Executive Summary

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Executive Summary

• 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.
• This chapter examines the firms decision to
  grant credit.

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Chapter Outline

• 29.1 Terms of the Sale
• 29.2 The Decision to Grant Credit
• Risk and Information
• 29.3 Optimal Credit Policy
• 29.4 Credit Analysis
• 29.5 Collection Policy
• 29.6 Other Aspects of Credit Policy
• 29.7 Summary Conclusions

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Introduction

• A firms credit policy is composed of
• Terms of the sale
• Credit analysis
• Collection policy
• This chapter discusses each of the components of
  credit policy that makes up the decision to grant
  credit.

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The Cash Flows of Granting Credit
Credit sale is made
Customer mails cheque
Firm deposits cheque
Bank credits firms account
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29.1 Terms of the Sale

• The terms of sale of composed of
• Credit Period
• Cash Discounts
• Credit Instruments

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Credit Period

• Credit periods vary across industries.
• Generally a firm must consider three factors in
  setting a credit period
• The probability that the customer will not pay.
• The size of the account.
• The extent to which goods are perishable.
• Lengthening the credit period generally increases
  sales

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Cash Discounts

• Often part of the terms of sale.
• Tradeoff between the size of the discount and the
  increased speed and rate of collection of
  receivables.
• An example would be 3/10 net 30
• The customer can take a 3 discount if he pays
  within 10 days.
• In any event, he must pay within 30 days.

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The Interest Rate Implicit in 3/10 net 30

• A firm offering credit terms of 3/10 net 30 is
  essentially offering their customers a 20-day
  loan.
• To see this, consider a firm that makes a 1,000
  sale on day 0

Some customers will pay on day 10 and take the
discount.
Other customers will pay on day 30 and forgo the
discount.
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The Interest Rate Implicit in 3/10 net 30
A customer that forgoes the 3 discount to pay on
day 30 is borrowing 970 for 20 days and paying
30 interest
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Credit Instruments

• Most credit is offered on open accountthe
  invoice is the only credit instrument.
• Promissory notes are IOUs that are signed after
  the delivery of goods
• Commercial drafts 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 allow a bank to substitute
  its creditworthiness for the customer, for a fee.
• Conditional sales contracts let the seller retain
  legal ownership of the goods until the customer
  has completed payment.

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29.2 The Decision to Grant Credit Risk and
Information

• Consider a firm that is choosing between two
  alternative credit policies
• In God we trusteverybody else pays cash.
• Offering their customers credit.

• The expected cash flows of the credit strategy
  are

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29.2 The Decision to Grant Credit Risk and
Information
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Example of the Decision to Grant Credit

• A firm currently sells 1,000 items per month on a
  cash basis for 500 each.
• If they offered terms net 30, the marketing
  department believes that they could sell 1,300
  items per month.
• The collections department estimates that 5 of
  credit customers will default.
• The cost of capital is 10 per annum.

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Example of the Decision to Grant Credit
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Example of the Decision to Grant Credit

• How high must the credit price be to make it
  worthwhile for the firm to extend credit?

The NPV of Net 30 must be at least as big as the
NPV of cash only
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The Value of New Information about Credit Risk

• The most that we should be willing to pay for new
  information about credit risk is the present
  value of the expected cost of defaults

In our earlier example, with a credit price of
500, we would be willing to pay 26,000 for a
perfect credit screen.
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Future Sales and the Credit Decision
We face a more certain credit decision with our
paying customers
Our first decision
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29.3 Optimal Credit Policy
Costs in dollars
Level of credit extended
C
At the optimal amount of credit, the
incremental cash flows from increased sales are
exactly equal to the carrying costs from the
increase in accounts receivable.
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29.3 Optimal Credit Policy

• Trade Credit is more likely to be granted if
• The selling firm has a cost advantage over other
  lenders.
• The selling firm can engage in price
  discrimination.
• The selling firm can obtain favourable tax
  treatment.
• The selling firm has no established reputation
  for quality products or services.
• The selling firm perceives a long-term strategic
  relationship.
• The optimal credit policy depends on the
  characteristics of particular firms.

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Organizing the Credit Function

• Firms that run strictly internal credit
  operations are self-insured against default risk.
• An alternative is to buy credit insurance through
  an insurance company.
• In Canada, exporters may qualify for credit
  insurance through the Export Development
  Corporation (EDC).
• Large corporations commonly extend credit through
  a wholly owned subsidiary called a captive
  finance company.
• Securitization occurs when the selling firm sells
  its accounts receivable to a financial
  institution.
• During 1991--92 recession, some Canadian
  companies tightened their credit-granting rules
  to offset the higher probability of customer
  bankruptcy.

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29.4 Credit Analysis

• Credit Information
• Financial Statements
• Credit Reports on Customers Payment History with
  Other Firms
• Banks
• Customers Payment History with the Firm
• Credit Scoring
• The traditional 5 Cs of credit
• Character
• Capacity
• Capital
• Collateral
• Conditions
• Some firms employ sophisticated statistical models

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Credit Scoring

• Credit scoring refers to the process of
• (1) calculating a numerical rating for a
  customer based on information collected,
• (2) granting or refusing credit based on the
  result.
• Financial Institutions have developed elaborate
  statistical models for credit scoring. This
  approach has the advantage of being objective as
  compared to scoring based on judgments on the 5
  Cs.
• Credit scoring is used for business customers by
  Canadian chartered banks. Scoring for small
  business loans is a particularly attractive
  application because the technique offers the
  advantages of objective analysis.

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29.5 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

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Average Collection Period

• Measures the average amount of time required to
  collect an account receivable.

• For example, a firm with average daily sales of
  20,000 and an investment in accounts receivable
  of 150,000 has an average collection period of

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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.

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Collection Effort

• Most firms follow a protocol for customers that
  are past due
• Send a delinquency letter.
• Make a telephone call to the customer.
• Employ a collection agency.
• 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.

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29.6 Other Aspects of Credit Policy/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.

Factor
Firm
Customer
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Factoring

• Factoring in Canada is conducted by independent
  firms where main customers are small businesses.
• What factoring does is remove receivables from
  the balance sheet and so, indirectly, it reduces
  the need for financing.
• Firms financing their receivables through a
  chartered bank may also use the services of a
  factor to improve the receivables collateral
  value. This is called maturity factoring with
  assignment of equity.

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Credit Management in Practice

• To make monitoring easy, treasury credit staff
  call up customer information from a central
  database.
• The system also provides collections staff with a
  daily list of accounts due for a telephone call
  with a complete history of each account.
• Credit analysis uses an early warning system that
  examines the solvency risk of existing and new
  commercial accounts. The software scores the
  accounts based on financial ratios.

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29.7 Summary Conclusions

1. The components of a firms 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.