CREDIT MANAGEMENT

The Cash Flows of Granting Credit

Credit sale Customer Firm Bank credits

is made mails check deposits firm’s
check account

Time

Cash collection

Accounts receivable
 COSTS & BENEFITS OF
CREDIT MANAGEMENT
 OPPORTUNITY COST

 COLLECTION COST

 BAD DEBTS

 INCREASED SALES

 INCREASE IN MARKET SHARE

 INCREASE IN PROFITS
 TERMS OF PAYMENT

• Cash Mode

• Bill of Exchange

• Letter of Credit

• Consignment
 CREDIT POLICY VARIABLES

The important dimensions of a firm’s credit policy are:

• Credit standards

• Credit period

• Cash discount

• Collection effort
 CREDIT STANDARDS

Liberal Stiff

• Sales Higher Lower

• Bad debt loss Higher Lower

• Investment Larger Smaller

in receivables

• Collection costs Higher Lower

IMPACT ON RESIDUAL INCOME
OF RELAXATION

P = [S(1 – V) - Sbn] (1 – t ) – k  I

where P = change in Profit

S = increase in sales

V = ratio if variable costs to sales

bn = bad debt loss ratio on new sales

t = corporate tax rate

I = increase in receivables investment

Q.PSD Ltd. is considering relaxing its credit standards.
S = Rs.15 million, bn = 0.10, V = 0.80,
ACP = 40 days, k = 0.10, t = 0.4
P = [15,000,000 (1 – 0.80) – 15,000,000 x 0.10] (1 – 0.4)
15,000,000
– 0.10 x x 40 x 0.80
360

= Rs.766,667
 CREDIT PERIOD

Longer Shorter

• Sales Higher Lower

• Investment in Larger Smaller

receivables

• Bad debts Higher Lower

IMPACT ON RESIDUAL
INCOME OF LONGER CREDIT PERIOD

P = [S(1 – V) - Sbn] (1 – t ) – k  I
 INCREASE IN RECEIVABLES INVESTMENT
S0 S
I = (ACPn – ACP0) + V (ACPn)
360 360

where: I = increase in receivables investment

ACPn = new average collection period (after lengthening
the credit period)
ACP0 = old average collection period
V = ratio of variable cost to sales
S = increase in sales
Q. X 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

P = [5,000,000 x 0.15 – 5,000,000 x 0.08] (0.6)

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

P = [S(1 – V) - DIS] (1 – t ) + k  I
DECREASING THE RIGOUR OF COLLECTION PROGRAMME

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

 Cash Discounts
• Often part of the terms of sale
• There is a tradeoff between the size of the
discount and the increased speed and rate of
collection of receivables.
• An example would be “3/10, net 30”
– The customer can take a 3% discount if s/he pays
within 10 days.
– In any event, s/he must pay within 30 days.
 The Interest Rate Implicit in
3/10, net 30
A firm offering credit terms of 3/10, net 30 is essentially offering their
customers a 20-day loan.
To see this, consider a firm that makes a $1,000 sale on day 0.

Some customers will pay on day 10 and take the discount.

$970

0 10 30
Other customers will pay on day 30 and forgo the discount.
$1,000

0 10 30
 Calculation of Cost of Cash Discount

Rate of discount x No. of days in a year

1- Rate of discount (Credit period-Discount
period)
 Credit terms Cost of trade credit(%)

2/10 Net 30 36.72

2/10 Net 45 20.99
1/10 Net 60 18.18
2/15 Net 30 48.98
 28.3 Optimal Credit Policy

Costs in Total costs

dollars
Carrying
Costs

Opportunity costs
C* Level of credit extended

At the optimal amount of credit, the incremental cash

flows from increased sales are exactly equal to the
carrying costs from the increase in accounts receivable.
 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 : The financial reserves of the customer

Collateral : The security offered by the customer

Conditions : The general economic conditions that
affect the customer
Case History : Checking customers past transaction to extend credit to
the customer
 MONITORING OF ACCOUNTS RECEIVABLES

• RECEIVABLES TURNOVER

• AVERAGE COLLECTION PERIOD (ACP)

• AGEING SCHEDULE

• COLLECTION MATRIX
 RECEIVABLES TURNOVER
• How quickly RECEIVABLES are CONVERTED in
to CASH

Receivables Turnover Rate

= Total Net Sales
Avg. Debtors*
(*including Bills Receivables)
 AVERAGE COLLECTION PERIOD (ACP)
• Time (no. of Days)
• the Credit Sales
• are converted
• In to Cash

ACP= 365/ Receivables Turnover

 AGEING SCHEDULE
• Statement showing
• AGE WISE GROUPING OF DEBTORS

OR
• Breaking up of Debtors
• according to the LENGTH OF TIME
• for which they have been OUTSTANDING
Age Group Amount Outstanding Percentage of Debtors
(in Days) (Rs.) to Total Debtors
Less Than 30 40,00,000 40

31-45 20,00,000 20

46-60 30,00,000 30

Above 60 10,00,000 10
Total 1,00,00,000 100
 COLLECTION MATRIX
• Shows
• the collection pattern (in months)
• for the CREDIT SALES
• made in a month
Percentage of Receivables January February March April May June
Collected During the Sales Sales Sales Sales Sales Sales

Month of sales 13 14 15 12 10 9
First following month 42 35 40 40 36 35
Second following month 33 40 21 24 26 26
Third following month 12 11 24 19 24 25
Fourth following month - - - 5 4 5
 Factoring
• The sale of a firm’s accounts receivable to a financial
institution (known as a factor)
• The firm and the factor agree on the basic credit
terms for each customer.

The factor pays an agreed-

upon percentage of the
accounts receivable to the
Customers send firm. The factor bears the
payment to the Factor risk of nonpaying
factor. customers.

Customer Firm
Goods
 TYPES OF FACTORING
TYPES/ Service Short term finance Sales Ledger Credit Protection
Administration

Recourse Yes Yes No

Non Recourse Yes Yes Yes

Maturity No Yes No

Invoice Discounting Yes No No