29 Chapter Credit Management When a firm sell good it can be paid immediately in cash or wait for a time to be paid (extend credit) Granting credit is investing in a customer, an investment tied up to the sale of a product or service Components of the credit policy o Terms of the sale firm must decide on certain conditions when selling its goods for credit o Credit analysis a firm must distinguish between customers that will pay and those not likely to pay o Collection policy firms must establish a policy for collecting the cash when it becomes due 29.1 Terms of the Sale 2/10, net 30 customer has 30 days from the invoice date within which to pay o a cash discount of 2 percent from the stated price is to be given if payment is made within 10 days Credit period 1. The probability that the customer will not pay high risk businesses have more restrictive credit terms 2. The size of the account less for small accounts since they are less important 3. The extent to which the goods are perishable if the collateral value of the goods are low and cannot be sustained for long periods, less credit will be granted Lengthening the credit period effectively reduces the price paid by the customer increases sales Cash discounts Compare discount versus no-discount policy with help of PV Take into account side effects changes in the level of sales and costs 29.2 The Decision to grant Credit: Risk and Information Refuse versus grant credit: 1. The delayed revenues from granting credit 2. The immediate costs of granting credit 3. The probability of payment 4. The appropriate required rate of return for delayed cash flows The value of new information about credit risk Obtaining a better estimate of the probability that a customer will default can lead to decisions better Cost of obtaining information of default probability versus savings from avoidance of granting credit to high risk customers 29.3 Optimal Credit Policy Optimal credit where incremental cash flows from increased sales are exactly equal to the carrying costs form the increase in accounts receivable Carrying costs = delay in receiving cash, the losses from bad debts and the costs of managing credit Opportunity costs = lost sales from refusing to offer credit
Chapter 29 Credit Management
In general, a firm will extend trade credit if it has a comparative advantage in doing so Tax credit is advantageous if the selling firm has a cost advantage over potential lenders, if the selling form has monopoly powers it can exploit, if the selling firm can reduce taxes by extending credit and if the product quality is difficult to determine Firm characteristics o More flexibility in its credit policy than in the prices it charges o Firms with excess capacity o High tax brackets o Repeat customers
29.4 Credit Analysis number of sources to determine creditworthiness Credit Information o Financial Statements key ratios o credit reports many orgs sell information on the credit strengths of business firms o banks provide some assistance to their business customers in acquiring information on the creditworthiness of other firms o payment history estimate of the probability of non-payment is a look at previous bills Credit Scoring (5 Cs) character willingness to meet credit obligations capacity ability to meet credit obligations capital financial reserves collateral pledged asset in case of default conditions general economic conditions 29.5 Collection Policy Average collection period = Accountsreceivable AveragedailySales