Fundamentals of corproate finance 3e chapter 14

Chapter Fourteen
Credit Management

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Chapter Organisation
14.1 Credit and Receivables
14.2 Terms of the Sale
14.3 Analysing Credit Policy
14.4 More on Credit Policy Analysis
14.5 Optimal Credit Policy
14.6 Credit Analysis
14.7 Collection Policy
14.8 Summary and Conclusions

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Chapter Objectives
•
•
•
•
•

•
•

Understand the components of credit policy and the cash
flows associated with granting credit.
Identify the factors that influence the length of the credit
period.
Calculate the cost of forgoing discounts in credit periods.
Outline the various credit policy effects.
Calculate the cost and NPV of switching policies.
Determine the optimal credit policy.
Discuss the five Cs of credit.

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Components of Credit Policy
•

Terms of sale
The conditions on which a firm sells its goods and services
for cash or credit.

•

Credit analysis
The process of determining the probability that customers will

not pay.

•

Collection policy
Procedures that are followed by a firm in collecting accounts
receivable.

•

Accounts receivable = Average daily sales × average
collection period

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Cash Flows from Granting Credit

Credit
sale is
made

Customer
mails
cheque

Firm deposits

cheque in
bank

Bank credits
firm’s
account

Time
Cash collection

Accounts receivable

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Terms of the Sale
•

Credit period
The length of time that credit is granted, usually between 30
and 120 days.

•

Cash discount
A discount that is given for a cash purchase to speed up the
collection of receivables.

•

Credit instrument
Evidence of indebtedness such as an invoice or promissory
note.

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Length of the Credit Period
Factors that influence the length of the credit period include:
–
–
–
–
–
–
–
–

buyer’s inventory period and operating cycle
perishability and collateral value of goods
consumer demand for the product
cost, profitability and standardisation
credit risk of the buyer
the size of the account

competition in the product market
customer type.

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Cost of the Credit
•
•

2/10, net 30 = buyer pays in 10 days to get a 2 per cent
discount, or within 30 days for no discount.
Buyer has an order for $1500 and ignores the credit period →
gives up $30 discount.

30 

EAR = 1 +

 1 470 
•

365

20

− 1 = 44.59%

The benefit obviously lies in paying early.

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Credit Policy Effects
•

Revenue effects—Payment is received later, but price and
quantity sold may increase.

•

Cost effects—Cost of sale is still incurred even though the
cash from the sale has not been received.

•

The cost of debt—The firm must finance receivables and,
therefore, incur financing costs.

•

The probability of non-payment—The firm always gets paid if
it sells for cash, but risks losses due to customer default if it
sells on credit.

•

The cash discount—Discounts induce buyers to pay early;
the size of the discount affects payment patterns and
amounts.

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Evaluating a Proposed Credit Policy
P = price per unit

Q’ = new quantity expected to be sold

v = variable cost per unit Q = current quantity sold per period
R = periodic required return

The benefit of switching is the change in cash flow:

New cash flow − old cash flow

[ ( P − v ) × Q' ] − [ ( P − v ) × Q]
rearranging

( P − v ) × ( Q' − Q )
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Evaluating a Proposed Credit Policy
•

The present value of switching is:
PV = [(P – v) × (Q’ – Q)]/R

•

The cost of switching is the amount uncollected for the period
plus the additional variable costs of production:
Cost = PQ + v(Q’ – Q)

•

And the NPV of the switch is:
NPV = –[PQ + v(Q’ – Q)] + [(P – v)(Q’ – Q)]/R

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Example—Evaluating a Proposed
Credit Policy

ABC Co. is thinking of changing from a cash-only policy to a
‘net 30 days on sales’ policy. The company has estimated
the following:
P = $55

v = $32 Q = 160

Q’ = 175

R = 2%

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Solution—Evaluating a Proposed
Credit Policy
Cash flow (old policy) = ( P − v ) × Q
= ( 55 − 32 ) × 160
= $3680
Cash flow (new policy) = ( P − v ) × Q'

= ( 55 − 32 ) × 175
= $4025

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Solution—Evaluating a Proposed
Credit Policy
Benefit of switching = ( P − v ) ( Q' − Q )
= ( 55 − 32) (175 − 160 )
= $345
(
[
P − v ) × ( Q' − Q ) ]
PV of switching =
R
345
=
0.02
= $17 250
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Solution—Evaluating a Proposed
Credit Policy
Cost of switching = PQ + v ( Q' − Q )
= ( 55 × 160 ) + 32 (175 − 160 )
= $8320
NPV of switching = − [ PQ + v ( Q' − Q ) ] + ( P − v ) ( Q' − Q ) /R
= − 8320 + 17 250

= $8930
Therefore, the switch is very profitable.
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Break-even Point

(
PQ )
Q' − Q =
[ ( P − v ) /R − v]
(
55 × 160 )
=
[ ( 55 − 32) / 0.02 − 32]
= 7.87 units
The switch is a good idea as long as the
company can sell an additional 7.87 units.
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Discounts and Default Risk
ABC Co. currently has a cash price of $55 per unit. If the
company extends the 30 day credit policy, the price will

increase to $56 per unit on credit sales. ABC Co. expects
0.5 per cent of credit to go uncollected (π). All other
information remains unchanged. Should the company switch
to the credit policy?

Percentage discount allowed for cash customers ( d )
( $56 − $55) = 1.79%
=
$56

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Discounts and Default Risk
NPV of changing credit terms:

NPV = − PQ + P' Q × ( d − π) /R
= − $55 × 160 + $56 × 160 × ( 0.0179 − 0.005) / 0.02
= − $3020.80

As the NPV of the change is negative, ABC Co.
should not switch.
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The Costs of Granting Credit
•

Opportunity costs are lost sales from refusing credit. These
costs go down when credit is granted.

•

Carrying costs are the cash flows that must be incurred when
credit is granted. They are positively related to the amount of
credit extended.
– The required return on receivables.
– The losses from bad debts.
– The costs of managing credit and credit collections.

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Optimal Credit Policy

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Credit Analysis
• Process of deciding which customers receive

credit.
• One-time sale—risk is variable cost only.
• Repeat customers—benefit is gained from onetime sale in perpetuity.
• Grant credit to almost all customers once as long
as variable cost is low relative to price (high
markup).

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The Five Cs of Credit
•
•
•
•
•

Character
Customer’s willingness to pay.
Capacity
Customer’s ability to pay.
Capital
Financial reserves/borrowing capacity.
Collateral

Pledged assets.
Conditions
Relevant economic conditions.

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Collection Policy
•

•

•

Monitoring receivables:
- Keep an eye on average collection period relative to your
credit terms.
Ageing schedule—compilation of accounts receivable by the
age of each account; used to determine the percentage of
payments that are being made late.
Collection procedures include:
– delinquency letters
– telephone calls
– employment of collection agency
– legal action.

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