Chapter Fourteen

Credit Management

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-1

Chapter Organisation
14.1 Credit and Receivables
14.2 Terms of the Sale
14.3 Analysing Credit Policy
14.4 More on Credit Policy Analysis
14.5 Optimal Credit Policy
14.6 Credit Analysis
14.7 Collection Policy
14.8 Summary and Conclusions

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-2

Chapter Objectives

Understand the components of credit policy and the cash

flows associated with granting credit.
Identify the factors that influence the length of the credit
period.
Calculate the cost of forgoing discounts in credit periods.
Outline the various credit policy effects.
Calculate the cost and NPV of switching policies.
Determine the optimal credit policy.
Discuss the five Cs of credit.

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-3

Components of Credit Policy

Terms of sale
The conditions on which a firm sells its goods and services for
cash or credit.

Credit analysis
The process of determining the probability that customers will
not pay.

Collection policy
Procedures that are followed by a firm in collecting accounts
receivable.

Accounts receivable = Average daily sales average

collection period

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-4

Cash Flows from Granting Credit

Credit
sale is
made

Customer
mails
cheque

Firm deposits
cheque in
bank

Bank credits
firms
account

Time
Cash collection

Accounts receivable

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-5

Terms of the Sale

Credit period
The length of time that credit is granted, usually between 30
and 120 days.

Cash discount
A discount that is given for a cash purchase to speed up the
collection of receivables.

Credit instrument
Evidence of indebtedness such as an invoice or promissory
note.

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-6

Length of the Credit Period

Factors that influence the length of the credit period include:

buyers inventory period and operating cycle

perishability and collateral value of goods
consumer demand for the product
cost, profitability and standardisation
credit risk of the buyer
the size of the account
competition in the product market
customer type.

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-7

Cost of the Credit

2/10, net 30 = buyer pays in 10 days to get a 2 per cent

discount, or within 30 days for no discount.
Buyer has an order for $1500 and ignores the credit period
gives up $30 discount.

30
EAR 1

1 470

365

20

1 44.59%

The benefit obviously lies in paying early.

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-8

Credit Policy Effects

Revenue effectsPayment is received later, but price and

quantity sold may increase.

Cost effectsCost of sale is still incurred even though the

cash from the sale has not been received.

The cost of debtThe firm must finance receivables and,

therefore, incur financing costs.

The probability of non-paymentThe firm always gets paid if

it sells for cash, but risks losses due to customer default if it
sells on credit.

The cash discountDiscounts induce buyers to pay early; the

size of the discount affects payment patterns and amounts.

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-9

Evaluating a Proposed Credit Policy

P = price per unit

Q = new quantity expected to be sold

v = variable cost per unit Q = current quantity sold per period

R = periodic required return

The benefit of switching is the change in cash flow:

New cash flow old cash flow

P v Q' P v Q
rearranging

P v Q' Q
Copyright 2004 McGraw-Hill Australia
Pty Ltd

14-10

Evaluating a Proposed Credit Policy

The present value of switching is:

PV = [(P v) (Q Q)]/R

The cost of switching is the amount uncollected for the period

plus the additional variable costs of production:
Cost = PQ + v(Q Q)

And the NPV of the switch is:

NPV = [PQ + v(Q Q)] + [(P v)(Q Q)]/R

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-11

ExampleEvaluating a Proposed
Credit Policy
ABC Co. is thinking of changing from a cash-only policy to a
net 30 days on sales policy. The company has estimated
the following:
P = $55

v = $32 Q = 160

Q = 175

R = 2%

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-12

SolutionEvaluating a Proposed
Credit Policy
Cash flow (old policy) P v Q

55 32 160
$3680

Cash flow (new policy) P v Q'

55 32 175
$4025

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-13

SolutionEvaluating a Proposed
Credit Policy
Benefit of switching P v Q' Q
55 32 175 160
$345

P v Q' Q
PV of switching
R
345

0.02
$17 250
Copyright 2004 McGraw-Hill Australia
Pty Ltd

14-14

SolutionEvaluating a Proposed
Credit Policy
Cost of switching PQ v Q' Q
55 160 32 175 160
$8320
NPV of switching PQ v Q' Q P v Q' Q /R
8320 17 250
$8930
Therefore, the switch is very profitable.
Copyright 2004 McGraw-Hill Australia
Pty Ltd

14-15

Break-even Point

PQ
Q' Q
P v /R v

55 160

55 32 / 0.02 32
7.87 units
The switch is a good idea as long as the
company can sell an additional 7.87 units.
Copyright 2004 McGraw-Hill Australia
Pty Ltd

14-16

Discounts and Default Risk

ABC Co. currently has a cash price of $55 per unit. If the
company extends the 30 day credit policy, the price will
increase to $56 per unit on credit sales. ABC Co. expects
0.5 per cent of credit to go uncollected (). All other
information remains unchanged. Should the company switch
to the credit policy?

Percentage discount allowed for cash customers d

$56 $55 1.79%

$56

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-17

Discounts and Default Risk

NPV of changing credit terms:

NPV PQ P' Q d /R
$55 160 $56 160 0.0179 0.005 / 0.02
$3020.80

As the NPV of the change is negative, ABC Co.

should not switch.
Copyright 2004 McGraw-Hill Australia
Pty Ltd

14-18

The Costs of Granting Credit

Opportunity costs are lost sales from refusing credit. These

costs go down when credit is granted.

Carrying costs are the cash flows that must be incurred when
credit is granted. They are positively related to the amount of
credit extended.
The required return on receivables.
The losses from bad debts.
The costs of managing credit and credit collections.

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-19

Optimal Credit Policy

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-20

Credit Analysis
Process of deciding which customers receive

credit.
One-time salerisk is variable cost only.
Repeat customersbenefit is gained from onetime sale in perpetuity.
Grant credit to almost all customers once as long
as variable cost is low relative to price (high
markup).

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-21

The Five Cs of Credit

Character
Customers willingness to pay.
Capacity
Customers ability to pay.
Capital
Financial reserves/borrowing capacity.
Collateral
Pledged assets.
Conditions
Relevant economic conditions.

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-22

Collection Policy

Monitoring receivables:
- Keep an eye on average collection period relative to your
credit terms.
Ageing schedulecompilation of accounts receivable by the
age of each account; used to determine the percentage of
payments that are being made late.
Collection procedures include:
delinquency letters
telephone calls
employment of collection agency
legal action.

Copyright 2004 McGraw-Hill Australia

Pty Ltd

14-23