Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default

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Corporate Finance FIN 622

Lesson 31

CREDIT POLICY

In this hand out we shall discuss the following topics:

Cash discounts

o Cost of discount

o Shortening average collection period

Credit instrument

Analyzing credit policy

o Revenue effect

o Cost effect

o Cost of debt

o Probability of default

Evaluating client worthiness

Optimal credit policy

Collection policy

One Example of debtors management

Cash Discounts:

Cash discounts are offered by the seller to buyer in order to improve its operating cycle and this involves

some cost that is the discount cost of receiving early payment. This discount is conditional subject to

payment within a stipulated period of time which is generally much shorter than normal credit period.

For example, term of "3/10, net 45" means that discount of 3% is available only if the payment is received

within first ten days of delivering goods otherwise, full invoice value will be payable by the debtor on 45th

day.

There's a cost of credit for seller. By availing a discount for early payment the buyer is often not in a

position to ignore the cash discount.

Let's see cost of discount to seller with the help of an example.

For example, the sale terms are 2/10 net 30 for a transaction in the amount of Rs. 100,000/-.

If buyer gives up discount, he pays Rs. 100,000/- on 30th day, and will loose Rs. 2,000/- (100,000 x 2%).

Look, foregoing Rs 2,000/- may look small but let's annualize it and express it in %age:

2,000/98,000 = 0.020408

Note this is for 20 days.

For computing the loss of not taking discount on annual basis,

We will have 365/20 = 18.25 - 20-days period in one year.

Effective annual rate (EAR) = (1.020408)18.25 = 44.58%

This is only for Rs 2000 on Rs 100,000/-. You can well imagine the business activity that runs in million of

rupees.

Discounts also, for seller, shorten the average collection period (ACP).

Shortening ACP:

A firm has 30 days collection period and it is offering terms of 2/10, net 30 and estimates that around 50%

customers will avail this opportunity by paying within 10 days. Remaining 50% will pay after 30 days. Now

the ACP will be as follows:

50% x 10 days + 50% x 30 days = 20 days

If average sales are rs.2 million per month, then receivable Rs 2 million x 1/3 = 666,666.00

Credit Instrument

The formal evidence of indebtedness is invoice or dispatch note.

When seller is supposed to dispatch goods invoice may or may not accompany goods, but may accompany a

dispatch note on which buyer acknowledges the receipt of goods upon arrival at buyer's premises.

Analyzing Credit Policy:

When a firm allows credit to its customers there are some effects that should be considered.

First, allowing credit to customers means that the revenues to the firm will be delayed. A firm may charge

higher prices to the customers for allowing them on credit and this will result in increased sales. Total

revenues may increase but still the company will receive it late.

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Corporate Finance FIN 622

Secondly, if the company allows credit to customers and then offers cash discounts for early payment from

debtors it will incur cost of discount. In other words, it is reducing its profits.

After allowing credit to parties the firm must arrange some loans to finance its short term operations. Such

finances do carry a handsome interest rate and this need to be considered.

Increasing sales by allowing generous credit to customers also increased the probability of default and thus

may incur bad debts.

Evaluating client worthiness:

A firm who is in process of granting credit to the customers should also consider the business character of

the customer. There are several ways that could guide the business as far as the credit worthiness of the

client and help decide whether to extend credit or not.

The following methods to evaluate the credit worthiness are widely used in business:

Financial statements of vendor

Market reputation

Banks

Previous payment record

Financial strength

Capacity

General economic conditions in vendors industry

We have discussed the credit policy and the question arises here that what should be the optimal credit

policy?

The trade off between allowing credit or not is a matter which we cannot quantify exactly. We can only

outline a optimal credit policy. Thus far, we have identified the following costs associated with granting

credit to the customers:

a) The return on receivables

b) The losses from customers' default bad debts

c) The collection and credit management cost

If a firm has very rigid credit policy then the cost associated will be low. Resultantly, there will be shortage

of credit (extended to customers) and the cost will incur in terms of opportunity cost. This opportunity cost

is the extra profit from sales due to the fact that credit was declined. (One way of increasing return is to

allow credit to customers or also called investment in debtors). This cost is reduced as credit period is

increased.

Optimal Credit Level

Total Cost

Carrying Cost

Opportunity

Cost

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Corporate Finance FIN 622

The total of carrying cost and the opportunity cost of credit policy is called the total credit cost curve. There

is a point on the total cost curve where the total credit cost curve is minimized. This point corresponds to

the optimal amount of credit or investment in receivables.

If the firm extends more credit than the minimum level the additional net cash flow from new customers

will not cover the carrying costs of the investment in receivables. If the level of receivables is below this

limit then the firm is forgoing profit opportunities.

In general the cost and benefits from extending credit will depend on the characteristics of particular firms

and industries. For example, it is likely that firms with excess capacity, lower operational costs and repeat

customers will extend credit more than other firms.

Collection Policy:

This is the last item in designing credit policy. This phase encompasses:

The company must keep track of average collection period (ACP). The monitoring of ACP will

also consider seasonal effects.

Aging schedule: a compilation of accounts receivable by the age of each account.

Collection effort for overdue or delinquent accounts.

To keep track of payment by customers most firms will monitor outstanding accounts. The ACP should not

be more than allowed to individual customers. However, the seasonal effects should also be considered

while monitoring the ACP. In seasonal times ACP will fluctuate but there should not be abnormal increase

in average period.

To monitor the un-wanted stretches in ACP, the firm can use the aging analysis. Under this analysis, each

customer receivable age is determined using the invoice date or processing date. Normally, the age is

determined in three or four categories set up on time basis. For example, if a customer account shows a

debit balance of Rs. 550,000/- on any specific date it can be broken down on aging basis like as follows:

Days

0 30

31- 60

61 90 > 90

75,000

150,000

200,000 125,000

If the firm in above example allows 60 days credit to this customer, then you can calculate that Rs.

325,000/- (sum of last two columns) is delinquent or overdue amount, which has a definite cost. This type

of analysis helps identify the overdue accounts and then efforts are directed to recover such amounts.

Collection effort is not just limited to send a letter or calling the client but there are some sensitive points

involved. A situation where a customer is source of substantial source of sales or a major client and loss of

which would be colossal, then it would be in firms interest not to press for recovery even if it over due.

However, the recovery process should be handled by the sales team and there must be sense of strong

relationship with the client. For normal clients we can use reminder, phone or send a representative for

quick collection.

In extreme circumstances, the company has to refuse additional supplies until the previous balance is paid

or even a legal action can be initiated for recovery. But it should be noted that there's a significant legal cost

involved in litigation.

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