LOS 6 Credit-Granting Decisions Learning Outcome Statements (LOS) identify information costs and the credit-granting decision understand the traditional approach in granting credit to marginal accounts understand the problems with the traditional approach define the uncertainty in credit-granting decisions understand credit limits

Introduction Credit granting decisions involves which of the selling firm’s credit applicants will be allowed to purchase goods and services on credit, and which will be required to pay cash. Since credit granting has economic value to buyers, the decision concerning which potential buyers can purchase on credit determines, to a large extent, the base of customers to which sales can be made. The size of the firm’s customer base is in turn an important determinant of the firm’s sales, cash flows, and value to shareholders. The outcomes of the firm’s credit granting decisions are sometimes called its credit standard policy.

Introduction The methods used to make these decisions are quite different from those used to make terms of sale decision. The difference arises from a divergence in the law that governs terms of sale and credit-granting decisions. For example, under the US antitrust statutes, the selling firm must grant the same terms of sale to all buying firms, if they grant credit to these firms. While the seller makes one terms of sale decision for all the customers purchasing a particular good or service, the firm may elect to make credit-granting decisions individually for each of the customers purchasing that good or service, if it seems optimal for the seller to consider each applicant individually.

Introduction The policies necessary for the proper management of credit granting are extremely important and need to be carefully formulated. Among the policy questions that must be addressed are: How much information should the firm collect on each credit applicant? What method of analysis should the seller use to determine which applicants should be granted credit? How many periods should be considered in evaluating the expected cash flows from selling to an applicant? How should the credit-related parameters of credit applicants be estimated?

The Decision to Grant Credit: Timing of Cash flow's 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 Q 0 X (P 0 - C 0 ) The expected cash flows of the credit strategy are:

The Decision to Grant Credit: Timing of Cash flow's

Now consider the same two policies, but only h% of our credit customers pay “In God we trust – everybody else pays cash.” Offering their customers credit. The only cash flow of the first strategy is Q 0 X (P 0 - C 0 ) The expected cash flows of the credit strategy are:

The Decision to Grant Credit: Timing of Cash flow's

Example of the Decision to Grant Credit A firm currently sells 1,000 items per month on a cash basis for $500 each, cost is $400. If they offered terms net 30, the marketing department believes that they could sell 1,300 items per month, price is $500, cost is $425. The collections department estimates that 5% of credit customers will default. The cost of capital is 10% per annum.

Example of the Decision to Grant Credit No creditNet 30 Quantity sold1,0001,300 Selling price$500 Unit cost$400$425 Probability of payment100%95% Credit period (in days)030 Discount rate p.a.10%

Example of the Decision to Grant Credit 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.

Futures sales and credit Decisions

Info Costs & the Credit-Granting Decision There is a list of sources of credit information, proceeding from the least costly to the most costly – The seller’s prior experience with the customer Credit agency ratings and reports Personal contact with the applicant’s bank and other creditors Analysis of the applicant’s financial statements Customer visit One important question in formulating credit-granting policies: which source of information should be used and how much information should be collected on credit applicants? The proper strategy for the collection of information in any decision situation revolves around the relative cost of the information versus the resulting cost of errors in decisions.

Credit Analysis Credit Information Financial Statements Credit Reports Banks Customer’s Payment History Credit Scoring: The traditional 5 C’s of credit Character Capacity Capital Collateral Conditions Some firms employ sophisticated statistical models.

Aging Schedule Age Account Amount % of Total value of A/R 0-10 days$50,00050% days25, days20,00020 Over 80 days5,000 5 $100, % If this firm a credit period of 60days, then 25% of accounts are late

Credit Granting to Marginal Accounts: Traditional Approach In the traditional approach to the credit-granting decision on marginal accounts, the credit analyst tries to assess the creditworthiness of the applicant. To perform this synthesis, it is useful to have some mechanism for organizing the information that has been collected. One such way of organizing this information is by characterizing the applicant along five dimensions, called Five C’s of Credit – (1) capital, (2) character, (3) collateral, (4) capacity, and (5) conditions.

Five C’s of Credit Capital – refers to an analysis of the applicant firm’s financial position – what are the applicant firm’s financial strengths or weaknesses? Character – the applicant must have both the funds to pay the debts and the willingness to pay the debts. Collateral – properties or assets that are offered to secure a loan or other credit. Collateral becomes subject to seizure on default. Capacity – management’s capacity to run the business and the applicant firm’s plant capacity. Conditions – economic conditions in the applicant’s industry and in the economy in general.

Problems with the Traditional Approach The traditional judgmental approach to credit-granting decisions on marginal accounts is very flexible. In the process of evaluation, the analyst can take into account any and all of the special features that may affect the desirability of the applicant as a customer. Set against this flexibility are several substantial disadvantages inherent in this decision methodology, such as 1. No analytic framework 2. No link to shareholder wealth maximization 3. No consistency to analysis 4. Difficult for the inexperienced analyst to execute

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. A score above 2.7 indicates good credit.

Credit Analysis: Multiple Discriminant Analysis Altman Z Score Formula

Credit Analysis: Multiple Discriminant 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?

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

Credit Limits: An Unanswered Question Up to this point, we have treated the credit-granting decision as dichotomous: the selling firm either granted credit to the applicant for the amount of the order or it did not. However, there is a third option: the seller may grant a limited amount of credit, called a credit line or a credit limit. In such a credit-granting system, the seller will specify a maximum amount of outstanding debt from each customer. If an additional order is placed so that the credit limit is exceeded, the order may be refused or the customer may be required to pay for prior orders so that this maximum is not violated.

Credit Limits: An Unanswered Question Credit limit is the maximum amount that a firm is willing to risk in an account. Credit limits helps the creditor in the following ways: It frees up valuable time for other credit management tasks It speeds up the sales process It reduces risk and improves collection activity and efforts It is an account monitoring tool Credit limits have also known to upset customers. Thus, the decision to communicate credit limits to your customers rests upon you. It has its advantages and disadvantages.

Issues to Consider When Setting Limits The strength/weakness of ‘product or service’ that is being sold The degree of ‘competition’ or ‘opportunities’ in the marketplace Whether you are a ‘secured’ or ‘unsecured’ creditor The financial strength of your customer The overall ‘margin’ that the product or service contributes to the bottom line The confidence that you have in your in-house ‘collection’ process The length of your terms to your customer because risk is directly proportional to the length of your terms

Methods of Setting Credit Limits Trade References Bank References Agency Credit Reports Payment Performance The Rating Financial Statements Past Performance Need Based

Credit Limits: An Unanswered Question In the following paragraphs, we discuss several cost and revenue items and possible reasons that limit the credit line, such as 1. Overbuying 2. Increase in production costs 3. Funds constraints 4. Changes in the firm’s systematic risk 5. Changes in the variance of the receivable portfolio 6. Agency problems 7. Credit limits and credit investigation