Download Chapter 5: Credit Management

Chapter 5
Accounts Receivable Management
A/R
Copyright  2005 by Thomson Learning, Inc.
The Cash Flow Timeline
Order
Placed
Order
Received
< Inventory >
Sale
Payment Sent Cash
Received
Accounts
Collection
< Receivable > < Float >
Time ==>
Accounts
< Payable >
Invoice Received
Disbursement
<
Float
>
Payment Sent
Cash Disbursed
Copyright  2005 by Thomson Learning, Inc.
Learning Objectives
Define credit policy and indicate its components.
 Describe the typical credit-granting sequence.
 Apply net present value analysis to credit extension
decisions.
 Define credit scoring and explain limitations.
 List the elements in a credit rating report.
 Describe how receivables management can benefit
from EDI.

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Trade Credit and Shareholder Value
Trade credit arises when goods sold under delayed
payment terms
 Traced to Romans due to obstacles faced in
transferring money through various trading areas
 Credit terms are taken for granted today
 Value can be added by managing three areas:

– aggregate investment in receivables
– credit terms
– credit standards
Over-investing in receivables can be costly
 ...but, if credit terms are not competitive, then lost
sales can be costly

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Principles of A/R Management
Minimize bad debts and outstanding receivables
 Maintain financial flexibility
 Optimize mix of company assets
 Convert receivables to cash in a timely manner
 Analyze customer risk
 Respond to customer needs

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A/R Management and Shareholder
Value
Marketing Strategy
Market Share Obj.
Aggregate Inv. in A/R
Total Dollar Investment
Credit Terms
Length of Time to Pay
Credit Standards
Acceptance of Marg Cust.
Max Shareholder Value
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Trade vs. Bank Credit
Length of terms
 Security
 Amounts involved
 Resource transferred (goods vs. money)
 Extent of analysis

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Why Extend Credit?
Financial Motive
 Operating Motive
 Contracting Cost Motive
 Pricing Motive
 All reasons are related to market imperfections

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Financial Motive
Potential of getting a higher price
 Sellers raise capital at lower rates than customers
and have cost advantages vis-à-vis banks due to:

– similarity of customers
– the information gathered in the selling process
– lower probability of default (the goods purchased are an
essential element of the buyer’s business)
– seller can more easily resell product if payment is not made.
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Operating Motive
Respond to variable and uncertain demand
 Change credit terms rather than:

– install extra capacity,
– building or depleting inventories,
– or forcing customers to wait.
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Contracting Cost Motive
Buyer gets to inspect goods prior to payment
 Seller has less theft with separation of collection
and product delivery

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Pricing Motive

Change price by changing credit terms
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Trends Affecting Trade Credit
Zero net working capital objective
 Improved internal and external credit-related
information
 Electronic commerce

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The Credit Decision Process
Marketing contact
Credit investigation
Time
Customer contact for information
Finalize written documents, e.g.. security agreements
Establish customer credit file
Financial analysis
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Basic Credit Granting Model
S - EXP(S)
NPV = ----------------- - VCR(S)
1 + iCP
Where:
NPV = net present value of the credit sale
VCR = variable cost ratio
S
= dollar amount of credit sale
EXP = credit administration and collection expense ratio
i
= daily interest rate
CP = collection period for sale
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Managing the Credit Policy
Should we extend credit?
 Credit policy components
 Credit-granting decision

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Should We Extend Credit?
Follow industry practice
 Extent and form of credit offer

– in-house credit card
– sell receivables to a factor
– captive finance company?
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Components of Credit Policy

Development of credit standards
– profile of minimally acceptable credit worthy customer

Credit terms
– credit period
– cash discount

Credit limit
– maximum dollar level of credit balances

Collection procedures
– how long to wait past due date to initiate collection efforts
– methods of contact
– whether and at what point to refer account to collection agency
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Credit-Granting Decision
Development of credit standards
 Gathering necessary information
 Credit analysis: applying credit standards
 Risk analysis

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Grant-Granting Sequence
Order and credit
request received
New/increased
credit limit
Yes
No
Yes
Material
change in
customer status
No
Size of proposed
credit limit
Large
Medium
Redo credit
investigation
Check new A/R
total vs credit lmt
Record
disposition
Small
No
Indepth
credit invest.
Moderate
credit invest.
Minimal
credit invest.
Extend Credit
Yes
Set up,post
A/R, ship
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Credit Standards

Based on five C's of Credit
–
–
–
–
–
Character
Capital
Capacity
Collateral
Conditions
Determine risk classification system
 Link customer evaluations to credit standards

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Gathering Information
credit reporting agencies, e.g.. Dun & Bradstreet
 credit interchange bureaus, NACM
 bank letters
 references from other suppliers
 financial statements
 field data gathered by sales reps

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Credit Analysis: Applying the
Standards

Nonfinancial
– concerned with willingness to pay, character

Financial
– ability to pay, financial ratios etc.. (other C’s of credit)

Credit scoring models
– Example:
Y = .000025(INCOME) + 0.50(PAYHIST) + 0.25(EMPLOYMT)
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Emergence of Expert Systems

Example of decision rule:
“If gross income is equal to or grater than $20,000
and the applicant has not been delinquent and
gross income per household member is equal to or
greater than $12,000 and debt/equity ratio is equal
to or greater than 30% but less than 50% and
personal property is equal to or greater than
$50,000, then grant credit.”
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Factors Affecting Credit Terms
Competition
 Operating cycle
 Type of good (raw materials vs finished goods,
perishables, etc.)
 Seasonality of demand
 Consumer acceptance
 Cost and pricing
 Customer type
 Product profit margin

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Cash Discounts
The lower the VC, the higher the feasible discount
 Based on company’s cost of funds
 Consider timing effect when changing discounts
 Should be based on product’s price elasticity
 Higher the bad debt experience, higher the optimal
discount

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Practice of Taking Cash Discounts
51% of firms always took cash discount
 40% sometimes
 9% take discount and pay late
 Study found that 4 or 5 companies would be more
profitable if cash discount was eliminated

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A/R Management in Practice
Discounts appear to be changed to match
competitors, not inflation or interest rates
 The higher a firm’s contribution margin, the more
likely the firm should be to offer discounts.
 A price cut is thought to have more impact than
instituting a cash discount
 The more receivables a firm has, does not
necessarily relate to use of penalty fees
 The greater amount of receivables does not relate
to a more active credit evaluation.

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Receivables, Collections, and EDI

If credit approval is delayed...
– buyers using EDI purchase orders and JIT manufacturing can
encounter serious problems.
– sellers can now ship within hours of receiving orders...thus seller
must be able to handle electronically transmitted orders.
Seller may also issues electronic invoices and be
paid electronically using an EDI-capable bank so
that remittance data can be automatically read by
seller’s A/R system
 Trend is for use of data transmission to automate
the cash application process

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Summary
Investment in A/R represents a significant
investment.
 Key aspects outlined

–
–
–
–
–
credit policy
credit standards
credit granting sequence
credit limits
credit terms
Management of A/R is influenced by what
competitors are doing not by shareholder wealth
considerations.
 Proper use of NPV techniques can ensure that
credit decisions enhance shareholder value.

Copyright  2005 by Thomson Learning, Inc.