Credit Management CHAPTER 6

Chapter Outline Credit and Receivables Components of Credit Policy Investment in Receivables Credit Policy Evaluation Optimal Credit Policy

Credit What is “credit sale”? Why do firms have “credit sales”? Are there any risks to “credit sales”? What is the trade-off of “credit sales”? Accounts receivable & trade credit

Components of Credit Policy Terms of sale (credit periods, cash discounts & period) Credit analysis (probability of payment and default) Collection policy (how to collect)

Cash Flow from Granting Credit Speed up the collection float!

Investment in Receivables What would the investment depend on? Kıyılar Balıkçılık: Average collection period = 30 days Credit sales per day = 1,000,000 TL Accounts Receivable balance?

Terms of Sale Credit period Cash discount Discount period Type of credit instrument Within industry & accross industries

The Basic Form 2/10 net 60 Purchase of 1,000,000 TL by Uşak Tarım What are the options? 5/10 net 45

The Credit Period Credit Period: length of time for which credit is granted Industry variation days Cash discount: - net credit period - cash discount period

The Credit Period Invoice: A bill for goods or sevices provided by the seller to the purchaser Invoice date: beginning of the credit period - Billing or shipping date - Receipt of goods - End of month (constant purchases)

Length of Credit Period Affecting Factors: -buyer’s inventory period -operating cycle of the buyer -perishability: more perishable=>shorter -consumer demand: established products => shorter new products=> longer

Length of Credit Period -cost: lower => shorter -credit risk: higher=>shorter -size of the acocunt: smaller=>shorter -competition: higher=>longer -customer type: customer differentiation

Cost of the Credit 2/10 net 30? Is the 2 % high enough to pay early? Çelik Üretim: Buys worth 1,000,000 on credit If not paid early? Cost? Credit Instrument: Evidence of Indebtedness

Evaluating a Credit Policy Local Producer: -currently sells for cash only -considering net 30 sales -Price = 49 TL Variable cost = 20 TL -Current quantity sold (Q) = 100 units/month -Future quantity to sell (Q*) = 110 u/month -No discounts/no taxes/no default risk -Should they switch?

Evaluating a Credit Policy Current monthly sales = Variable cost = Total cash flow = Fixed costs? Future monthly sales = Total cash flow = Monthly change =

Evaluating a Credit Policy Interest rate = 2 % monthly PV of monthly 290 = Costs? Extra variable cost = Uncollected amount = Total cost of this month = Why only this month? SWITCH or NOT?

Optimal Credit Policy Cashflow of increased sale = Carrying costs of credit Carrying costs: * required return on receivables * losses from bad debt * costs of credit management & collection Opportunity costs (forgone sales)

Optimal Credit Policy Credit cost curve = (carrying costs, opp. costs of forgone sales) Below optimal => ??? Over optimal => ???

Optimal Credit Policy

Customer Credit Analysis ONE TIME SALE: Customer wants to buy 1 unit on credit at P. No credit => no sale Credit => pay in 1 month or default Default probability => π One time sale Required return on acc. rec. => R Variable cost => v GRANT CREDIT?

Customer Credit Analysis ONE TIME SALE: If credit granted: Cash outflow? When? Cash inflow? When? v=20 P=49 R=%2 π=20 % NPV? GRANT CREDIT? BREAK EVEN DEFUALT PROBABILITY?

Customer Credit Analysis REPEAT BUSINESS: If new customer does not default at first => never defaults (assumption) cost v this month if no default=> P next month If customer pays=>cycle goes on forever

Customer Credit Analysis REPEAT BUSINESS: PV of every month’s sale? First month’s cost? NPV of extending credit? GRANT CREDIT?

Customer’s 5 C’s Character Capacity Capital Collateral Conditions

Policy Change Example EGE Chemicals: R=25 % Varible cost=70 % of sales All sales are on credit ADOPT A NEW POLICY??? Current PolicyPolicy IPolicy II Annual Sales5,000,0006,000,0006,750,000 Receivable Turnover432.4 Doubtful Rec.450,000600,000750,000

Policy Change Example EGE Chemicals: Compare marginal costs vs. benefits Ignore fixed costs? Current PolicyPolicy IPolicy II Annual Sales5,000,0006,000,0006,750,000 Receivable Turnover432.4 Doubtful Rec.450,000600,000750,000 Average Receivables???

Policy Change Example Policy I NET BENEFIT??? Marginal Benefit Sales increase Profit increase Doubtful sale inc. Net profit increase Marginal Cost Acc. rec. increase Invest. in acc. rec. Cost of marginal inc.

Policy Change Example Policy II NET BENEFIT??? ANY POLICY CHANGES??? Marginal Benefit Sales increase Profit increase Doubtful sale inc. Net profit increase Marginal Cost Acc. rec. increase Invest. in acc. rec. Cost of marginal inc.

END OF CHAPTER