Chapter 28 CREDIT MANAGEMENT

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OUTLINE

Terms of Payment
Credit Policy Variables Credit Evaluation

Credit Granting Decision

Control of Accounts Receivable Credit Management in India
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TERMS OF PAYMENT

Cash Terms
Open Account Consignment Bill of Exchange Letter of Credit

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CREDIT POLICY 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 Sales Bad debt loss Investment in receivables Higher Higher Larger Stiff Lower Lower Smaller

Collection costs

Higher

Lower

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IMPACT ON RESIDUAL INCOME OF RELAXATION RI = [S(1 V) - Sbn] (1 t ) k I

where RI = change in residual income

S = increase in sales

V = ratio if variable cost to sales

bn = bad debt loss ratio on new sales

= corporate tax rate

I = increase in receivables investment

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EXAMPLE

Pioneer Limited standards.

is

considering

relaxing

its

credit

S = Rs.15 million, bn = 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 360 = Rs.766,667
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x 40 x 0.80

CREDIT PERIOD Longer Shorter

Sales
Investment in

Higher
Larger

Lower
Smaller

receivables
Bad debts Higher Lower

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IMPACT ON RESIDUAL INCOME OF LONGER CREDIT PERIOD

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

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INCREASE IN RECEIVABLES INVESTMENT

I = (ACPn ACP0) S0 + V (ACPn) 360 where: I 360 S

= increase in receivables investment

ACPn = new average collection period (after lengthening the credit period)
ACP0 = old average collection period

V
S

= ratio of variable cost to sales

= increase in sales
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EXAMPLE
Zenith Limited is considering extending its credit period from 30 to 60 days. S = Rs.50 million, S = Rs.5 million, V = 0.85, bn = 0.08, k = 0.10, t = 0.40

RI = [5,000,000 x 0.15 5,000,000 x 0.08] (0.6)

50,000,000 + 0.85 x 60 x 5,000,000 0.10 (60 30) x 360 360 = [750,000 400,000] (0.6) 0.10 [4,166,667 + 708,333] = 277,500
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LIBERALISING THE CASH DISCOUNT POLICY

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

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DECREASING THE RIGOUR OF COLLECTION PROGRAMME

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

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ERRORS IN CREDIT EVALUATION In assessing credit risks, two types of errors occur :

Type I error A good customer is misclassified as a poor credit risk Type II error A bad customer is misclassified as a good credit risk

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TRADITIONAL CREDIT ANALYSIS Five Cs of Credit Character : The willingness of the customer to honour his obligations Capacity : The operating cash flows of the customer

Capital
Collateral

: The financial reserves of the customer

: The security offered by the customer

Conditions : The general economic conditions that affect the customer

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SEQUENTIAL CREDIT ANALYSIS

Should credit be granted?

Strong

Character

Weak

Capacity

Capacity

Strong
Capital

Strong

Weak
Capital Capital

Weak
Capital

Strong
Excellent risk

Weak

Strong Weak
Fair risk

Strong

Weak

Strong

Weak
Dangerous risk

Doubtful risk

How much credit should be granted ?

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NUMERICAL CREDIT RATING INDEX

Factor

Factor weight 0.30 0.20 0.20 0.10 0.20

Rating 3 2

Factor score 1.20 0.80 0.60 0.40 1.00 4.00

Past payment Net profit margin Current ratio Debt-equity ratio Return on equity

Rating index

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DISCRIMINANT ANALYSIS
Z = 1 Current ratio + 0.1 Return on equity
Current + ratio
+

+
+ + + + + + + +

+
+

Return on equity
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RISK CLASSIFICATION SCHEME

Risk Class 1 2 3 4 5

Description Customers with no risk of default Customers with negligible risk of default (default rate less than 2 percent) Customers with little risk of default (default rate between 2 percent and 5 percent) Customers with some risk of default (default rate between 5 percent and 10 percent) Customers with significant risk of default (default rate in excess of 10 percent)

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CREDIT GRANTING DECISION

Expected Pre-tax Profit

p (Revenue Cost) (1 p) Cost
Rev Cost

p Cost

0
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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 the probability that the customer would default is 0.2. The revenues from the sale would be Rs.1,200 and the cost of sale would be Rs.800.

The expected profit from offering credit, given the above information, is:
0.8 (1,200 800) 0.2 (800) = Rs.160

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REPEAT ORDER
Expected profit on Probability of payment Expected profit on + and repeat order x repeat order initial order [ p1(REV1 COST1) (1-p1) COST1] + p1 x [ p2 (REV2 COST2) (1-p2) COST2] [0.9 (2000-1500) 0.1(1500)] + 0.9 [0.95 (2000-1500) 0.05 (1500)] = 660

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DECISION TREE FOR GRANTING CREDIT

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CONTROL OF ACCOUNTS RECEIVABLES Days Sales Outstanding Ageing Schedule Collection Matrix

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COLLECTION MATRIX

Percentage of Receivables Collected During the Month of sales First following month Second following month Third following month Fourth following month

January Sales 13 42 33 12 -

February Sales 14 35 40 11 -

March Sales 15 40 21 24 -

April Sales 12 40 24 19 5

May Sales 10 36 26 24 4

June Sales 9 35 26 25 5

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SUMMING UP
The important dimensions of a firms credit policy are : credit standards, credit period, cash discount, and collection effort
In general, liberal credit standards tend to push sales up by attracting more customers. However, this is accompanied by a higher incidence of bad debt loss, a larger investment in receivables, 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, and discriminant analysis. The traditional approach to credit analysis calls for assessing a prospective customer in terms of the five Cs of credit, viz. character, capacity, capital, collateral, and conditions. Three methods are commonly employed for monitoring accounts receivable : days sales outstanding, ageing schedule, and collection matrix.
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