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Unformatted text preview: t still be processed
in a judgmental manner. Computerized information systems can assist in making
better credit decisions, but, in the final analysis, most credit decisions are really
exercises in informed judgment.1 Self-Test Questions What are credit terms?
What is credit quality, and how is it assessed? 1Credit analysts use procedures ranging from highly sophisticated, computerized “credit-scoring” systems, which actually calculate the statistical probability that a given customer will default, to informal procedures, which involve going
through a checklist of factors that should be considered when processing a credit application. The credit-scoring systems use various financial ratios such as the current ratio and the debt ratio (for businesses) and income, years with the
same employer, and the like (for individuals) to determine the statistical probability of default. Credit is then granted
to those with low default probabilities. The informal procedures often involve examining the “5 C’s of Credit”: character, capacity, capital, collateral, and conditions. Character is obvious; capacity is a subjective estimate of ability to
repay; capital means how much net worth the borrower has; collateral means assets pledged to secure the loan; and
conditions refers to business conditions, which affect ability to repay. Other Factors Influencing Credit Policy 27-3 Setting the Collection Policy
Collection policy refers to the procedures the firm follows to collect past-due
accounts. For example, a letter might be sent to customers when a bill is 10 days
past due; a more severe letter, followed by a telephone call, would be sent if payment is not received within 30 days; and the account would be turned over to a collection agency after 90 days.
The collection process can be expensive in terms of both out-of-pocket expenditures and lost goodwill—customers dislike being turned over to a collection agency.
However, at least some firmness is needed to prevent an undue lengthening of the
collection period and to minimize outright losses. A balance must be struck between
the costs and benefits of different collection policies.
Changes in collection policy influence sales, the collection period, and the bad
debt loss percentage. All of this should be taken into account when setting the credit
policy. Self-Test Question How does collection policy influence sales, the collection period, and the bad
debt loss percentage? Cash Discounts
The last element in the credit policy decision, the use of cash discounts for early
payment, is analyzed by balancing the costs and benefits of different cash discounts. For example, a firm might decide to change its credit terms from “net 30,”
which means that customers must pay within 30 days, to “2/10, net 30,” where a
2 percent discount is given if payment is made in ten days. This change should produce two benefits: (1) It should attract new customers who consider the discount
to be a price reduction, and (2) the discount should lead to a reduction in the days
sales outstanding, because some existing customers will pay more promptly in
order to get the discount. Offsetting these benefits is the dollar cost of the discounts. The optimal discount percentage is established at the point where the marginal costs and benefits are exactly offsetting.
If sales are seasonal, a firm may use seasonal dating on discounts. For example,
Slimware Inc., a swimsuit manufacturer, sells on terms of 2/10, net 30, May 1 dating. This means that the effective invoice date is May 1, even if the sale was made
back in January. The discount may be taken up to May 10; otherwise, the full
amount must be paid on May 30. Slimware produces throughout the year, but retail
sales of bathing suits are concentrated in the spring and early summer. By offering
seasonal dating, the company induces some of its customers to stock up early, saving Slimware some storage costs and also “nailing down sales.” Self-Test Questions How can cash discounts be used to influence sales volume and the DSO?
What is seasonal dating? Other Factors Influencing Credit Policy
In addition to the factors discussed in previous sections, two other points should be
made regarding credit policy. 27-4 Chapter 27 Providing and Obtaining Credit Profit Potential
We have emphasized the costs of granting credit. However, if it is possible to sell on
credit and also to impose a carrying charge on the receivables that are outstanding,
then credit sales can actually be more profitable than cash sales. This is especially
true for consumer durables (autos, appliances, and so on), but it is also true for certain types of industrial equipment. Thus, GM’s General Motors Acceptance Corporation (GMAC) unit, which finances automobiles, is highly profitable, as is Sears’
credit subsidiary.2 Some encyclopedia companies even lose money on cash sales but
more than make up these losses from the carrying charges on their credit sales.
Obviously, such companies would rather sell on credit than for cash!
The carrying charges on out...
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