CREDIT MANAGEMENT

The Cash Flows of Granting Credit

Credit sale is made

Customer mails check

Firm deposits check

Bank credits firm’s

account

Accounts receivable

Cash collection

Time

COSTS & BENEFITS OF CREDIT MANAGEMENT

OPPORTUNITY COST

COLLECTION COST

BAD DEBTS

INCREASED SALES

INCREASE IN MARKET SHARE

INCREASE IN PROFITS

TERMS OF PAYMENT

• Cash Mode

• Bill of Exchange

• Letter of Credit

• Consignment

CREDIT POLICY VARIABLES

The important dimensions of a firm’s credit policy are:

• Credit standards

• Credit period

• Cash discount

• Collection effort

CREDIT STANDARDS

Liberal Stiff

• Sales Higher Lower

• Bad debt loss Higher Lower

• Investment Larger Smaller in receivables

• Collection costs Higher Lower

IMPACT ON RESIDUAL INCOME OF RELAXATION

P = [S(1 – V) - Sbn] (1 – t ) – k I

where P = change in Profit

S = increase in sales

V = ratio if variable costs to sales

bn = bad debt loss ratio on new sales

t = corporate tax rate

I = increase in receivables investment

Q.PSD Ltd. is considering relaxing its credit standards.

S = Rs.15 million, bn = 0.10, V = 0.80,

ACP = 40 days, k = 0.10, t = 0.4

P = [15,000,000 (1 – 0.80) – 15,000,000 x 0.10] (1 – 0.4)

15,000,000 – 0.10 x x 40 x 0.80

360

= Rs.766,667

CREDIT PERIOD

Longer Shorter

• Sales Higher Lower

• Investment in Larger Smaller

receivables

• Bad debts Higher Lower

IMPACT ON RESIDUAL

INCOME OF LONGER CREDIT PERIOD

P = [S(1 – V) - Sbn] (1 – t ) – k I

INCREASE IN RECEIVABLES INVESTMENT

S0 S

I = (ACPn – ACP0) + V (ACPn) 360 360

where: I = increase in receivables investment

ACPn = new average collection period (after lengthening the credit period)

ACP0 = old average collection period

V = ratio of variable cost to sales

S = increase in sales

Q. X Limited is considering extending its credit period from 30 to 60 days.

S = Rs.50 million, S = Rs.5 million, V = 0.85, bn = 0.08,

k = 0.10, t = 0.40

P = [5,000,000 x 0.15 – 5,000,000 x 0.08] (0.6)

– 0.10 (60 – 30) x + 0.85 x 60 x

= [750,000 – 400,000] (0.6) – 0.10 [4,166,667 + 708,333]

= – 277,500

50,000,000360

5,000,000360

LIBERALISING THE CASH DISCOUNT POLICY

P = [S(1 – V) - DIS] (1 – t ) + k I

DECREASING THE RIGOUR OF COLLECTION PROGRAMME

RI = [S(1 – V) - BD] (1 – t ) – k I

Cash Discounts

• Often part of the terms of sale• There is a 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 s/he pays

within 10 days.– In any event, s/he must pay within 30 days.

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.

Other customers will pay on day 30 and forgo the discount.

0 10 30

$970

0 10 30

$1,000

Calculation of Cost of Cash Discount

Rate of discount x No. of days in a year1- Rate of discount (Credit period-Discount

period)

Credit terms Cost of trade credit(%)

2/10 Net 30 36.722/10 Net 45 20.991/10 Net 60 18.182/15 Net 30 48.98

28.3 Optimal Credit Policy

Carrying Costs

Total costs

C*

Costs in dollars

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

TRADITIONAL CREDIT ANALYSIS

Five Cs of Credit

Character : The willingness of the customer to honour his obligations

Capacity : The operating cash flows of the customer

Capital : The financial reserves of the customer

Collateral : The security offered by the customer

Conditions : The general economic conditions that affect the customer

Case History : Checking customers past transaction to extend credit to

the customer

:

MONITORING OF ACCOUNTS RECEIVABLES

• RECEIVABLES TURNOVER

• AVERAGE COLLECTION PERIOD (ACP)

• AGEING SCHEDULE

• COLLECTION MATRIX

RECEIVABLES TURNOVER

• How quickly RECEIVABLES are CONVERTED in to CASH

Receivables Turnover Rate= Total Net Sales

Avg. Debtors* (*including Bills Receivables)

AVERAGE COLLECTION PERIOD (ACP)

• Time (no. of Days)• the Credit Sales• are converted• In to Cash

ACP= 365/ Receivables Turnover

AGEING SCHEDULE

• Statement showing • AGE WISE GROUPING OF DEBTORS

OR• Breaking up of Debtors• according to the LENGTH OF TIME• for which they have been OUTSTANDING

Age Group(in Days)

Amount Outstanding (Rs.)

Percentage of Debtorsto Total Debtors

Less Than 30

31-45

46-60

Above 60

40,00,000

20,00,000

30,00,000

10,00,000

40

20

30

10

Total 1,00,00,000 100

COLLECTION MATRIX

• Shows • the collection pattern (in months)• for the CREDIT SALES• made in a month

Percentage of Receivables January February March April May June Collected During the Sales Sales Sales Sales Sales Sales Month of sales 13 14 15 12 10 9 First following month 42 35 40 40 36 35 Second following month 33 40 21 24 26 26 Third following month 12 11 24 19 24 25 Fourth following month - - - 5 4 5

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.

Firm

Factor

Customer

Customers send payment to the factor.

The factor pays an agreed-upon percentage of the

accounts receivable to the firm. The factor bears the

risk of nonpaying customers.

Goods

TYPES OF FACTORINGTYPES/ Service Short term finance Sales Ledger

AdministrationCredit Protection

Recourse Yes Yes No

Non Recourse Yes Yes Yes

Maturity No Yes No

Invoice Discounting Yes No No