Chapter 20

Credit Management Key Issues

• Granting Credit should increase revenue

  • increase Q and/or P

• There are costs to granting credit

  • cost of financing receivables

  • cost of collecting from customers

  • chance that some customers won’t pay

Purpose of Credit management

• examines the tradeoff between increased sales and the costs of granting credit

Components of Credit Policy

• Terms of Sale

• Credit Analysis

• Collection Policy

Terms of Sale

• Credit period

• Cash discount period

• type of credit instrument (A/R)

Credit analysis

• distinguishing between good customers that will pay vs bad customers that will default

Collection policy

• effort expended on collecting on receivables

Terms of Sale Basic form

• 2/10 net 45

• 2% discount if paid in 10 days,

• full amount must be paid in 45 days if discount not taken

Finding the implied interest rate when customers do not take the discount

• no discount (net 45) = 35 day loan

• discounted price is the loan amount

• discount is the interest

Finding EAR for Cash Discount

• Discount Rate x Purchase Price = Interest

• Period rate = discounted period / (purchase price - interest)

• Period = (total days - discount period)

• 365 / Period = periods per year

• Annualized Rate = (Period Rate x 100) x periods per year

• Effective Annual Rate = (1+ Period Rate)^(periods per year) - 1

Average Collection Period for Cash Discounts

• Average Collection Period = % of customers w/ discount x discount period + % customers w/o discount x total days

Average accounts receivable

• A/R Turnover = 365 / ACP

• Average A/R = Credit Sales / A/R Turnover

Factors of Length of Credit Period

1. Perishability and collateral value

2. Consumer demand

3. Cost, profitability, and standardization

4. Credit risk

5. Size of account

6. Competition

7. Customer type

Credit Policy Effects

• Revenue Effects

• Cost effects

• Cost of debt

• probability of non payment

• cash discount

Revenue effects

• delay in receiving cash from sale

• may be able to increase P/Q

Cost effects

• cost of sale is still incurred but the cash from the sale has not been received (AP)

Cost of debt

• must finance receivables

Probability of nonpayment

• some % of customers will not pay for products purchased

Cash discount

• some customers will pay early and pay less than the full sales price

NPV of a Proposed Policy

• Calculate Cash flow for current and proposed policy (Q x (P-v))

• New policy CF - old policy CF

• Month 1: Initial Investment = New Policy CF (0 Rev credit terms) - Old policy CF

• NPV = -II + Net cash flow/required return