Optimum Credit Policy

By Rahul Sasidharan MGT 1105131

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.

Components of Credit Policy

A firms credit policy is composed of: Terms of sale Credit analysis Collection policy

Term of Sales

Conditions under which a firm extends credit to customers

Credit Period Cash Discount Credit Instrument

Credit Analysis
The process of determining the likelihood that the customer will or will not pay

Collection Policy
The procedures that a firm follows to make sure that payments are duly paid against accounts recievables

-Terms of SalesCredit Period

The duration of the time period allowed to a customer to pay the credit offered. Factors in deciding extend:

The probability of the customer not pay.ing. The size of the account. The extent to which goods are perishable.

Lengthening the credit period generally increases sales

-Terms of SalesCash Discount

The discount offered in the purchase price to induce timely payment 5/8 net 30; 2/10 net 30 Means The customer can avail 5% discount if he pays in 8 days and; avail 2% discount paying back in 10 days In any of these two cases net 30 is unconditionally the deadline or the maximum allowable credit period

Invoice: Most credit is offered on open accountthe invoice is the only credit instrument. Promissory notes: They are IOUs that are signed after the delivery of goods Commercial drafts: They call for a customer to pay a specific amount by a specific date. The draft is sent to the customers bank, when the customer signs the draft, the goods are sent. Bankers acceptances: They allow a bank to substitute its creditworthiness for the customer, for a fee. Conditional sales contracts: They let the seller retain legal ownership of the goods until the customer has completed payment.

-Terms of SalesCredit Instrument

The basic evidence of indebtedness in a credit transaction

Collection Policy
No credit Credit

The Decision to Grant Credit: Risk and Information

The only cash flow of the first Q 0 (P0 C0 ) strategy is The expected cash flows of the credit strategy are:

C Q
' 0

' 0

h Q P

' ' 0 0

We incur costs up front

and get paid in 1 period by h % of our customers.

cash only strategy is ' ' h Q P The NPV of ' ' 0 0 NPV = C Q + credit 0 0 the credit (1 + rB ) strategy is The decision to grant credit depends on ' ' four factors: PQ
1. The delayed revenues from granting credit,
0 0

The Decision to Grant Credit: Risk and Information The NPV of the NPV = Q (P
cash 0

C0 )

C 2. The immediate costs of granting credit,

3. The probability of repayment, 4. The discount rate,

rB

' 0

' 0

Optimal Credit Policy

Total costs Carrying Costs

incremental cash flows from increased sales are exactly equal to the carrying

Costs in Rupees

Opportunity costs C*

Level of credit At the optimal amount of credit, the extended

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

Collection Policy
Collection refers to obtaining payment on past-due accounts. Collection Policy is composed of

The firms willingness to extend credit as reflected in the firms investment in receivables. Collection Effort

Average Collection Period

Measures the average amount of time required to collect an account receivable.
Accounts receivable Average collection period = Average dailysales

For example, daily sales investment in $150,000 has period of

a firm with average of $20,000 and an accounts receivable of anRs average 150,000 collection
Rs 20,000day = 7.5 days

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.

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.

Factoring
The sale of a firms accounts receivable to a financial institution (known as a factor). The firm and the factor agree on the basic credit terms for each customer.
Customers send payment to the factor The factor pays an agreedupon percentage of the accounts receivable to the firm. The factor bears the risk of nonpaying customers

Factor

Customer

Goods

Firm

Summary
1. The components of a firms optimum 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 firms method for dealing with past-due accountsit is an integral part of the decision to extend credit.

Thank you