Short-Term Financial Management Chapter 5 – Accounts Receivable Management

Chapter 5 Agenda Accounts Receivable Management Identify and define the components of credit policy, describe the typical credit-granting sequence, apply net present value analysis to credit extension decisions, define credit scoring and explain its limitations, and list the elements in a credit rating report.

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.

Trade Credit In most industries, it is customary to offer trade credit, allowing customers a delay between receipt of goods (sometimes title transfer) and the obligation to pay for it. Also known as supplier financing, credit extension allows deferred payment from customers and is essentially a short- term, interest-free loan. It can be based on ‘standard’ terms, or can vary to attract new customers or large orders. Trade credit does not have an explicit cost to the firm. It is considered a cost of doing business or built into product pricing. Its convenience can capture new business, trigger larger orders, build relationships, and generate repeat sales.

Trade Credit vs. Bank Loans Trade credit dwarfs short-term bank credit as a mechanism for financing inventory. Firms regularly use both, back-to-back. Firms offer, and customers use, trade credit for the following reasons: Information Advantage – As a player in the same space, the firm understands the other players. Control Advantage – Customers are motivated to pay given the need for sound supplier relationships. Salvage Value Advantage – Firms can repossess and resell inventory due to non-payment more effectively.

Trade Credit Offering trade credit can have a significant impact on top line growth; it also results in a significant balance sheet account…accounts receivable. The marketing strategy must strike the balance between growing sales/capturing market share considering: Making prudent credit decisions. Carrying and managing the accounts receivable book Administrative costs

Managing The Credit Function Management of the credit function includes: Credit Administration Establishing a credit policy, along with planning, executing, monitoring, and controlling all aspects of the credit function. Credit Policy Includes credit standards, credit terms, credit limits, credit analysis and investigation, etc.

Managing Trade Credit So, managing trade credit considers: Aggregate Investment Credit Terms Credit Standards Decisions on trade credit are influenced by the sales and market share objectives for the firm.

Managing Trade Credit

Managing Trade Credit Trade credit management includes the aggregate investment. Overinvesting in receivables is costly since: It is often financed with short-term bank credit. It reduces liquidity and limits alternative investments. It could signal an ‘aging’ credit book increasing the chances of bad debts.

Managing Trade Credit Trade credit management setting credit terms. If the length of time to pay is uncompetitive, orders (and customers) are at risk to competitors selling in the same space.

Managing Trade Credit Trade credit management includes establishing credit standards. What is the credit profile of a marginally acceptable customer? How much credit should be offered? Too stringent terms can lead to lost sales and customers. Too lenient terms can lead to charge-offs

The Credit Administration Function The Credit Administration function should: Control bad debts. Control the level of A/R. Maintain financial flexibility. Optimize the mix of company assets. Convert receivables to cash. Analyze customer risk. Minimize administrative costs.

Credit Granting Sequence

Credit Policy Part of Credit Administration is establishing the Credit Policy, which includes the following decision variables: 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 customer. Collection Process (Chapter 6)- Determine how and when past-due accounts are handled.

Credit-Granting Process Marketing contact Credit investigation Customer contact for information Finalize written documents Establish customer credit file Financial analysis Time

Credit Standards Financial and non-financial data is used to establish the profile of the minimally acceptable credit-worthy customer. The process is similar to the underwriting process at a bank. Marginal account might include: Smaller amounts and/or shorter terms. A probationary period. Collateral or a Bank Letter of Credit.

Credit Standards Unique customer data is gathered to assess credit- worthiness and is compared to the benchmark, including: Client-provided data, such as financial statements and receivable agings (next slide) from which ratio and trend analysis and industry comparisons can be performed. Subscriber-based credit reporting agencies, such as D&B, which provide company history and family, business registration, operations, SIC and NAICS, payment records, maximum credit lines, financial statements, banking, public filings (suits, liens, judgments, UCC), and other credit and financial information. Information from banks, industry and trade associations, and other suppliers, including publicly-available information. SIC – Standard Industry Classification NAICS – North American Industry Classification System

Credit-Scoring Models Firms regularly model a firms likelihood to pay. Credit-scoring Models are predictive models that use collective, historical borrower data to assess the likelihood of future default of a potential, single borrower.

Sample Credit Scoring Model A model could be based on company and credit attributes, such as those below. These attributes are weighted based on predictive importance: Credit History of Principals / Business Unused Credit Industry Type Available Liquid Assets Net Worth of Principals

Credit Terms Once a customer is approved for credit, the firm must define how long the customer has to pay (Credit Period) and/or any Cash Discounts offered. The Credit Period must be defined, but usually begins with the invoice date and ends when the payment is received at the remittance address. Some firms use the date the goods are shipped or received.

Credit Terms Factors affecting Credit Terms include: Competition (standard terms exist within industries) Customer’s operating cycle Type of goods (raw materials, finished goods, perishables, etc.) Seasonality of demand Consumer acceptance Cost and pricing Customer type Product profit margin

Credit Terms Cash Discounts provide a financial incentive to encourage early customer payments. “2/10, net 30” The customer may deduct 2% of the entire invoice amount if paid within 10 days; if the discount is not taken, the invoice is due in 30 days (the customer pays $98 per $100 invoiced amount). “2/10, prox net 30” The customer may deduct 2% of the entire invoice amount if paid within 10 days; if the discount is not taken, the invoice is due on the 30th day of the following month. 60% of firms offer cash discounts, but they are offered only to select customers.

Credit Terms Earlier receipt of A/R from offering Cash Discounts reduces short-term borrowing (increases short-term investing). The optimal cash discount is based on: The level of variable costs (the lower are variable costs, the higher the feasible discount). The firm’s cost of funds. The portion of customers likely to take the discount. The elasticity of the product’s price. The level of charge-offs (the higher are bad debts, the higher the optimal discount).

Credit Terms Firms must decide whether to impose (and/or enforce) late penalties. If a firm is too aggressive, it could drive customers to the competition.

Credit Limits Credit Limits are the amount of cumulative credit offered to a single customer or group of customers and is determined by: Percentage of the customer’s net worth. Percentage of the high credit amount reported by other suppliers. Judgment (gut call).

Calculating NPV of Potential Sale Once the customer has been approved for credit, the NPV of the potential sale is calculated to ensure the deal makes money. Consider the following sales opportunity: $1,000 order from new customer. Eligible for firm’s standard 30-day credit terms. S ($1,000) = Dollar amount of credit sale VCR (0.70 of Sales) = Variable cost ratio EXP (0.04 of Sales/CP) = Credit administration/collection expense ratio i (0.13/365) = Daily interest rate CP (30 days) = Collection period for sale The firm will spend variable costs (labor plus raw materials) associated with the sale today, but will not receive the invoice amount for 30 days. EXP are uniquely associated with the prospect and are, therefore, variable costs. The more ‘risk’ that is taken in the underwriting process, the higher EXP are expected to be. Technically, DIH should be included but, so long as the RELATIVE timing is consistent, the calculation will lead to the same conclusion.

Calculating NPV of Potential Sale $1,000 order, 30-day credit terms VCR (0.70 of Sales) = Variable cost ratio S ($1,000) = Dollar amount of credit sale EXP (0.04 of Sales/CP) = Credit administration/collection expense ratio i (0.13/365) = Daily interest rate CP (30 days) = Collection period for sale 0 30 Days $1,000 х 70% = $700 $1,000 – 4%($1,000) = $960 $949.85 - $700 = $249.85 Variable Costs A/R Collected

Calculating NPV of Potential Sale The following formula can be used: Where: NPV = Net present value of the credit sale VCR = Variable cost ratio S = Dollar amount of credit sale EXP = Credit administration/collection expense ratio (end-of-period) i = Daily interest rate CP = Collection period for sale (days) NPV > 0  Extend Credit NPV = 0  Probably Extend Credit NPV < 0  Do Not Extend Credit

Calculating NPV of Potential Sale $1,000 order, 30-day credit terms VCR (0.70 of Sales) = Variable cost ratio S ($1,000) = Dollar amount of credit sale EXP (0.04 of Sales/CP) = Credit administration/collection expense ratio i (0.13/365) = Daily interest rate CP (30 days) = Collection period for sale Positive, so make sale $1,000 - $40 = ----------------------- - $700 = $249.85 1 + (.13/365 х 30)

Calculating NPV How is NPV affected if the new client does not pay exactly on time (or pays early or does not pay at all)? The longer someone owes you, the greater the chance you will never get paid! Risk can be incorporated into the analysis based on a probability distribution of payment dates.

Calculating NPV – Example Cont’d Continuing with this example, we can model how late payments affect the result. $1,000 - $40 = ----------------------- - $700 = $249.85 1 + (.13/365 х 30) Before, our calculation assumed that the customer paid exactly on-time at the 30-day mark. We can use collective, historical customer data to predict more realistic payment timing for the new customer.

Calculating NPV – Example Cont’d Assume the new customer is expected to mirror the firm’s historical collection experience  VCR (0.70 of Sales) = Variable cost ratio S ($1,000) = Dollar amount of credit sale EXP (0.04 of Sales/CP) = Credit administration/collection expense ratio Incurred at this rate beginning in the second cp through the fourth ,then turned over to collection agency that collects, on average, 80% of invoice one month after referral and charges a 25% commission on the amount collected. i (0.13/365) = Daily interest rate CREDIT TERMS (Net 30 days) CP (Various) = Collection period for sale These are four possible outcomes. Existing customers fall into one (and ONLY one) of these four CP buckets. The average DSO for each bucket is indicated. The weighted-average DSO is 45 days. If not for the differences between EXP and uncollected accounts, you could simply discount the cash flows based on the weighted-average DSO (45 days).

Calculating NPV – Example Cont’d Assume the new customer is expected to mirror the firm’s historical collection experience  VCR (0.70 of Sales) = Variable cost ratio S ($1,000) = Dollar amount of credit sale EXP (0.04 of Sales/CP) = Credit administration/collection expense ratio Incurred at this rate beginning in the second cp through the fourth ,then turned over to collection agency that collects, on average, 80% of invoice one month after referral and charges a 25% commission on the amount collected. i (0.13/365) = Daily interest rate CREDIT TERMS (Net 30 days) CP (Various) = Collection period for sale As DSO increases, the NPV decreases since it takes longer to receive the money. In addition, we incur additional EXP. Assume all EXP is recognized when the invoice is paid.

Calculating NPV – Example Cont’d Assume the new customer is expected to mirror the firm’s historical collection experience  VCR (0.70 of Sales) = Variable cost ratio S ($1,000) = Dollar amount of credit sale EXP (0.04 of Sales/CP) = Credit administration/collection expense ratio Incurred at this rate beginning in the second cp through the fourth ,then turned over to collection agency that collects, on average, 80% of invoice one month after referral and charges a 25% commission on the amount collected. i (0.13/365) = Daily interest rate CREDIT TERMS (Net 30 days) CP (Various) = Collection period for sale For the segment that is turned over to the collection agency, the AVERAGE amount collected is 80%, which includes some accounts for which no receipts are made. The agency sends the amount collected, on average, in 152 days.

Calculating NPV – Example Cont’d Timeline for EXP (0.04 of Sales/CP) Incurred at this rate beginning in the second cp through the fourth ,then turned over to collection agency that collects, on average, 80% of invoice one month after referral and charges a 25% commission on the amount collected. EXP 152 DSO 90 DSO 45 DSO 15 DSO 1 2 3 4 The customer will pay in ONE of these discrete CP ranges; with the average DSO indicated (the mid-point).

Calculating NPV – Example Cont’d Timeline for EXP (0.04 of Sales/CP) Incurred at this rate beginning in the second cp through the fourth ,then turned over to collection agency that collects, on average, 80% of invoice one month after referral and charges a 25% commission on the amount collected. EXP 152 DSO 90 DSO 45 DSO 15 DSO Cumulative Cash Flows If the new customer pays on time like 40% of our customers (in the first CP), there is no EXP incurred.

Calculating NPV – Example Cont’d Timeline for EXP (0.04 of Sales/CP) Incurred at this rate beginning in the second cp through the fourth ,then turned over to collection agency that collects, on average, 80% of invoice one month after referral and charges a 25% commission on the amount collected. EXP 152 DSO 90 DSO 45 DSO 15 DSO Cash Flows $1,000 х 4% = $40 Cumulative $40 Instead, if the customer pays in the second CP, an initial $40 EXP is incurred, and recognized at t=45 days.

Calculating NPV – Example Cont’d Timeline for EXP (0.04 of Sales/CP) Incurred at this rate beginning in the second cp through the fourth ,then turned over to collection agency that collects, on average, 80% of invoice one month after referral and charges a 25% commission on the amount collected. EXP 152 DSO 90 DSO 45 DSO 15 DSO Cash Flows $40 $40 Cumulative $40 $80 If the customer pays in the third CP, another $40 EXP is incurred, for total EXP of $80, recognized at t=90 days.

Calculating NPV – Example Cont’d Timeline for EXP (0.04 of Sales/CP) Incurred at this rate beginning in the second cp through the fourth ,then turned over to collection agency that collects, on average, 80% of invoice one month after referral and charges a 25% commission on the amount collected. EXP 152 DSO 90 DSO 45 DSO 15 DSO Cash Flows $40 $40 $40 + ($1,000 х 80% х 25%) = $240 Cumulative $40 $80 $ 320 If the customer pays in the last CP, a final $40 EXP is incurred, for total EXP of $120 at t=152 days. At this point, the agency commissions are also paid.

Calculating NPV – Example Cont’d Calculate the NPV for each, independent possible outcome below using this formula: Weight and add the possible outcomes. Remember, only one will actually occur. NPV still positive. 1 $320 = [25% x $800] + [3 x ($1,000 X .04)] 2 $480 = $800 - $320 after write-off of bad debt

Final Thoughts Our goal is to design a credit policy that combines mutually- exclusive alternatives such that NPV is maximized. In theory, if no credit policy alternative results in a positive NPV, credit terms would not be offered and the firm would sell on a cash-only basis. Or, the pricing and/or cost structure of the sale would require adjustment.