Chapter28 Credit Management

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Chapter 28CREDIT MANAGEMENT

Centre for Financial Management , Bangalore


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OU TLINE

Terms of Payment

Credit Policy Variables

Credit Evaluation

Credit Granting Decision

Control of Accounts Receivable

Credit Management in India



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TERMS O F PAYMENT

Cash Terms

O pen Account

Consignment

Bill of Exchange

Letter of Credit



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CREDIT P O LICY VARIABLES

The important dimensions of a firms credit policy are:

Credit standards

Credit period

Cash discount

Collection effort



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CREDIT STANDARDS

Liberal Stiff

Sales Higher Lower

Bad debt loss Higher Lower

Investment Larger Smaller

in receivables

Collection costs Higher Lower



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IMPACT O N RESID U AL INC O MEO F RELAXATI O N

( RI = [( S (1 V ) - ( Sb n ] (1 t ) k ( I

where ( RI = change in residual income

( S = increase in sales

V = ratio if variable costs to sales

b n = bad debt loss ratio on new sales

t = corporate tax rate

( I = increase in receivables investment



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EXAMPLE

Pioneer Limited is considering relaxing its creditstandards.

( S = Rs. 15 million, b n = 0.10, V = 0.80,

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

( RI = [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



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CREDIT PERI O D

Longer Shorter

Sales Higher Lower

Investment in Larger Smaller

receivables

Bad debts Higher Lower



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IMPACT O N RESID U AL

INC O ME O F L O NGER CREDIT PERI O D

( RI = [( S (1 V ) - ( Sb n ] (1 t ) k ( I



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INCREASE IN RECEIVABLESINVESTMENT

S 0 ( S

( I = ( ACP n ACP 0) + V ( ACP n )360 360

where: ( I = increase in receivables investment

ACP n = new average collection period (after lengtheningthe credit period)

ACP 0 = old average collection periodV = ratio of variable cost to sales

( S = increase in sales



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EXAMPLE

Zenith Limited is considering extending its credit periodfrom 30 to 60 days.

S = Rs. 50 million, ( S = Rs. 5 million, V = 0.8 5,b n = 0.08, k = 0.10, t = 0.40

( RI = [5,000,000 x 0. 15 5,000,000 x 0.08 ] (0.6)

0.10 (60 30) x + 0.8 5 x 60 x

= [750,000 400,000 ] (0.6) 0. 10 [4, 166,667 + 708,333 ]

= 277, 500

50,000,000

360

5,000,000360



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LIBERALISING THE CASH

DISC OU NT P O LICY

( RI = [( S (1 V ) - ( DIS ] (1 t ) + k ( I



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DECREASING THE RIG OU R

O F C O LLECTI O N PR O GRAMME

( RI = [( S (1 V ) - ( BD ] (1 t ) k ( I



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ERR O RS IN CREDIT EVAL U ATI O N

In assessing credit risks, two types of errors occur :

Type I error A good customer is misclassified as apoor credit risk

Type II error A bad customer is misclassified as a goodcredit risk



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TRADITI O NAL CREDIT ANALYSIS

Five Cs of Credit

Character : The willingness of the customer to honourhis obligations

Capacity : The operating cash flows of the customer

Capital : The financial reserves of the customer

Collateral : The security offered by the customerConditions : The general economic conditions that

affect the customer



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Shouldcredit be

granted?

Character

CapacityCapacity

Capital Capital CapitalCapital

Excellent risk Fair risk Doubtful risk Dangerousrisk

How muchcredit

should begranted ?

SEQ U ENTIAL CREDIT ANALYSIS

Strong Weak

StrongWeak Weak

Strong

StrongStrong

StrongWeak Weak Weak

Weak Strong



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NU MERICAL CREDIT RATING INDEX

Factor Factor Rating Factor weight 5 4 3 2 1 score

ast ayme t 0.30 1.20et rofit margi 0.20 0.80

rre t ratio 0.20 0.60e t-eq ity ratio 0. 10 0.40et r o eq ity 0.20 1.00

ati g i e 4.00



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p

Rev Cost

Cost

0

CREDIT GRANTING DECISI O N

Expected Pre-tax Profit

p (Revenue Cost) (1 p) Cost



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EXAMPLE

ABC Company is considering offering credit to a customer.The probability that the customer would pay is 0.8 and theprobability that the customer would default is 0.2. Therevenues from the sale would be Rs. 1,200 and the cost of

sale would be Rs.800.

The expected profit from offering credit, given theabove information, is:

0.8 (1 ,200 800) 0.2 (800) = Rs. 160



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Expected profit on Probability of payment Expected profit oninitial order and repeat order repeat order

[ p1(REV 1 C O ST 1) (1- p1) C O ST 1]

+ p1 x [ p2 (REV 2 C O ST 2) (1- p2) C O ST 2]

[0.9 (2000- 1500) 0. 1(15 00) ]

+ 0.9 [0.9 5 (2000- 1500) 0.0 5 (15 00)]

= 660

+ x

REPEAT O RDER



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DECISI O N TREE F O R GRANTING CREDIT



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C O NTR O L O F ACC OU NTS

RECEIVABLES

Days Sales O utstanding

Ageing Schedule

Collection Matrix



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C O LLECTI O N MATRIX

P erce n tage o f Receivabl es Ja nu ary e br u ary Marc A pr i l May J un eC oll ected D u r i n g t e S al es S al es S al es S al es S al es S al es

Month of sales 13 14 15 12 10 9First following month 42 3 5 40 40 36 3 5 Second following month 33 40 2 1 24 26 26Third following month 12 11 24 19 24 2 5 Fourth following month - - - 5 4 5



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SU MMING U P

The important dimensions of a firms credit policy are : creditstandards, credit period, cash discount, and collection effort

In general, liberal credit standards tend to push sales up byattracting more customers. However, this is accompanied by ahigher incidence of bad debt loss, a larger investment inreceivables, and a higher cost of collection. Stiff credit standards

have opposite effects.Three broad approaches are used for credit evaluation :traditional credit analysis, numerical credit scoring, anddiscriminant analysis.

The traditional approach to credit analysis calls for assessing aprospective customer in terms of the five Cs of credit, viz.character, capacity, capital, collateral, and conditions.

Three methods are commonly employed for monitoring accountsreceivable : days sales outstanding, ageing schedule, and

collection matrix. Centre for Financial Management , Bangalore

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Chapter28 Credit Management