300$425 + (1.10)30/365 = $60,181.58
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Slide 17
Example of the Decision to Grant
Credit
How high must the credit price be to makeit worthwhile for the firm to extend credit?
The NPV of Net 30 must be at least as big as
the NPV of cash only:
PROF. KULBIR SINGH (IMT-NAGPUR)
365/30
'
0
)10.1(
95.0300,1425$300,1000,100$
+=
P
95.0300,1)10.1()425$300,1000,100($'
0
365/30
=+ P
50.532$95.0300,1
)10.1()425$300,1000,100($ 365/30'0 =
+=P
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Slide 18
The Value of New Information aboutCredit Risk
The most that we should be willing to pay fornewinformation about credit risk is the presentvalue of the expected cost of defaults:
$0
(1 +RB)C0 Q0 +NPVdefault= (1 h)
PROF. KULBIR SINGH (IMT-NAGPUR)
C0 Q0NPVdefault= (1 h)
C0 Q0 (1 h) = $4251,300(1 0.95) = $27,625
In our earlier example, with a credit price of$500, we would be willing to pay $27,625 for aperfectcredit screen.
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Slide 19
Future Sales and the Credit Decision
Customer pays
h = 100%
Customer pays
Information is
revealed at the
We face a more certain credit
decision with ourpaying
customers: Givecredit
PROF. KULBIR SINGH (IMT-NAGPUR)
ro a ty =
Customerdefaults
(Probability = 1h)Our first decision:
We refuse further
sales to deadbeats.
end of the first
period:
Give
credit
Do not
give credit
Do not
give credit
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Slide 20
3. Optimal Credit Policy
Carrying
Costs
Total (Credit) costs (curve)Costs in
dollars
PROF. KULBIR SINGH (IMT-NAGPUR)
C* 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.
Opportunity costs
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Slide 21
Optimal Credit Policy
Trade Credit is more likely to be granted if:
1. The selling firm has a cost advantage over otherlenders.
2. The selling firm can engage in price discrimination.
PROF. KULBIR SINGH (IMT-NAGPUR)
3. The selling firm can obtain favorable tax treatment.
4. The selling firm has no established reputation forquality products or services.
5. The selling firm perceives a long-term strategicrelationship.
The optimal credit policy depends on thecharacteristics of particular firms.
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Slide 22
4. Credit Analysis
Credit Information Financial Statements Credit Reports on Customers Payment
History with Other Firms
PROF. KULBIR SINGH (IMT-NAGPUR)
Customers Payment History with the
Firm
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Slide 23
Credit Analysis
Credit Scoring: The traditional 5 Cs of credit
Character
Capacity
PROF. KULBIR SINGH (IMT-NAGPUR)
Collateral Conditions
Some firms employ sophisticatedstatistical models
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Slide 24
5. Collection Policy
Collection refers to obtaining paymenton past-due accounts.
Collection Policy is composed of:
The firms willingness to extend credit as
PROF. KULBIR SINGH (IMT-NAGPUR)
reflected in the firms investment inreceivables
Collection effort
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Slide 25
Average Collection Period
Measures the average amount of timerequired to collect an account receivable:
Average Collection Period =Accounts receivable
PROF. KULBIR SINGH (IMT-NAGPUR)
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
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Slide 26
Accounts Receivable AgingSchedule
Shows receivables by age of account
The longer an account has been unpaid,
the less likely it is to be paid.
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Slide 27
Collection Effort
Most firms follow a protocol for customersthat are past due:
1. Send a delinquency letter
PROF. KULBIR SINGH (IMT-NAGPUR)
.
3. Employ a collection agency
4. Take legal action against the customer
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Slide 28
Collection Effort
There is a potential for a conflict ofinterest between the collectionsdepartment and the sales department.
PROF. KULBIR SINGH (IMT-NAGPUR)
antagonizing a customer and being takenadvantage of by a deadbeat.
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Slide 29
Factoring
The sale of a firms accounts receivable toa financial institution (known as a factor)
The firm and the factor agree on the basiccredit terms for each customer.
The factor a s an a reed-
PROF. KULBIR SINGH (IMT-NAGPUR)
Firm
Factor
Customer
Customers send
payment to the
factor.
upon percentage of the
accounts receivable to the
firm. The factor bears the
risk of nonpaying
customers.
Goods
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Slide 30
6. How to Finance Trade Credit
There are three general ways of financingaccounting receivables:
1. Secured Debt Referred to as asset-based receivables financing.
The predominant form of receivables financing.
PROF. KULBIR SINGH (IMT-NAGPUR)
2. Captive Finance Company Large companies with good credit ratings often form a
finance company as a subsidiary of the firm.
3. Securitization Occurs when the selling firm sells its accountsreceivable to a financial institution, which then poolsthe receivables and sells securities backed by theseassets.
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Slide 31
Quick Quiz
Explain a credit term quoted 2/10, net 30.
Discuss the process used for evaluating
the creditworthiness of potential
PROF. KULBIR SINGH (IMT-NAGPUR)
.
Identify the optimal credit policy.