CREDIT MANAGEMENT

TERMS OF PAYMENT

• Cash Terms

• Open Account

• Consignment

• Bill of Exchange

• Letter of Credit
 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

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

where RI = change in residual income

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
 EXAMPLE
Pioneer Limited 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
RI = [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

RI = [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
 EXAMPLE
Zenith 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

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

– 0.10 (60 – 30) x + 0.85 x 60 x 5,000,000

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

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

DECREASING THE RIGOUR OF COLLECTION PROGRAMME

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

 ERRORS IN CREDIT EVALUATION

In assessing credit risks, two types of errors occur :

Type I error A good customer is misclassified as a

poor credit risk

Type II error A bad customer is misclassified as a good

credit risk
 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
 SEQUENTIAL CREDIT ANALYSIS

Should
credit be
granted?

Strong Weak
Character

Capacity Capacity

Strong Strong
Weak Weak
Capital
Capital Capital Capital

Strong Weak Strong Weak

Strong Weak Strong Weak

Excellent risk Dangerous

Fair risk Doubtful risk
risk

How much
credit
should be
granted ?
 NUMERICALCREDIT
NUMERICAL CREDIT RATING
RATING INDEX
INDEX

Factor
Factor Factor
Factor Rating
Rating Factor
Factor
weight
weight 55 44 3 3 2 2 1 1 scorescore

Past
Pastpayment
payment 0.30
0.30  1.201.20
Net
Netprofit
profit margin 0.20
0.20  0.800.80
Current ratio
Current ratio 0.20
0.20  0.600.60
Debt-equity ratio
Debt-equity ratio 0.10
0.10  0.400.40
Return on
Return on equity
equity 0.20
0.20  1.001.00

Rating index 4.00

Rating index 4.00

 Centre for Financial Management , Bangalore

 DISCRIMINANT ANALYSIS
Z = 1 Current ratio + 0.1 Return on equity

+
Current
+
ratio +
+ +
+
+
° +
+ +
° °
+
+ +
°
+
° °
° °
°
+ +
° °
°
Return on equity
RISK CLASSIFICATION SCHEME
 CREDIT GRANTING DECISION
Expected Pre-tax Profit
p (Revenue – Cost) – (1 – p) Cost

Rev – Cost
r p ays
ome
Cust
p
Custome
r defaults
d it (1 – p ) – Cost
cre
ffer
O
Refu
se cred
it
0
 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
revenues from the sale would be Rs.1,200 and the cost of
sale would be Rs.800.

The expected profit from offering credit, given the above

information, is:

0.8 (1,200 – 800) – 0.2 (800) = Rs.160

 REPEAT ORDER

Expected profit on Probability of payment Expected profit on

initial order + and repeat order x repeat order

[ p1(REV1 – COST1) – (1-p1) COST1]

+ p1 x [ p2 (REV2 – COST2) – (1-p2) COST2]

[0.9 (2000-1500) – 0.1(1500)]

+ 0.9 [0.95 (2000-1500) – 0.05 (1500)]

= 660
 DECISION TREE FOR GRANTING CREDIT

s
Pay = 0.95
p1

t
c redi Def
ault
ffer s
O (1 –
p1 ) =
0.05
s
Pay
= 0.9
p1

redit
e rc De
Off fau
(1 l ts
–p
1 )=
0.1
 CONTROL OF ACCOUNTS RECEIVABLES

• Days’ Sales Outstanding

• Ageing Schedule

• Collection Matrix
 COLLECTION MATRIX

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
 SUMMING UP
• The important dimensions of a firm’s credit policy are : credit standards, credit period, cash
discount, and collection effort.
• In general, liberal credit standards tend to push sales up by attracting more customers.
However, this is accompanied by a higher incidence of bad debt loss, a larger investment in
receivables, and a higher cost of collection. Stiff credit standards have opposite effects.
• Three broad approaches are used for credit evaluation : traditional credit analysis,
numerical credit scoring, and discriminant analysis.
• The traditional approach to credit analysis calls for assessing a prospective customer in
terms of the five Cs of credit, viz. character, capacity, capital, collateral, and conditions.
• Three methods are commonly employed for monitoring accounts receivable : days’ sales
outstanding, ageing schedule, and collection matrix.