Copyright  1998 by Harcourt Brace &Company Chapter 6 Credit Policy and Collections Order Order Sale Cash Placed Received Received Accounts Collection Accounts Collection Time ==> Time ==> Accounts Disbursement Accounts Disbursement Invoice Payment Cash Invoice Payment Cash Received Sent Paid Received Sent Paid Order Order Sale Cash Placed Received Received Accounts Collection Accounts Collection Time ==> Time ==> Accounts Disbursement Accounts Disbursement Invoice Payment Cash Invoice Payment Cash Received Sent Paid Received Sent Paid

Copyright  1998 by Harcourt Brace &Company Objectives v Specify advantages of NPV in evaluating credit policy alternatives v Calculate the NPV of alternative credit policies and select the best policy v Identify the 3 major traditional measures of collection patterns, calculate them, and understand their flaws v Calculate and interpret uncollected balance percentages and relate to traditional measures v Describe present corporate credit policy practices v List and explain the major differences encountered when extending credit internationally

Copyright  1998 by Harcourt Brace &Company Evaluate Changes in Credit Policy v Credit term change decision variables –effect on dollar profits –sales effect –receivables effect –return on investment effect v 84% can estimate: – default probability –credit limits –opportunity cost of funds invested in receivables –company’s overall cost of capital

Copyright  1998 by Harcourt Brace &Company Incremental Profit vs NPV v Financial statement approach v NPV approach

Copyright  1998 by Harcourt Brace &Company Changing Credit Terms, EQ 6.1 Z N = [(1+g)S E ](1-d N )P N (1-b N ) / (1 + iDP N )PV discount pmts + [(1+g)S E ](1-P N )(1-b N ) / (1 + iCP N )PV non-discount pmts - VCR [(1+g)S E ]PV variable cost pmts - EXP N [(1+g)S E ] / (1 + iCP N )PV credit expense pmts Z N = [(1+g)S E ](1-d N )P N (1-b N ) / (1 + iDP N )PV discount pmts + [(1+g)S E ](1-P N )(1-b N ) / (1 + iCP N )PV non-discount pmts - VCR [(1+g)S E ]PV variable cost pmts - EXP N [(1+g)S E ] / (1 + iCP N )PV credit expense pmts

Copyright  1998 by Harcourt Brace &Company Changing Credit Terms, EQ 6.2 Z E = S E (1-d E )P E (1-b E ) / (1 + iDP E )PV discount pmts + S E (1-P E )(1-b E ) / (1 + iCP E )PV non-discount pmts - VCR (S E )PV variable cost pmts - EXP E S E / (1 + iCP E )PV credit expense pmts Z E = S E (1-d E )P E (1-b E ) / (1 + iDP E )PV discount pmts + S E (1-P E )(1-b E ) / (1 + iCP E )PV non-discount pmts - VCR (S E )PV variable cost pmts - EXP E S E / (1 + iCP E )PV credit expense pmts

Copyright  1998 by Harcourt Brace &Company Changing Credit Terms, EQ 6.3, 6.4 EQ 6.3  Z = Z N - Z E Decision Rule: IF  Z > 0 then Accept policy change IF  Z < 0 then Reject policy change EQ 6.4  NPV =  Z / i EQ 6.3  Z = Z N - Z E Decision Rule: IF  Z > 0 then Accept policy change IF  Z < 0 then Reject policy change EQ 6.4  NPV =  Z / i

Copyright  1998 by Harcourt Brace &Company Monitoring Collections v Receivables turnover –least favored technique v Days sales outstanding, DSO –ranked almost as high as aging schedules v Aging schedules –ranked as most favored technique

Copyright  1998 by Harcourt Brace &Company Problem v All three traditional measures have a serious flaw –All three are influenced by sales trends –Choice of averaging period impacts turnover and DSO v Increasing sales tends to: –improve aging schedules –worsen DSO and turnover

Copyright  1998 by Harcourt Brace &Company Solution v Payment or Balance Fraction Approach

Copyright  1998 by Harcourt Brace &Company Collection Procedures v Typical collection effort –initial contact within 10 days of delinquency –then reminder letter followed by phone call –sales force notified –last resort, reference to collection agency/legal action v Collection agency –Phase 1 - computer generated collection letter, when accounts are 45 to 90 days past due –Phase 2 - commissioned collectors used v Companies tend to be more aggressive the larger the receivables balance v Companies understand the good-will tradeoff when selecting collection methods

Copyright  1998 by Harcourt Brace &Company International Credit Management v Credit policy analysis –lengthening terms increases exchange rate risk –also increases default risk –harder to get D&B reports –harder to get bank credit information v Modifying monitoring and collections –legal remedies for late payment or nonpayment differ by country

Copyright  1998 by Harcourt Brace &Company Summary v This chapter developed the framework for applying the NPV model to credit policy decisions v The NPV approach was applied to changes in credit standards, the credit period, cash discounts v Traditional monitoring tools include aging, DSO and receivables turnover v Improved monitoring measure –uncollected balance percentage –a reliable and unbiased measure of customer payment behavior v Collection procedures were reviewed v The chapter concluded with a look at benchmarking and the impact of foreign sales