1. Trade Credit and Shareholder Value
Trade credit arises when goods sold under delayed payment terms
Credit extended by manufacturers and wholesalers to their customers.
When credit terms are offered, the seller is exchanging the title to the goods for the buyer's promise to pay at an agreed-upon later date.
Credit managers believe that the convenience of vendor financing may result in larger purchases. They also believe that credit customers may be more stable and more likely to become repeat purchasers.

2. 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

3. A/R Management and Shareholder Value
Marketing Strategy
Market Share Obj.
Aggregate Inv. in A/R
Credit Terms
Credit Standards
Total Dollar Investment
Length of Time to Pay
Acceptance of Marg Cust.
Max Shareholder Value

4. Trade vs. Bank Credit Length of terms Security Amounts involved
Resource transferred (goods vs. money)
Extent of analysis

5. Why Extend Credit? Financial Motive Operating Motive
Contracting Motive
Pricing Motive
All reasons are related to market imperfections

6. Financial Motive
The financial motive refers to sellers charging a higher price when selling on credit, generating a greater present-value profit based on the implicit interest rate charged.
Sellers raise capital at lower rates than customers and have cost advantages vis-a-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.

7. Operating Motive
Under the operating motive, suppliers respond to variable and uncertain demand by the way in which they extend trade credit, instead of using more costly responses such as installing extra capacity, building or depleting inventories, or forcing customers to wait in line.
Change credit terms rather than:
install extra capacity,
building or depleting inventories,
or forcing customers to wait.

8. Contracting Cost Motive
The argument that sales contracting costs between buyers and sellers are reduced for buyers because they can inspect the quantity and quality of goods prior to payment and reduce the payment if some goods are missing or defective.
Seller has less theft with separation of collection and product delivery
Seller observes the creditworthiness – whether the buyer takes the cash discounts

9. Pricing Motive
The pricing motive is attributed to a situation in which sellers in certain industries are unable to alter their prices, perhaps because they are part of an oligopoly or due to governmental regulation; unpublished variations in credit policy allow these sellers to effectively charge varying amounts to their customers.

10. Credit administration involves establishing credit policy as well as planning, organizing, directing and controlling all aspects of credit function.
Credit policy includes credit standard, setting credit limit, competitive approaches to credit investigation, credit term and collection activity.

11. 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

12. Tricia Velasquez wishes to apply NPV analysis to a newly received order. The company’s credit terms are net 45 days. Its opportunity cost of funds is 12 percent. The order dollar amount is $30,000. She finds out from the cost accounting department that variable costs are approximately 65 percent of sales and that incremental credit administration and collection expenses approach 1 percent of sales.
a. Assuming that the customer will pay according to the credit terms, with perfect certainty, should Tricia approve the order?

13. Establishing a Credit Policy
Should we extend credit?
Credit policy components
Credit-granting decision

14. 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?

15. 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

16. Credit-Granting Decision
Development of credit standards
Gathering necessary information
Credit analysis: applying credit standards
Risk analysis

17. Grant-Granting Sequence
Order and credit
request received No
Yes
New/increased
credit limit
Material
change in customer status
Redo credit
investigation
Yes No
Check new A/R
total vs credit lmt
Size of proposed
credit limit
Record
disposition
Large
Medium
Small No
Extend Credit
Indepth
credit invest.
Moderate
credit invest.
Minimal
credit invest.
Yes
Set up,post
A/R, ship

18. Credit Standards Based on five C's of Credit
Character- moral uprightness, integrity, trustworthiness
Capital- net worth. In liquidation asset value
Capacity- ability to repay debt as measured by the ability to generate cash flows
Collateral- assets pledged as a security
Conditions-general and economic environment, reason for loan request
Determine risk classification system
Link customer evaluations to credit standards

19. Gathering Information
Getting necessary information about the customer
Cost of additional information>decision making benefit
credit reporting agencies,- Major source of credit information e.g.. Dun & Bradstreet
credit interchange bureaus- The Bureaus are departments of local credit associations that provide information
bank letters
references from other suppliers
financial statements
field data gathered by sales reps

20. 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 = (INCOME) (PAYHIST) (EMPLOYMT)

21. 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.”

22. Establishing credit limit
Why do companies set credit limit?
Surveys indicated ‘ Control risk exposure as the primary reason’ followed by customer financial position
Traditional approaches:
Setting credit limit equal to customer’s need
10% of customer’s net worth
Judgment

23. Credit terms
Information about the due date of the invoice and whether a cash discount can be availed for earlier payment
Credit period is the allowed time for payment
Payment period starts with the invoice date but sometimes there is exception

24. Factors Affecting Credit Terms
Competition
Operating cycle
Type of good (raw materials vs finished goods, perishables, etc.)
Seasonality of demand
Cost
Customer type
Product profit margin

25. Cash discount
The percentage amount that can be subtracted from the invoice if the payment is made within the discount period.
Difference between cash discount and trade discount
Sales may not increase as much as the increase in the credit period, rather it may have an adverse effect on sales.

26. Should a seller offer 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

27. 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

28. 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.