CREDIT MANAGEMENT

LEARNING OBJECTIVES

• After going through this topic, students should be

able to:
 Describe the terms of payment used widely in
practice.
 Discuss the important dimensions of a firm’s credit
policy.
 Explain the approaches used for credit analysis
 Discuss the methods used for control of receivables.
TERMS OF PAYMENT

• The major terms of payment are:

 Cash terms
 Open Account : Credit sales are generally on open
account.
 Consignment: When goods are sent on consignment,
they are merely shipped but not sold to the
consignee.
 Bill of exchange
 Letter of Credit: issued by a bank on behalf of its
client to the seller.
CREDIT POLICY VARIABLES

• Credit Standards: To judge whether credit standards should

be relaxed or tightened we must measure the impact of credit
standard on residual income. Residual income is the surplus
left after providing for a charge for additional capital when
credit standards are relaxed.
• The effect of relaxing standards may be calculated as follows:
∆RI = [∆S(1-V) - ∆Sbn] (1-t) – k∆I: where ∆RI is change in
residual income, ∆S is the increase in sales, V is the ratio of
variable costs to sales, bn is the bad debt loss ratio on new
sales, t is the corporate tax rate, k is the post tax cost of
capital, and ∆I is the increase in receivables investment.
(Note that ∆I = ∆S/360 x ACP x V)
Example:

• The current sales of Pioneer Limited are $100 million. The company
classifies its customers into 4 credit categories, 1 to 4. Credit rating
diminishes as one goes from category 1 to 4. Pioneer presently
extends unlimited credit to customers in category 1 and 2, limited
credit to customers in category 3, and no credit to customers in
category 4. As a result of this credit policy, the company is foregoing
sales to the extent of $10 million to customers in category 4. The
firm is considering the adoption of a liberal policy under which
customers in category 3 would be extended unlimited credit and
customers in category 4 would be extended limited credit. Such
relaxation would increase the sales by $15 million on which bad debt
losses would be 10%. The contribution margin ratio, (1-V) for the
firm is 20%, average collection period, ACP, is 40 days, and the post-
tax cost of funds, k, is 10% The tax rate is 40%.
 Continued….
• Given the above information, the effect of relaxing
the credit policy on residual income would be:
• [15000000(1-0,80) – 15000000x0,1])1-0,4) -0,10x
150000 x40 x 0,80 = $766 667
360
Since the impact of change in credit standards on
residual income is positive, the proposed change is
desirable.
Credit Period:

• The credit period refers to the length of time customers are

allowed to pay for their purchases.
• Since the effects of lengthening the credit period are similar
to that of relaxing the credit standards, we may estimate the
effect on residual income of change in credit period by using
the same formula:
∆RI = [∆S(1-V) - ∆Sbn] (1-t) – k∆I, excepting ∆I, the components
of this formula are calculated as before. Here ∆I, is calculated
as : ∆I = (ACPn – ACP0) S0 + V(ACPn) ∆S
360 360
ACPn is the new average collection period.
Example

• Zenith Corporation currently provides 30 days of credit to its customers. Its

present level of sales is $50 million. The firm’s cost of capital is 10% and the
ratio of variable costs to sales is 0,85. Zenith is considering extending the
credit period to 60 days. Such an extension is likely to push sales up by $5
million. The bad debt proportion on additional sales would be 8%. The tax
rate is 40%.
• The effect of lengthening the credit period would be:
[5000000x0,15- 5000000 x 0,08](0,6)
- 0,10[(60 – 30) x 50 000000 + 0,85 x 60 x 5000000 ]
360 360
= [750000 – 400000](0,6) – 0,10[4166667 + 708333]
= -277 500
Since the impact of credit change is negative, the proposed change is not
desirable.
Cash Discount

• Liberalising the cash discount policy may mean that the discount
percentage is increased and / or the discount period is lengthened.
The effect of such an action on net profit may be estimated by the
following formula:
∆RI = [∆S (1- V) - ∆BD](1 –t) – k∆I where ∆BD is the increase in bad
debt cost. (∆BD = bn(So + ∆S) – b0So)
• Example: ABC Company is considering relaxing its collection effort.
Its sales are $40 million, its average collection period is 20 days, its
variable costs to sales ratio, V, is 0,80, its cost of capital, k, is 12%,
and its bad debt ratio is 0,05. The relaxation in collection effort is
expected to push sales up to $5 million, increase the average
collection period to 40 days, and raise the bad debt ratio to 0,06.
The tax rate is 40%.
 Continued……
• Given the above information, the effect of relaxing the
collection effort on net profit would be:
[5000000(0,2) – 700000](0,6)
- 0,12[40000000 (40 – 20) + 5000000 x40x0,80]
360 360
= - $140 000
Since the effect on profit is negative, it is not worthwhile to
relax the collection effort.
{NB ∆I = S0 (ACPn – ACP0) +∆S ACPnV }
360 360
CREDIT EVALUATION

• Proper assessment of credit risks is important as it helps in

establishing credit limits. In assessing credit risks, two types of
errors occur:
 Type 1 error : A good customer is misclassified as a poor credit risk.
 Type 2 error : A bad customer is misclassified as a good credit risk.
• Both the errors are costly. Type 1 error leads to loss of profit on
sales to good customers who are denied credit. Type 2 error results
in bad-debt losses on credit sales made to risky customers.
• While misclassification errors cannot be eliminated wholly, a firm
can mitigate their occurrence by doing proper credit evaluation.
Traditional Credit Analysis

• This calls for assessing a prospective customer in terms of the

“five C’s of credit”:
 Character : The willingness of the customer to honour his
obligations. It reflects integrity.
 Capacity : The ability of the customer to meet credit
obligations from the operating cash flows.
 Capital : The financial reserves of the customer.
 Collateral : The security offered by the customer in the form
of pledged assets.
 Conditions: The general economic conditions that the
customer is in.
 Continued……
• To get information on the five C’s, a firm may rely on the
following:
 Financial Statements : These may contain a wealth of
information : current ratio, acid test ratio, debt-equity ratio,
EBIT to total assets ratio, and return on equity
 Bank References: The banker of the prospective customer may
be another source of information.
 Experience of the Firm: one’s own experience is very
important.
 Prices and Yield on Securities: For listed companies, valuable
inferences can be derived from stock market data.
Numerical Credit Scoring:

• The system may involve the following steps:

1. Identify factors relevant for credit evaluation.
2. Assign weights to these factors that reflect their relative
importance.
3. Rate the customer on various factors, using a suitable rating
scale (usually a 5- point scale is used)
4. For each factor, multiply the factor rating with the factor
weight to get the factor score.
5. Add all the factor scores to get the overall customer rating
index.
6. Based on the rating index, classify the customer.
Example: Construction of a Credit Rating Index.

Factor Factor Rating Factor

Weight 5 4 3 2 1 .
Past payment 0,30 √ 1,20
Net profit margin 0,20 √ 0,80
Current ratio 0,20 √ 0,60
Debt-equity ratio 0,10 √ 0,40
Return on equity 0,20 √ 1,00
Rating index 4,00
Risk Classification Scheme

• On the basis of information and analysis in the credit

investigation process, customers may be classified into various
risk categories. A simple risk classification scheme is shown
below.
• The risk classification scheme described below is one of the
many risk classification schemes that may be used. Each firm
would have to develop a risk classification scheme
appropriate to its needs and circumstances.
 Risk Classification Scheme

Risk Class Description .

1 Customers with no risk of default
2 Customers with negligible risk of default
(default rate less than 2 %)
3 Customers with little risk of default (default
rate between 2% and 5%)
4 Customers with some risk of default (default
rate between 5% and 10%)
5 Customers with significant risk of default
(default rate in excess of 10%) .
CREDIT GRANTING DECISION

• Once the creditworthiness of a customer has been assessed the

next question is: Should the credit be offered? If there is no
possibility of a repeat order, the situation may be represented by
a decision tree, where p represents the probability that the
customer pays his dues, (1 – p) is the probability that the
customer defaults, REV is the revenue from sale, COST is the cost
of goods sold. The expected profit for the action ‘offer credit’ is:
p(REV – COST) – (1 – p)COST
The expected profit for the action ‘refuse credit’ is 0. Obviously,
if the expected profit of the cost of action ‘offer credit’ is
positive, it is desirable to extend credit, otherwise not.
Example

• ABC Company is considering offering credit to a

customer. The probability that the customer would
pay is 0,8 and the probability that the customer
would default is 0,2. The revenue from the sale
would be $1 200 and the cost of sale would be $800.
• The expected profit for the action ‘offer credit’ is:
0,8(1 200 – 800) – 0,2(800) = $160
 Example of decision tree

Customer pays (p) REV - COST

Offer credit Customer defaults (1-p) - COST

Refuse credit
0
CONTROL OF ACCOUNTS RECEIVABLES

• Days Sales Outstanding: The days sales outstanding (DSO) at

a given time ‘t’ may be defined as the ratio of accounts
receivable outstanding at that time to average daily sales
figure during the preceding 30 days, 60 days, 90 days, or some
other relevant period.
• DSOt = Accounts receivable at time ‘t’
Average daily sales
• To illustrate the calculation of this measure, consider the
monthly sales and month-end accounts receivable for a
company:
 Continued….
Sales and Receivables Data
$ million .
Month Sales Receivables Month Sales Receivables
January 150 400 July 190 340
February 156 360 August 200 350
March 158 320 September 210 360
April 150 310 October 220 380
May 170 300 November 230 400
June 180 320 December 240 420
If the DSO is calculated at the end of each quarter, we get the
following picture:
 Continued….
Quarter Days Sales
Outstanding
First 320 = 62 days
(150+156+158)/90
Second 320 = 58 days
(150+170+180)/91
Third 360 = 55 days
(190+200+210)/92
Fourth 420 = 56 days
(220+230+240)/92
 Continued…..
• Looking at the DSO we see that it decreased slightly
over last year, suggesting that the collections improved
a little.
• According to this method, accounts receivable are
deemed to be in control if the DSO is equal to or less
than a certain norm. If the value of the DSO exceeds
the specified norm, collections are considered to be
slow.
• Ageing Schedule: The ageing schedule (AS) classifies
outstanding accounts receivables at a given point of
time into different age brackets.
 Continued…..
Age Group (in days ) Percent of Receivables
0 - 30 35
31 - 60 40
61 - 90 20
˃ 90 5
The actual AS of the firm is compared with some standard
AS to determine whether accounts receivables are in
control. A problem is indicated if the actual AS shows a
greater proportion of receivables, compared with the
standard AS, in the higher age groups.
Collection Mix

• The average collection period and the ageing schedule have

traditionally been very popular. However they suffer from a
limitation in that they are influenced by the sales pattern as well
as the payment behaviour of the customers. If sales are
increasing, the ACP and AS will differ from what they would be if
sales are constant. This holds even when the payment behaviour
of customers remains unchanged. The reason is simple: a greater
portion of sales is billed currently. Similarly, decreasing sales lead
to the same results. The reason here is that a smaller portion of
sales is billed currently.
• In order to study correctly the changes in payment behaviour of
customers, it is helpful to look at the pattern of collections
associated with credit sales.
 Continued….
• For example, the credit sales during January are collected as
follows : 13% in January (the month of the sales), 42% in
February (the first following month), 33% in March (the
second following month), and 12% in April (the third following
month)
• From the collection pattern, one can judge whether the
collection is improving, stable, or deteriorating. A secondary
benefit of such analysis is that it provides a historical record of
collection percentages that can be useful in projecting the
pattern of collections from future sales.
 Collection Matrix

Percentage January February March April May June

Of Receivables
Collected During the Sales Sales Sales Sales Sales Sales
Month of sales 13 14 15 12 10 9
1st following month 42 35 40 40 36 35
2nd following month 33 40 21 24 26 26
3rd following month 12 11 24 19 24 25
4th following month - - - 5 4 5