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McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Corporate FinanceRoss Westerfield Jaffe

Sixth Edition

29

Chapter Twenty Nine

Credit Management

Prepared by

Gady Jacoby

ni!ersity of Manitoba

and

"ebo#$ %intablian

%merican ni!ersity of

&eir#t

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ha!ter *utline

29#1 &erms of the Sale29#2 &he +ecision to $rant redit:

,is and .nformation

29# *!timal redit /olicy

29#0 redit nalysis

29# ollection /olicy

29#3 *ther s!ects of redit /olicy

29#4 Summary 5 onclusions

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.ntroduction

• firm's credit !olicy is com!osed of: 6 &erms of the sale

6 redit analysis

6 ollection !olicy

• &his cha!ter discusses each of the com!onents of

credit !olicy that maes u! the decision to grant

credit#

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&he ash 7lo"s of $ranting redit

redit sale

is made

ustomer

mails

che8ue

7irm

de!osits

che8ue

an credits

firm's

account

ccounts receivale

ash collection

&ime

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29#1 &erms of the Sale

• &he terms of sale of com!osed of 6 redit /eriod

6 ash +iscounts

6 redit .nstruments

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redit /eriod

• redit !eriods vary across industries#• $enerally a firm must consider three factors in

setting a credit !eriod: 6 &he !roaility that the customer "ill not !ay#

6 &he sie of the account# 6 &he extent to "hich goods are !erishale#

• ;engthening the credit !eriod generally increasessales

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ash +iscounts

• *ften !art of the terms of sale#• &radeoff et"een the sie of the discount and the

increased s!eed and rate of collection ofreceivales#

• n exam!le "ould e =>1? net ?@ 6 &he customer can tae a A discount if he !ays "ithin 1?

days#

6 .n any event% he must !ay "ithin ? days#

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&he .nterest ,ate .m!licit in >1? net ?

firm offering credit terms of >1? net ? is essentiallyoffering their customers a 2?-day loan#

&o see this% consider a firm that maes a B1%??? sale on day ?

Some customers "ill !ay on day 1? and tae the discount#

*ther customers "ill !ay on day ? and forgo the discount#

? 1? ?

B94?

? 1? ?

B1%???

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? 1? ?

CB94? -B1%???

customer that forgoes the A discount to !ay on day ? is orro"ing B94? for 2? days and !aying B? interest:

32?

)1(

???%1B94?B

r +=

94?B

???%1B)1( 32? =+ r

A#4040#?1

94?B

???%1B 2?3

==−

=r

&he .nterest ,ate .m!licit in >1? net ?

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redit .nstruments

• Dost credit is offered on open account the invoice is theonly credit instrument#

• Promissory notes are .*Fs that are signed after the deliveryof goods

• Commercial drafts call for a customer to !ay a s!ecificamount y a s!ecific date# &he draft is sent to the customer's

an% "hen the customer signs the draft% the goods are sent#

• Banker’s acceptances allo" a an to sustitute itscredit"orthiness for the customer% for a fee#

• onditional sales contracts let the seller retain legalo"nershi! of the goods until the customer has com!leted !ayment#

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29#2 &he +ecision to $rant redit: ,isand .nformation

• onsider a firm that is choosing et"een t"oalternative credit !olicies: 6 =.n $od "e trusteveryody else !ays cash#@

6 *ffering their customers credit#

)( ??? C P Q −×• &he only cash flo" of the first strategy is

• &he expected cash flo"s of the credit strategy are:G

?

G

? P Qh×

? 1

G

?

G

?QC −

We incur costs u!

frontH

Hand get !aid in 1 !eriod

y hA of our customers#

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29#2 &he +ecision to $rant redit: ,isand .nformation

)( ??? C P Q NPV cash −×=•&he I/J of the cash only strategy is

)1(

G?

G?G

?

G

?

B

credit r

P QhQC NPV +

×+−=

•&he I/J of the credit strategy is

&he decision to grant credit de!ends on four factors:

1# &he delayed revenues from granting credit%

2# &he immediate costs of granting credit%

# &he !roaility of re!ayment% h

0# &he discount rate% r B

G

?

G

?Q P G

?

G

?QC

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Exam!le of the +ecision to $rant redit

• firm currently sells 1%??? items !er month on acash asis for B?? each#

• .f they offered terms net ?% the mareting

de!artment elieves that they could sell 1%?? items

!er month#

• &he collections de!artment estimates that A of

credit customers "ill default#

• &he cost of ca!ital is 1?A !er annum#

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&he I/J of cash only: ???%1??B)0??B??(B???%1 =−×=

'o Credit 'et ()Kuantity sold 1%??? 1%??

Selling !rice B?? B??

Fnit cost B0?? B02

/roaility of !ayment 1??A 9A

redit !eriod (days) ? ?

+iscount rate !#a# 1?A

&he I/J of Iet ?:

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• Lo" high must the credit !rice e to mae it"orth"hile for the firm to extend creditM

&he I/J of Iet ? must e at least as ig as

the I/J of cash only:

3>?

G

?

)1?#1(

9#???%102B??%1???%1??B

××+×−=

P

9#???%1)1?#1()02B??%1???%1??(BG

?

3>?

××=××+ P

?#2B9#???%1

)1?#1()02B??%1???%1??(B 3>?G? =×

××+= P

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&he Jalue of Ie" .nformation aoutredit ,is

• &he most that "e should e "illing to !ay for new information aout credit ris is the !resent value of

the ex!ected cost of defaults:

)1(

)1(

?B)1(

G

?

G

?

G?G?

hQC

r hQC NPV

B

default

−××−=

++−××−=

.n our earlier exam!le% "ith a credit !rice of B??% "e "ould

e "illing to !ay B23%??? for a perfect credit screen#

???%23B)9#?1(??%10??B)1(G?G

? =−××=−×× hQC

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7uture Sales and the redit +ecision

+o not

give credit

$ive

credit

ustomer !aysh = 1??A

ustomer !ays(/roaility N h)

ustomerdefaults

(/roaility N 16 h)

$ive

credit

+o not

give credit

*ur first decision:

We refuse further

sales to deadeats#

We face a more certain creditdecision "ith our paying

customers:

.nformation is

revealed at theend of the first

!eriod:

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arrying

osts

&otal costs

C O

osts indollars

;evel of credit extended

t the o!timal amount of credit% the incremental cash

flo"s from increased sales are exactly e8ual to the

carrying costs from the increase in accounts receivale#

*!!ortunity costs

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• &rade redit is more liely to e granted if:1# &he selling firm has a cost advantage over other lenders#

2# &he selling firm can engage in !rice discrimination#

# &he selling firm can otain favourale tax treatment#

0# &he selling firm has no estalished re!utation for

8uality !roducts or services#

# &he selling firm !erceives a long-term strategic

relationshi!#

• &he o!timal credit !olicy de!ends on the

characteristics of !articular firms#

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*rganiing the redit 7unction

• 7irms that run strictly internal credit o!erations are self-insured against default ris#

• n alternative is to uy credit insurance through aninsurance com!any#

•.n anada% ex!orters may 8ualify for credit insurancethrough the Ex!ort +evelo!ment or!oration (E+)#

• ;arge cor!orations commonly extend credit through a"holly o"ned susidiary called a ca!tive finance com!any#

• Securitiation occurs "hen the selling firm sells its accounts

receivale to a financial institution#• +uring 1991--92 recession% some anadian com!anies

tightened their credit-granting rules to offset the higher !roaility of customer anru!tcy#

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redit Scoring

• redit scoring refers to the !rocess of:(1) calculating a numerical rating for a customer ased on

information collected%

(2) granting or refusing credit ased on the result#

• 7inancial .nstitutions have develo!ed elaorate statisticalmodels for credit scoring# &his a!!roach has the advantage

of eing oPective as com!ared to scoring ased on

Pudgments on the 's#

• redit scoring is used for usiness customers y anadianchartered ans# Scoring for small usiness loans is a

!articularly attractive a!!lication ecause the techni8ue

offers the advantages of oPective analysis#

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29# ollection /olicy

• Collection refers to otaining !ayment on !ast-dueaccounts#

• ollection /olicy is com!osed of 6 &he firm's "illingness to extend credit as reflected in the

firm's investment in receivales# 6 ollection Effort

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verage ollection /eriod

• Deasures the average amount of time re8uired tocollect an account receivale#

salesdailyverage

receivaleccounts !eriodcollectionverage =

• 7or exam!le% a firm "ith average daily sales ofB2?%??? and an investment in accounts receivale

of B1?%??? has an average collection !eriod of

days#4day???%2?B

???%1?B=

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ccounts ,eceivale ging Schedule

• Sho"s receivales y age of account#• &he aging schedule is often augmented y the

!ayments !attern#

• &he !ayments !attern descries the laggedcollection !attern of receivales#

• &he longer an account has een un!aid% the less

liely it is to e !aid#

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29#3 *ther s!ects of redit /olicy>7actoring

• &he sale of a firm's accounts receivale to afinancial institution (no"n as a factor )#

• &he firm and the factor agree on the asic creditterms for each customer#

7irm

7actor

ustomer

ustomers send

!ayment to the

factor

&he factor !ays an agreed-

u!on !ercentage of the

accounts receivale to the

firm# &he factor ears the

ris of non!aying

customers

$oods

29 29

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7actoring

• 7actoring in anada is conducted y inde!endentfirms "here main customers are small usinesses#

• What factoring does is remove receivales from

the alance sheet and so% indirectly% it reduces the

need for financing#

• 7irms financing their receivales through a

chartered an may also use the services of a

factor to im!rove the receivales' collateral value#&his is called maturity factoring "ith assignment

of e8uity#

29 ?

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redit Danagement in /ractice

• &o mae monitoring easy% treasury credit staff callu! customer information from a central dataase#

• &he system also !rovides collections staff "ith a

daily list of accounts due for a tele!hone call "ith a

com!lete history of each account#

• redit analysis uses an early "arning system that

examines the solvency ris of existing and ne"

commercial accounts# &he soft"are scores theaccounts ased on financial ratios#

29 1

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29#4 Summary 5 onclusions

1# &he com!onents of a firm's credit !olicy are the terms ofsale% the credit analysis% and the collection !olicy#

2# &he decision to grant credit is a straightfor"ard I/J !rolem#

# dditional information aout the !roaility of customer

default has value% ut must e "eighed against the cost ofthe information#

0# &he o!timal amount of credit is a function of the conditionsin "hich a firm finds itself#

# &he collection !olicy is the firm's method for dealing "ith !ast-due accountsit is an integral !art of the decision toextend credit#

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