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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 forsuppliers

Collateral

The inventory with a customer is more valuable to a supplier than tocustomers bank

Information costs

Easier for supplier to assess creditworthiness

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The Cash Flows from Granting Credit

Creditsale ismade

Customermailscheck

Firm depositscheck inbank

Bank creditsfirmsaccount

Cash collection

Accounts receivable

Time

Creditmanagement

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Components of Credit Policy

Terms of sale

Conditions under which a firm sells itsgoods and services for cash or credit.

Credit AnalysisThe process of determining the probability

that customers will or will not pay.

Collection PolicyProcedures followed by a firm in collectingaccounts 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

Opportunity costsare the lost sales from refusing credit. These costs godown when credit is granted.

Cost indollars

Amount of creditextended

Optimal

amountof credit

Total costs

Carrying costs

Opportunitycosts

Carrying costsarethe cash flows that

must be incurredwhen credit isgranted. They arepositively related tothe amount ofcredit extended.

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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

C= the firms investment in the sale r= the required return

t= time at which payment is expected

Cr

Rp

NPV t +

= )1(

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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 thiscustomer?

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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 ofsale.

You estimate that SLSC has a 95% probability of payingon time, which is in 3 months, and a 5% probability ofpaying nothing.

If the opportunity cost of funds is 18%, calculate theNPV 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 creditstandards

Monitoring receivables

Taking actions for slow payments

Controlling & administering the firmscredit functions

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Sources of Credit Information

A credit application, including references

Applicants 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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Character

Willingness to pay Capacity

Ability to pay

Capital Financial reserves

Collateral

Pledged assets

Conditions Relevant economic conditions

The five Cs of credit:

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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.