Prepared by Professor Wei Wang Queen’s University © 2011 McGraw–Hill Ryerson Limited Chapter Twenty Nine Credit Management

2-1 © 2011 McGraw–Hill Ryerson Limited 29-1 Executive Summary When a firm sells goods and services: (1) it can be paid in cash immediately or (2) it can wait for a time to be paid by extending credit to its customers. Granting credit is investing in a customer, an investment tied to the sale of a product or service. This chapter examines the firm’s decision to grant credit.

2-2 © 2011 McGraw–Hill Ryerson Limited 29-2 Chapter Outline 29.1 Terms of the Sale 29.2 The Decision to Grant Credit: Risk and Information 29.3 Optimal Credit Policy 29.4 Credit Analysis 29.5 Collection Policy 29.6 Other Aspects of Credit Policy 29.7 Summary & Conclusions

2-3 © 2011 McGraw–Hill Ryerson Limited 29-3 Introduction A firm’s credit policy is composed of: –Terms of the sale –Credit analysis –Collection policy This chapter discusses each of the components of credit policy that makes up the decision to grant credit.

2-4 © 2011 McGraw–Hill Ryerson Limited 29-4 Terms of the Sale LO29.1 The terms of sale are composed of –Credit Period –Cash Discounts –Credit Instruments

2-5 © 2011 McGraw–Hill Ryerson Limited 29-5 The Cash Flows of Granting Credit (Figure 29.2) LO29.1 Credit sale is made Customer mails cheque Firm deposits cheque Bank credits firm’s account Accounts receivable Cash collection Time

2-6 © 2011 McGraw–Hill Ryerson Limited 29-6 Credit Period LO29.1 Credit periods vary across industries. Generally a firm must consider three factors in setting a credit period: –The probability that the customer will not pay. –The size of the account. –The extent to which goods are perishable. Lengthening the credit period generally increases sales

2-7 © 2011 McGraw–Hill Ryerson Limited 29-7 Cash Discounts LO29.1 Often part of the terms of sale. Tradeoff between the size of the discount and the increased speed and rate of collection of receivables. An example would be “3/10 net 30” –The customer can take a 3% discount if he pays within 10 days. –In any event, he must pay within 30 days.

2-8 © 2011 McGraw–Hill Ryerson Limited 29-8 The Interest Rate Implicit in 3/10 net 30 LO29.1 A firm offering credit terms of 3/10 net 30 is essentially offering their customers a 20-day loan. To see this, consider a firm that makes a $1,000 sale on day 0 Some customers will pay on day 10 and take the discount. Other customers will pay on day 30 and forgo the discount $ $1,000

2-9 © 2011 McGraw–Hill Ryerson Limited $970 -$1,000 A customer that forgoes the 3% discount to pay on day 30 is borrowing $970 for 20 days and paying $30 interest: The Interest Rate Implicit in 3/10 net 30 LO29.1

2-10 © 2011 McGraw–Hill Ryerson Limited Credit Instruments LO29.1 Most credit is offered on open account—the invoice is the only credit instrument. Promissory notes are IOUs that are signed after the delivery of goods Commercial drafts call for a customer to pay a specific amount by a specific date. The draft is sent to the customer’s bank, when the customer signs the draft, the goods are sent. Banker’s acceptances allow a bank to substitute its creditworthiness for the customer, for a fee. Conditional sales contracts let the seller retain legal ownership of the goods until the customer has completed payment.

2-11 © 2011 McGraw–Hill Ryerson Limited The Decision to Grant Credit: Risk and Information LO29.2 Consider a firm that is choosing between two alternative credit policies: –“In God we trust—everybody else pays cash.” –Offering their customers credit. The only cash flow of the first strategy is The expected cash flows of the credit strategy are: 01 We incur costs up front… …and get paid in 1 period by h% of our customers.

2-12 © 2011 McGraw–Hill Ryerson Limited The Decision to Grant Credit: Risk and Information LO29.2 The NPV of the cash only strategy is: The NPV of the credit strategy is: The decision to grant credit depends on four factors: 1.The delayed revenues from granting credit, 2.The immediate costs of granting credit, 3.The probability of repayment, h 4.The discount rate, r B

2-13 © 2011 McGraw–Hill Ryerson Limited Example of the Decision to Grant Credit LO29.2 A firm currently sells 1,000 items per month on a cash basis for $500 each. If they offered terms net 30, the marketing department believes that they could sell 1,300 items per month. The collections department estimates that 5% of credit customers will default. The cost of capital is 10% per annum.

2-14 © 2011 McGraw–Hill Ryerson Limited Example of the Decision to Grant Credit LO29.2 The NPV of cash only = 1,000×($500 – $400) = $100,000 No CreditNet 30 Quantity sold1,0001,300 Selling price$500 Unit cost$400$425 Probability of payment100%95% Credit period (days)030 Discount rate per annum 10% The NPV of Net 30: 1,300×$500×0.95 –1,300×$425 + (1.10) 30/365 = $60,181.58

2-15 © 2011 McGraw–Hill Ryerson Limited Example of the Decision to Grant Credit LO29.2 How high must the credit price be to make it worthwhile for the firm to extend credit? The NPV of Net 30 must be at least as big as the NPV of cash only:

2-16 © 2011 McGraw–Hill Ryerson Limited The Value of New Information about Credit Risk LO29.2 The most that we should be willing to pay for new information about credit risk is the present value of the expected cost of defaults: $0 (1 + r B ) –C 0 × Q 0 ′′ + NPV default = × (1 – h) –C 0 × Q 0 ′′ NPV default = × (1 – h) C 0 × Q 0 ′′ × (1 – h) = $425×1,300×(1 – 0.95) = $27,625 In our earlier example, with a credit price of $500, we would be willing to pay $27,625 for a perfect credit screen.

2-17 © 2011 McGraw–Hill Ryerson Limited Future Sales and the Credit Decision (Figure 29.5) LO29.2 Do not give credit Give credit Customer pays h = 100% Customer pays (Probability = h) Customer defaults (Probability = 1– h) Give credit Do not give credit Our first decision: We refuse further sales to deadbeats. We face a more certain credit decision with our paying customers: Information is revealed at the end of the first period:

2-18 © 2011 McGraw–Hill Ryerson Limited Optimal Credit Policy (Figure 29.6) LO29.3 Carrying Costs Total costs C*C* Costs in dollars Level of credit extended At the optimal amount of credit, the incremental cash flows from increased sales are exactly equal to the carrying costs from the increase in accounts receivable. Opportunity costs

2-19 © 2011 McGraw–Hill Ryerson Limited Optimal Credit Policy LO29.3 Trade Credit is more likely to be granted if: 1.The selling firm has a cost advantage over other lenders. 2.The selling firm can engage in price discrimination. 3.The selling firm can obtain favourable tax treatment. 4.The selling firm has no established reputation for quality products or services. 5.The selling firm perceives a long-term strategic relationship. The optimal credit policy depends on the characteristics of particular firms.

2-20 © 2011 McGraw–Hill Ryerson Limited Organizing the Credit Function LO29.3 Firms that run strictly internal credit operations are self-insured against default risk. An alternative is to buy credit insurance through an insurance company. In Canada, exporters may qualify for credit insurance through the Export Development Corporation (EDC). In 2005, EDC provided a total of $57.5 billion in financing for the sale of equipment and services by various Canadian suppliers.

2-21 © 2011 McGraw–Hill Ryerson Limited Credit Analysis LO29.4 Credit Information –Financial Statements –Credit Reports on Customer’s Payment History with Other Firms –Banks –Customer’s Payment History with the Firm Credit Scoring: –The traditional 5 C’s of credit Character Capacity Capital Collateral Conditions –Some firms employ sophisticated statistical models

2-22 © 2011 McGraw–Hill Ryerson Limited Credit Scoring LO29.4 Credit scoring refers to the process of: (1) calculating a numerical rating for a customer based on information collected, (2) granting or refusing credit based on the result. Financial Institutions have developed elaborate statistical models for credit scoring. This approach has the advantage of being objective as compared to scoring based on judgments on the 5 C’s. Credit scoring is used for business customers by Canadian chartered banks. Scoring for small business loans is a particularly attractive application because the technique offers the advantages of objective analysis.

2-23 © 2011 McGraw–Hill Ryerson Limited Collection Policy LO29.5 Collection refers to obtaining payment on past-due accounts. Collection Policy is composed of –The firm’s willingness to extend credit as reflected in the firm’s investment in receivables. –Collection Effort

2-24 © 2011 McGraw–Hill Ryerson Limited Average Collection Period LO29.5 Measures the average amount of time required to collect an account receivable. For example, a firm with average daily sales of $20,000 and an investment in accounts receivable of $150,000 has an average collection period of

2-25 © 2011 McGraw–Hill Ryerson Limited Accounts Receivable Aging Schedule LO29.5 Shows receivables by age of account. The aging schedule is often augmented by the payments pattern. The payments pattern describes the lagged collection pattern of receivables. The longer an account has been unpaid, the less likely it is to be paid.

2-26 © 2011 McGraw–Hill Ryerson Limited Collection Effort LO29.5 Most firms follow a protocol for customers that are past due: 1.Send a delinquency letter. 2.Make a telephone call to the customer. 3.Employ a collection agency. 4.Take legal action against the customer. There is a potential for a conflict of interest between the collections department and the sales department. You need to strike a balance between antagonizing a customer and being taken advantage of by a deadbeat.

2-27 © 2011 McGraw–Hill Ryerson Limited Other Aspects of Credit Policy LO29.6 Factoring The sale of a firm’s accounts receivable to a financial institution (known as a factor). The firm and the factor agree on the basic credit terms for each customer. Firm Factor Customer Customers send payment to the factor The factor pays an agreed- upon percentage of the accounts receivable to the firm. The factor bears the risk of nonpaying customers Goods

2-28 © 2011 McGraw–Hill Ryerson Limited Factoring LO29.6 Factoring in Canada is conducted by independent firms where main customers are small businesses. What factoring does is remove receivables from the balance sheet and so, indirectly, it reduces the need for financing. Firms financing their receivables through a chartered bank may also use the services of a factor to improve the receivables’ collateral value. This is called maturity factoring with assignment of equity.

2-29 © 2011 McGraw–Hill Ryerson Limited How to Finance Trade Credit LO29.6 There are three general ways of financing accounting receivables: 1.Secured Debt –Referred to as asset-based receivables financing. –The predominant form of receivables financing. 2.Captive Finance Company –Large companies with good credit ratings often form a finance company as a subsidiary of the firm. 3.Securitization –Occurs when the selling firm sells its accounts receivable to a financial institution, which then pools the receivables and sells securities backed by these assets.

2-30 © 2011 McGraw–Hill Ryerson Limited Summary & Conclusions LO The components of a firm’s credit policy are the terms of sale, the credit analysis, and the collection policy. 2.The decision to grant credit is a straightforward NPV problem. 3.Additional information about the probability of customer default has value, but must be weighed against the cost of the information. 4.The optimal amount of credit is a function of the conditions in which a firm finds itself. 5.The collection policy is the firm’s method for dealing with past-due accounts—it is an integral part of the decision to extend credit.

2-31 © 2011 McGraw–Hill Ryerson Limited Quick Quiz Explain a credit term quoted “2/10, net 30.” Discuss the process used for evaluating the creditworthiness of potential customers. Identify the optimal credit policy. Describe the credit-scoring process. What is factoring?