Short-Term Financial Management Chapter 6 – Credit Policy & Collections

Chapter 6 Agenda Credit Policy & Collections Calculate the net present value of proposed and existing credit policies, identify and utilize techniques used to assess collection patterns, and describe present corporate credit policy practices.

Cash Flow Timeline The firm is a system of cash flows. These cash flows are unsynchronized and uncertain. The cash conversion period is the time between when cash is received versus paid. The shorter the cash conversion period, the more efficient the firm’s working capital.

Credit Policy & Collections Before, we developed strategies for extending credit to individual customers. Since a significant amount of cash can be tied up in A/R, in this chapter, we look at the: Credit Policy decisions (portfolio management) that affect all customers, as well as Collections practices and account receivable portfolio monitoring techniques.

Credit Policy & Collections Strategic changes to Credit Policy are considered when: Sales volume and/or profits can be enhanced. Receivables performance is unsatisfactory. Competitors change credit terms.

Credit Policy & Collections Financial Managers consider the following variables: Loosening or tightening credit standards. Lengthening or shortening credit period. Offering, reducing, or discontinuing cash discounts. Imposing and/or enforcing late fees.

Credit Policy & Collections Credit Managers can predict the impact from credit policy changes on Sales Default probabilities Delinquency

Value Maximizing Decisioning Net Present Value (NPV) is the difference between the present value of the cash inflows and the present value of the cash outflows. Credit managers select the credit policy that combines mutually-exclusive alternatives such that NPV is maximized.

Changing Credit Terms Before we said our goal is to design a credit policy that maximizes NPV. There are a variety of decision variables that can be combined and/or altered to impact Z (NPV from one day’s average sales). If the credit policy is changed, most variables will change.

Changing Credit Terms If we offer a cash discount, not all customers will take it. The cash flow amounts for discount takers versus non-discount takers will vary, as will the timing of the cash flows. Further, the bad debt experience for each could vary. Z = PV of Sales To Discount Takers + PV of Sales to Non-Discount Takers – Variable Operating Costs – PV of Credit/Collection Costs

Modeling Z The model assumes: All sales are sold on trade credit. All variables can be estimated with accuracy. The bad debt loss rate applies, evenly, to: New and existing customers. Customers taking and customers not taking the cash discounts, if offered. Other than the change in receivables, no new fixed assets or inventory is required. The VCR does not change. If the Credit Manager prefers, adjustments to these model decisions can be incorporated.

Modeling Z Before, we calculated the NPV from a single sale, using the following formula. Now, we will model the NPV of a single average day’s sales (Z):

Modeling Credit Terms Z = S(1-d)p(1-b) / (1 + iDP)  PV of Sales To Discount Takers + S(1-p)(1-b) / (1 + iCP)  PV of Sales To Non-Discount Takers ‐ VCR(S)  Variable Operating Costs1 ‐ EXP(S) / (1 + iCP)  PV of Credit/Collection Costs 1 Assume that the firm has excess capacity and will have no increase in fixed costs or fixed assets as a result of the policy change.

Modeling Credit Terms Illustrative Z = S(1-d)p(1-b) / (1 + iDP) + S(1-p)(1-b) / (1 + iCP) ‐ VCR(S) ‐ EXP(S) / (1 + iCP) ($13,699)(1-.02)(.75)(1-.05)/[1+(.14/365)(12)] + ($13,699)(1-.75)(1-.05) / [1+(.14/365)(45)] ‐ (.70)($13,699) ‐ (.02)($13,699) / [1+(.14/365)(45)] = $9,521 + $3,198 - $9,589 - $269 = $2,861 Can compare to other options. Note: rounding impacts results on this slide.

Changing Credit Terms If credit terms are already offered, the NPV of the existing terms ( ZE ) can be compared to combinations of new terms ( ZN ): Z = ZN – ZE The aggregate NPV is calculated from the daily NPV (Z): NPV = Z / i Decision Rule: If Delta Z > 0  Accept policy change If Delta Z = 0  Indifferent about policy change If Delta Z < 0  Reject policy change

Modeling Changes to Credit Terms ZE = SE(1-dE)pE(1-bE) / (1 + iDPE)  PV of Discounted Invoices + SE(1-pE)(1-bE) / (1 + iCPE)  PV of Non-Discounted Invs ‐ VCR (SE)  Variable Cost Pmts ‐ EXPE (SE) / (1 + iCPE)  PV of Credit Expense Pmts ZE = Existing Policy This analysis assumes policy changes will increase (or decrease) sales and incorporates (g) sales growth, where SN = (1+g)(SE). Note you would include a decrease in sales with (1-g)(SE). ZN = [(1+g)SE](1-dN)pN(1-bN) / (1 + iDPN) + [(1+g)SE](1-pN)(1-bN) / (1 + iCPN) ‐ VCR [(1+g)SE] ‐ EXPN[(1+g)SE] / (1 + iCPN) ZN = New Policy

Credit Policy Modeling Example Lengthening Credit Period (no cash discount) Offer net-60 rather than net-30 terms.

Credit Policy Modeling Example Lengthening Credit Period (no cash discount) Offer net-60 rather than net-30 terms. First, calculate ZE. ZE = SE(1-dE)pE(1-bE) / (1 + iDPE) + SE(1-pE)(1-bE) / (1 + iCPE) ‐ VCR (SE) ‐ EXPE (SE) / (1 + iCPE) ($82,192)(1-0)(1-.05) / [1 + (.14/365)(50)] ‐ (0.70)($82,192) ‐ (0.02)($82,192) / [1 + (.14/365)(50)] = $76,613 - $57,534 - $1,613 = $17,466

Credit Policy Modeling Example Lengthening Credit Period (no cash discount) Offer net-60 rather than net-30 terms. Now, calculate ZN. ZN = [(1+g)SE](1-dN)pN(1-bN) / (1 + iDPN) + [(1+g)SE](1-pN)(1-bN) / (1 + iCPN) ‐ VCR [(1+g)SE] ‐ EXPN[(1+g)SE] / (1 + iCPN) ($95,890)(1-0)(1-.06) / [1 + (.14/365)(75)] ‐ (0.70)($95,890) ‐ (0.025)($95,890) / [1 + (.14/365)(75)] = $87,616 - $67,123 - $2,330 = $18,163

Credit Policy Modeling Example Lengthening Credit Period (no cash discount) Offer net-60 rather than net-30 terms Compare results: Z = ZN – ZE Z = $18,163 – $17,466 = $697 ∆Z > 0, so accept policy change Calculate the aggregate NPV: NPV = Z / i NPV = $697 / (0.14/365) = $1,816,997

Another Modeling Example Introduce Cash Discount Offer 2/10, net-30 rather than net-30 terms.

Another Modeling Example Introduce Cash Discount Offer 2/10, net-30 rather than net-30 terms. First, calculate ZE. ZE = SE(1-dE)pE(1-bE) / (1 + iDPE) + SE(1-pE)(1-bE) / (1 + iCPE) ‐ VCR (SE) ‐ EXPE (SE) / (1 + iCPE) ($54,795)(1-.03) / [1+(.12/365)(35)] ‐ (0.60)($54,795) ‐ (0.04)($54,795) / [1 + (.12/365)(35)] = $52,546 - $32,877 - $2,167 = $17,502

Another Modeling Example Introduce Cash Discount Offer 2/10, net-30 rather than net-30 terms. Now, calculate ZN. ZN = [(1+g)SE](1-dN)pN(1-bN) / (1 + iDPN) + [(1+g)SE](1-pN)(1-bN) / (1 + iCPN) ‐ VCR [(1+g)SE] ‐ EXPN[(1+g)SE] / (1 + iCPN) ($56,438)(1-.02)(.4)(1-.025)/[1+(.12/365)(10)] + ($56,438)(1-.4)(1-.025) / [1+(.12/365)(35)] ‐ (0.60) ($56,438) ‐ (0.04)($56,438) / [1 + (.12/365)(35)] = $21,500 + $32,641 - $33,863 - $2,231 = $18,046

Another Modeling Example Cash Discount Offer 2/10, net-30 rather than net-30 terms. Compare results: Z = ZN – ZE Z = $18,046 - $17,502 = $544 ∆Z > 0, so accept policy change Calculate the aggregate NPV: NPV = Z / i NPV = $544 / (0.12/365) = $1,654,501

Competitor Reaction Sometimes, a firm has no competitive threat, regardless of terms offered. Otherwise, competitors are likely to react to unilateral changes to credit policy by matching the terms. This can be incorporated into the analysis. A revised sales estimate would be made (quantity of pricing).

Monitoring Receivables Nothing is more important than getting paid! The diligent management of A/R is crucial to: Accelerate collection of cash. Reduce collection costs. Increase likelihood of payment. Credit Managers watch trends for: Days Sales Outstanding (DSO). Accounts Receivable Turnover. Aging Schedules (organizes A/R into categories-next slide).

Credit Policy & Collections Last time we said the Credit Policy includes: Credit Standards Create a profile of the minimally acceptable credit-worthy customer. Credit Terms Define how long the customer has to pay and/or the offering of Cash Discounts. Credit Limits Determine the amount of cumulative credit offered to a single customer and/or group of customers. Collection Process (Chapter 6) Determine how and when past-due accounts are handled.

Collection Procedures Firms try to strike the balance between collection activities and protecting the relationship with the customer. The typical collection effort includes: Contact past due customer (letter or phone call) within 10 days of delinquency. Notify the sales force of the delinquency. As a last resort, refer the account to a collection agency, which can include legal action.

Trends in Receivables