Financial Decisions

4a. Receivables Management

Credit granting

Instructor: A. Ashta

References: Ross, Westerfield Jordan: Ch. 17

Emery, Finnerty & Stowe: Ch. 23

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 Why keep accounts receivables?
• Credit sales create accounts receivables

• Accounts receivables cost money (interest)

• So why grant credit?

• Financial intermediation
– Cheaper than bank for customers, more profitable for than banks for
suppliers
• Collateral
– The inventory with a customer is more valuable to a supplier than to
customer’s bank
• Information costs
– Easier for supplier to assess creditworthiness
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 The Cash Flows from Granting Credit

Credit Customer Firm deposits Bank credits

sale is mails check in firm’s
made check bank account

Time

Credit Cash collection

management

Accounts receivable

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 Components of Credit Policy

• Terms of sale
– Conditions under which a firm sells its
goods and services for cash or credit.
• Credit Analysis
– The process of determining the probability
that customers will or will not pay.
• Collection Policy
– Procedures followed by a firm in collecting
accounts receivable.
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Determinants of Length of Credit Period
– Product market competition
– More competition means more credit offered
– The size/ countervailing power of buyer
– Customer type
– Wholesaler, retailer or final consumer
– Credit risk
– Perishability and collateral value
– Consumer demand
– New customers require longer credit period
– Cost, profitability and standardization
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 Costs of Granting Credit
Cost in
dollars Carrying costs are
Optimal the cash flows that
amount Total costs must be incurred
of credit when credit is
Carrying costs granted. They are
positively related to
the amount of
credit extended.

Opportunity
costs Amount of credit
extended

Opportunity costs are the lost sales from refusing credit. These costs go
down when credit is granted.
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 The Basic Credit Granting Decision

• Credit should be granted if the NPV of granting credit is

positive.

• The NPV of the Basic Credit Granting Decision

 Let
 R = amount of sale
 p = probability of payment p× R
 C = the firm’s investment in the sale NPV = −C
 r = the required return (1 + r ) t

 t = time at which payment is expected

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 The Basic Credit Granting Decision

Mohawk Carpets is considering extending $5,000

of credit to a customer. Mohawk has invested
$3,750 in the sale and it estimates that the customer
has a 75% probability of making the payment.

The payment is due in 2 months, and the required

rate of return in 20% APY (Annual Percentage
Yield = compound return).

Should Mohawk grant credit to this customer?

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 The Basic Credit Granting Decision

What is the minimum probability of payment

that Mohawk would require from this
customer?

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 Try Emery, Finnerty, Wade Q.B1
• SLSC wants to make a $ 200,000 credit purchase from
your firm.

• Your investment in this credit sale is the 70% of cost of

sale.

• You estimate that SLSC has a 95% probability of paying

on time, which is in 3 months, and a 5% probability of
paying nothing.

• If the opportunity cost of funds is 18%, calculate the

NPV of granting the credit.
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 Credit Policy Decisions

• Choice of credit terms

• CBD; COD: net 30; or 2/10, net 30
• Setting evaluation methods and credit
standards
• Monitoring receivables
• Taking actions for slow payments
• Controlling & administering the firm’s
credit functions
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 Sources of Credit Information

• A credit application, including references

• Applicant’s payment history
• Information from sales representatives
• Financial statements for recent years
• Reports from credit rating agencies
• Dun & Bradstreet Credit Services
• Credit bureau reports
• Industry association credit files
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 The five C’s of credit:

• Character
• Willingness to pay
• Capacity
• Ability to pay
• Capital
• Financial reserves
• Collateral
• Pledged assets
• Conditions
• Relevant economic conditions
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 Credit Scoring Models

• These combine several financial variables to

create a single score or index.
• Credit is granted if the score is above a pre-
specified cut-off value.
• Advantages:
– Easy to compute
– Easy to change standards
– Avoids bias or discrimination
• Requires large samples to “calibrate.”

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