Credit Management and Collection Fundamentals of Corporate Finance Chapter 10 Credit Management and Collection Slides by Matthew Will McGraw Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 1 1 1 1 1 2

Topics Covered Terms of Sale Credit Agreements Credit Analysis The Credit Decision Collection Policy Bankruptcy 2

Terms of Sale Terms of Sale - Credit, discount, and payment terms offered on a sale. Example - 5/10 net 30 5 - percent discount for early payment 10 - number of days that the discount is available net 30 - number of days before payment is due 3

Terms of Sale A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier. We can calculate the implicit cost of this loan 5

Terms of Sale Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given? 7

Credit Agreements Terminology open account=sales are made without formal debt contract promissory note=a note evidencing promise to pay commercial draft or bill of exchange ,demand for payment sight draft =demand for immediate payment time draft=demand for payment at a stated future date like sight draft trade acceptance=written demand that has been accepted by an industrial company to pay a given sum of money at a future date banker’s acceptance=example of trade acceptance Letter of credit=letter from a bank stating that it has established a credit in the company’s favor 8

Credit Analysis Credit Analysis - Procedure to determine the likelihood a customer will pay its bills. Credit agencies, such as Dun & Bradstreet provide reports on the credit worthiness of a potential customer. Financial ratios can be calculated to help determine a customer’s ability to pay its bills. 9

Credit Analysis Numerical Credit Scoring categories The customer’s character The customer’s capacity to pay The customer’s capital The collateral provided by the customer The condition of the customer’s business 10

Credit Analysis Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time. 12

Credit Analysis Example - If the Altman Z score cut off for a credit worthy business is 2.7 or higher, would we accept the following client? 14

Credit Analysis Example - If the Altman Z score cut off for a credit worthy business is 2.7 or higher, would we accept the following client? A score above 2.7 indicates good credit. 15

Credit Analysis Credit analysis is only worth while if the expected savings exceed the cost. Don’t undertake a full credit analysis unless the order is big enough to justify it. Undertake a full credit analysis for the doubtful orders only. 16

The Credit Decision Credit Policy - Standards set to determine the amount and nature of credit to extend to customers. Credit Scoring – What your lender won’t tell you. Extending credit gives you the probability of making a profit, not the guarantee. There is still a chance of default. Denying credit guarantees neither profit or loss. 17

The Credit Decision The credit decision and its probable payoffs Payoff = Rev - Cost Payoff = - Cost Customer pays = p Customer defaults = 1-p Payoff = 0 Offer credit Refuse credit 20

The Credit Decision Based on the probability of payoffs, the expected profit can be expressed as: The break even probability of collection is: 23

Collection Policy Collection Policy - Procedures to collect and monitor receivables. Aging Schedule - Classification of accounts receivable by time outstanding. 24

Collection Policy Sample aging schedule for accounts receivable 25

Bankruptcy Bankruptcy - The reorganization or liquidation of a firm that can not pay its debts. Workout - Agreement between a company and its creditors establishing the steps the company must take to avoid bankruptcy. Liquidation - Sale of bankrupt firm’s assets. Reorganization - Restructuring of financial claims on failing firm to allow it to keep operating. 26

Summary Credit Management involves five steps. The first is to establish normal terms of sale. This means that you must decide the length of the payment period and the size of any cash discounts. In most industries these conditions are standardized. The second step is to decide the form of the contract with your customer. Most domestic sales are made on open account. In this case the only evidence that the customer owes you money is the entry in your ledger and a receipt signed by the customer. Particularly, if the customer is located in a foreign country, you may require a more formal contract. We looked at 3 such devices – the promissory note, the trade acceptance and the letter of credit

Summary The third step is to assess each customer’s creditworthiness. There are a variety of sources of information – your own experience with the customer, the experience of other creditors, the assessment of credit agency, a check with the customers bank, the market value of the customers securities and an analysis of the customers financial statements. Firms that handle a large volume of credit information often use a formal system for combining the data from various sources into an overall credit score. Such numerical scoring systems help separate the borderline cases from the obvious sheep or goats.

Summary The fourth step is to establish a sensible credit limits. The job of the Credit Manager is not to minimize the number of bad debts; it is to maximize profits, This means that you should increase the customer’s credit limit as long as the probability of payment times the expected profit is greater than the probability of default times the cost of the goods. Remember, not to be shortsighted in reckoning the expected profit. It is often worth accepting the marginal applicant if there is a chance that the applicant may become a regular and reliable customer.

Summary The fifth and final step is to collect. Doing so requires tact and judgment. You want to be firm with the truly delinquent customer but you do not want to offend the good one by writing demanding letters just because a check has been delayed in the mail. You will find it easier to spot troublesome accounts if you keep a careful record of the aging of receivables.

Summary These five steps are interrelated. For example, you can afford more liberal terms of sale if you are very careful about whom you grant credit to. You can accept higher risk customers if you are very active in pursuing any late payers .A good credit policy is one that adds up to a sensible whole.

Web Resources Web Links www.nacm.org www.dnb.com www.ny.frb.org/pihome/addpub/credit.html www.creditworthy.com http://bankrupt.com http://finance.yahoo.com www.myfico.com www.jaxworks.com/zscore2.htm www.kmv.com www.abiworld.org www.bankruptcydata.com Click to access web sites Internet connection required Web Links