Chapter 5: Credit ManagementChapter 5
The Cash Flow Timeline
Placed Received Received
Learning Objectives
Describe the typical credit-granting sequence.
Apply net present value analysis to credit extension decisions.
Define credit scoring and explain limitations.
List the elements in a credit rating report.
Describe how receivables management can benefit from EDI.
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Trade Credit and Shareholder Value
Trade credit arises when goods sold under delayed payment terms
Traced to Romans due to obstacles faced in transferring money through various trading areas
Credit terms are taken for granted today
Value can be added by managing three areas:
aggregate investment in receivables
Over-investing in receivables can be costly
...but, if credit terms are not competitive, then lost sales can be costly
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Conclusion
Maintain financial flexibility
Convert receivables to cash in a timely manner
Analyze customer risk
A/R Management and Shareholder Value
Marketing Strategy
Acceptance of Marg Cust.
Trade vs. Bank Credit
Extent of analysis
Why Extend Credit?
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Financial Motive
Potential of getting a higher price
Sellers raise capital at lower rates than customers and have cost advantages vis-a-vis banks due to:
similarity of customers
the information gathered in the selling process
lower probability of default (the goods purchased are an essential element of the buyer’s business)
seller can more easily resell product if payment is not made.
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Operating Motive
Change credit terms rather than:
install extra capacity,
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Contracting Cost Motive
Buyer gets to inspect goods prior to payment
Seller has less theft with separation of collection and product delivery
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Pricing Motive
Trends Affecting Trade Credit
Improved internal and external credit-related information
Electronic commerce
The Credit Decision Process
Establish customer credit file
Basic Credit Granting Model
VCR = variable cost ratio
EXP = credit administration and collection expense ratio
i = daily interest rate
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Managing the Credit Policy
Should we extend credit?
Should We Extend Credit?
in-house credit card
captive finance company?
Components of Credit Policy
Development of credit standards
Credit terms
credit period
cash discount
Credit limit
Collection procedures
how long to wait past due date to initiate collection efforts
methods of contact
whether and at what point to refer account to collection agency
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Credit-Granting Decision
Risk analysis
Grant-Granting Sequence
Credit Standards
Character
Capital
Capacity
Collateral
Conditions
Gathering Information
credit interchange bureaus, NACM
Credit Analysis: Applying the Standards
Nonfinancial
Financial
ability to pay, financial ratios etc.. (other C’s of credit)
Credit scoring models
Emergence of Expert Systems
Example of decision rule:
“If gross income is equal to or grater than $20,000 and the applicant has not been delinquent and gross income per household member is equal to or greater than $12,000 and debt/equity ratio is equal to or greater than 30% but less than 50% and personal property is equal to or greater than $50,000, then grant credit.”
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Factors Affecting Credit Terms
Type of good (raw materials vs finished goods, perishables, etc.)
Seasonality of demand
Cash Discounts
Based on company’s cost of funds
Consider timing effect when changing discounts
Should be based on product’s price elasticity
Higher the bad debt experience, higher the optimal discount
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Practice of Taking Cash Discounts
51% of firms always took cash discount
40% sometimes
9% take discount and pay late
Study found that 4 or 5 companies would be more profitable if cash discount was eliminated
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A/R Management in Practice
Discounts appear to be changed to match competitors, not inflation or interest rates
The higher a firm’s contribution margin, the more likely the firm should be to offer discounts.
A price cut is thought to have more impact than instituting a cash discount
The more receivables a firm has, does not necessarily relate to use of penalty fees
The greater amount of receivables does not relate to a more active credit evaluation.
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Receivables, Collections, and EDI
If credit approval is delayed...
buyers using EDI purchase orders and JIT manufacturing can encounter serious problems.
sellers can now ship within hours of receiving orders...thus seller must be able to handle electronically transmitted orders.
Seller may also issues electronic invoices and be paid electronically using an EDI-capable bank so that remittance data can be automatically read by seller’s A/R system
Trend is for use of data transmission to automate the cash application process
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Summary
Key aspects outlined
credit limits
credit terms
Management of A/R is influenced by what competitors are doing not by shareholder wealth considerations.