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.

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

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

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

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

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.

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.

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 is the contracting cost motive. Seller has less theft with separation of collection and product delivery

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.

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.

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

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?

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

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?

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

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

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

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 ability to generate cash Collateral- Conditions-general and economic environment, reason for loan request Determine risk classification system Link customer evaluations to credit standards

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

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 = .000025(INCOME) + 0.50(PAYHIST) + 0.25(EMPLOYMT)

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.”

Establishing credit limit Why do companies set credit limit? Surveys indicated ‘ Control risk exposure as the primary reason’ followed by customer financial position Some traditional approaches Setting credit limit equal to customer’s need 10% of customer’s net worth Judgment - Probability of payment decreases with the amount of credit increases. So credit granting and credit limit setting?

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

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

Survey Results Two-thirds offered credit but no cash discount. Most popular credit period was net 30 One-fourth offered cash discounts, 70% had 2/10, net 30 with 25% offering 1/10, net 30 Industry influence: 80% of wholesalers vs 36% of service firms offered cash discounts 80% of firms charged a late fee, usually 15-20%.

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 would not increase as much as the increase in the credit period, rather it will have an adverse effect on sales.

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

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

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.