1. Copyright 2005 by Thomson Learning, Inc. Chapter 6 Credit Policy and Collections Order Order Sale Payment Sent Cash Placed Received Received Accounts Collection Accounts Collection Time ==> Time ==> Accounts Disbursement Accounts Disbursement Invoice Received Payment Sent Cash Disbursed Invoice Received Payment Sent Cash Disbursed Order Order Sale Payment Sent Cash Placed Received Received Accounts Collection Accounts Collection Time ==> Time ==> Accounts Disbursement Accounts Disbursement Invoice Received Payment Sent Cash Disbursed Invoice Received Payment Sent Cash Disbursed

2. Copyright 2005 by Thomson Learning, Inc. Objectives v Specify advantages of NPV in evaluating credit policy alternatives. v Calculate the NPV of alternative credit policies and select the best policy. v Identify the 3 major traditional measures of collection patterns, calculate them, and understand their flaws. v Calculate and interpret uncollected balance percentages and relate to traditional measures. v Describe present corporate credit policy practices. v List and explain the major differences encountered when extending credit internationally.

3. Copyright 2005 by Thomson Learning, Inc. Evaluate Changes in Credit Policy v Credit term change decision variables –effect on dollar profits –sales effect –receivables effect –return on investment effect v 84% can estimate: –default probability –credit limits –opportunity cost of funds invested in receivables –companys overall cost of capital

4. Copyright 2005 by Thomson Learning, Inc. Incremental Profit vs NPV v Financial statement approach v NPV approach

5. Copyright 2005 by Thomson Learning, Inc. Changing Credit Terms, EQ 6.1 Z N = [(1+g)S E ](1-d N )P N (1-b N ) / (1 + iDP N )PV discount pmts + [(1+g)S E ](1-P N )(1-b N ) / (1 + iCP N )PV non-discount pmts - VCR [(1+g)S E ]PV variable cost pmts - EXP N [(1+g)S E ] / (1 + iCP N )PV credit expense pmts Z N = [(1+g)S E ](1-d N )P N (1-b N ) / (1 + iDP N )PV discount pmts + [(1+g)S E ](1-P N )(1-b N ) / (1 + iCP N )PV non-discount pmts - VCR [(1+g)S E ]PV variable cost pmts - EXP N [(1+g)S E ] / (1 + iCP N )PV credit expense pmts

6. Copyright 2005 by Thomson Learning, Inc. Changing Credit Terms, EQ 6.2 Z E = S E (1-d E )P E (1-b E ) / (1 + iDP E )PV discount pmts + S E (1-P E )(1-b E ) / (1 + iCP E )PV non-discount pmts - VCR (S E )PV variable cost pmts - EXP E S E / (1 + iCP E )PV credit expense pmts Z E = S E (1-d E )P E (1-b E ) / (1 + iDP E )PV discount pmts + S E (1-P E )(1-b E ) / (1 + iCP E )PV non-discount pmts - VCR (S E )PV variable cost pmts - EXP E S E / (1 + iCP E )PV credit expense pmts

7. Copyright 2005 by Thomson Learning, Inc. Changing Credit Terms, EQ 6.3, 6.4 EQ 6.3 Z = Z N - Z E Decision Rule: IF Z > 0 then Accept policy change IF Z < 0 then Reject policy change EQ 6.4 NPV = Z / i EQ 6.3 Z = Z N - Z E Decision Rule: IF Z > 0 then Accept policy change IF Z < 0 then Reject policy change EQ 6.4 NPV = Z / i

8. Copyright 2005 by Thomson Learning, Inc. Monitoring Collections v Receivables turnover –least favored technique v Days sales outstanding, DSO –ranked almost as high as aging schedules v Aging schedules –ranked as most favored technique

9. Copyright 2005 by Thomson Learning, Inc. Problem v All three traditional measures have a serious flaw –All three are influenced by sales trends –Choice of averaging period impact turnover and DSO v Increasing sales tends to: –improve aging schedules –worsen DSO and turnover

10. Copyright 2005 by Thomson Learning, Inc. Solution v Uncollected Balance Percentage

11. Copyright 2005 by Thomson Learning, Inc. Collection Procedures v Typical collection effort –initial contact within 10 days of delinquency –then reminder letter followed by phone call –sales force notified –last resort, reference to collection agency/legal action v Collection agency –Phase 1 - computer generated collection letter, when accounts are 45 to 90 days past due –Phase 2 - commissioned collectors used v Companies tend to be more aggressive the larger the receivables balance v Companies understand the good-will tradeoff when selecting collection methods

12. Copyright 2005 by Thomson Learning, Inc. Evaluating the Credit Department v Reducing investment in receivables –reduce invoice float –fine-tune credit administration and credit policy –outsourcing and automating –reduce discrepancies and deductions –improve monitoring and collections using benchmark data v Organizational integration and key account management –develop better understanding of needs and wants of key accounts –prioritize accounts by potential value –make credit terms and policies integral part of well designed sales and marketing offering

13. Copyright 2005 by Thomson Learning, Inc. International Credit Management v Credit policy analysis –lengthening terms increases exchange rate risk –also increases default risk –harder to get D&B reports –harder to get bank credit information v Modifying monitoring and collections –legal remedies for late payment or nonpayment differ by country

14. Copyright 2005 by Thomson Learning, Inc. Summary v This chapter developed the framework for applying the NPV model to credit policy decisions. v The NPV approach was applied to changes in credit standards, the credit period, cash discounts. v Traditional monitoring tools include aging, DSO and receivables turnover. v Improved monitoring measure –uncollected balance percentage –a reliable and unbiased measure of customer payment behavior v Collection procedures were reviewed. v The chapter concluded with a look at benchmarking and the impact of foreign sales.