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Credit Management

Credit and Collection Policies

Influences of Credit Policy
Sales Investment Levels Bad Debt Losses Collection Costs

Credit Terms
Credit Period Discounts

Aging Schedule

Credit Management
Credit Collection Policies (cont.)
Collection Policy
In the case of delinquency certain actions and procedures have to be followed which are in accordance with the written credit policy and legal requirements Collection policies directly impact bad debt losses and ACP (average collection period) Particular collection methods used and the amount of money spent on collections have a direct impact on bad debts and ACP Aggressive collection policies can sometimes reduce sales or force customers to avail discounts

Credit Management
Credit and Collection Procedures
Sources of Information
Financial Statements Dun & Bradstreet Bank References Credit Bureaus

Credit Analysis
Heuristic Approach
Credit, Requirements, Pay Habits, Years in Business, Profit Margin, Current Ratio, Total Debt to Asset Ratio, Inventory Turnover, Qualitative Factors

Statistical Approach

Credit Management
Credit Analysis
Financial Ratio Analysis Numerical Credit Scoring
Check list for 5Cs Character Capacity Capital Collateral Condition of customers business Z Score = 3.3 x EBIT / Total Assets + 1.0 x Sales / Total Assets + 0.6 x Market Value of Equity / Total Book Debt + 1.4 x retained earnings / total assets + 1.2 x working capital / total assets

Credit Management
Credit and Collection Procedures
Collection Procedures
Write a letter Phone call Personal visit Use a collection agency Legal action

Credit Management
The Credit Decision (using Cost and Benefit Analysis)
Increase ACP to increase sales at the cost of higher financing costs Decrease ACP to decrease sales at the cost of giving discounts

Credit Period
Credit Sales = USD24mn per year Credit Terms = net / 30 Profit Margin = 20% Level of A/R = Credit Sales / Avg. Rec. Turnover, ARTO = 360 / Credit Period Market Department comes and says that if you increase net / 30 to net / 60 then sales will increase by USD6mn Borrowing rate = 20% What do you do?

Credit Management
Credit Period (cont).
Profit from additional sales = USD6mn x 20% = USD1.2mn Present level of A/R = 24/12* = USD2mn. *(360 / 30 = 12) Proposed level of A/R in existing customers = 24 / 6 = USD4mn *(360 / 60 = 6) Increase in level of A/R due to additional sales = (6 x 0.8) / 6 = USD0.8mn Existing customers are taken at gross and new customers are taken at cost Increase in level of investment in A/R = USD2mn + USD0.8mn = USD2.8mn Increase in cost of financing = USD2.8mn x 20% = USD0.56mn Saving to company = USD1.2mn USD0.56mn = USD0.64mn Therefore company should increase credit period from net 30 to net 60

Credit Management
Effective annual rate = (1+ discount / discounted price)365/extra days credit 1 Discount
Sales = USD24mn Credit Terms = 2/10, net 30 Borrowing rate = 17% 30% customers will avail discount and 70% will not avail. Is this a viable proposition ACP = (0.3 x 10) + (0.7 x 30) = 3 + 21 = 24 days ARTO = 360/24 = 15 Opportunity Cost of giving discount = 0.3 x USD24mn x 0.02 = USD0.144mn

Credit Management
Discount (Cont.)
Present level of A/R = 24/12 = USD2mn Proposed level of A/R = 24/15 = USD1.6mn Decrease in level of A/R = USD2mn USD1.6mn = USD0.4mn Saving in financing of A/R = USD0.4mn x 17% = USD0.068mn Net Saving = USD0.068mn USD0.144mn = USD0.076mn Therefore it is better not to give discounts

Credit Management
The Credit Decision (using time value of money) Expected Profit (One time order)
Exp = p x PVSPmt (Rev - Cost) (1 p) x PV(Cost)

Expected profit (Repeat Orders)

Exp = p x PVPerpetuity (Rev - Cost) (1 p) x PV(Cost)

Breakeven probability of collection

p = PV(Cost) / PV(Rev)

Credit Management
Workouts Liquidation Reorganization