A/R
Order Placed
Payment Sent Cash Received Accounts Collection < Receivable > < Float >
Sale
Time ==>
Accounts < Payable > Disbursement < Float >
Invoice Received
Learning Objectives
Define credit policy and indicate its components. Describe the typical credit-granting sequence. Apply net present value analysis to credit extension decisions. Define credit scoring and explain limitations. List the elements in a credit rating report. Describe how receivables management can benefit from EDI (Electronic Data Interchange).
Over-investing in receivables can be costly ...but, if credit terms are not competitive, then lost sales can be costly
Conclusion
Minimize bad debts and outstanding receivables Maintain financial flexibility Optimize mix of company assets Convert receivables to cash in a timely manner Analyze customer risk Respond to customer needs
Credit Terms
Credit Standards
Length of terms
TC: Short, Usually < 90 days BC: Longer and may be repaid on a seasonal basis
Security
TC: Unsecured BC: Usually secured, relatively high standards if not
Amounts involved
TC: Small BC: Larger
Extent of analysis
TC: Varies with exposure BC: Usually more in-depth
Financial Motive
Potential of getting a higher price Sellers raise capital at lower rates than customers and have cost advantages vis-a-vis banks due to:
similarity of customers the information gathered in the selling process lower probability of default (the goods purchased are an essential element of the buyers business) seller can more easily resell product if payment is not made.
Operating Motive
Respond to variable and uncertain demand Change credit terms rather than:
install extra capacity, building or depleting inventories, or forcing customers to wait.
Pricing Motive
Credit investigation
Time
Financial analysis
Copyright 2005 by Thomson Learning, Inc.
S - EXP(S) NPV = ----------------- - VCR(S) 1 + iCP Where: NPV = net present value of the credit sale VCR = variable cost ratio (per $ of sale) S = dollar amount of credit sale EXP = credit administration and collection expense ratio (per $ of sale) i = daily interest rate CP = collection period for sale (days)
Copyright 2005 by Thomson Learning, Inc.
Credit terms
credit period cash discount
Credit limit
maximum dollar level of credit balances
Collection procedures
how long to wait past due date to initiate collection efforts methods of contact whether and at what point to refer account to collection agency
Credit-Granting Decision
Development of credit standards Gathering necessary information Credit analysis: applying credit standards Risk analysis
Grant-Granting Sequence
Order and credit request received New/increased credit limit Yes Size of proposed credit limit Large Indepth credit invest. Medium Moderate credit invest. Small No Yes Material change in customer status No
No
Minimal credit invest. Extend Credit Yes Set up,post A/R, ship
Copyright 2005 by Thomson Learning, Inc.
Credit Standards
Gathering Information
credit reporting agencies, e.g.. Dun & Bradstreet credit interchange bureaus, NACM (National Association of Credit Management) bank letters references from other suppliers financial statements field data gathered by sales reps
Non-financial
concerned with willingness to pay, character
Financial
ability to pay, financial ratios etc.. (other Cs of credit)
Risk analysis
Use Expected NPV (see page 169)
Example of decision rule: If gross income is equal to or grater than $20,000 and the applicant has not been delinquent and gross income per household member is equal to or greater than $12,000 and debt/equity ratio is equal to or greater than 30% but less than 50% and personal property is equal to or greater than $50,000, then grant credit.
Cash Discounts
The lower the VC, the higher the feasible discount Based on companys cost of funds Consider timing effect when changing discounts Should be based on products price elasticity Higher the bad debt experience, higher the optimal discount
Seller may also issues electronic invoices and be paid electronically using an EDI-capable bank so that remittance data can be automatically read by sellers A/R system Trend is for use of data transmission to automate the cash application process
Summary
Investment in A/R represents a significant investment. Key aspects outlined
credit policy credit standards credit granting sequence credit limits credit terms
Management of A/R is influenced by what competitors are doing not by shareholder wealth considerations. Proper use of NPV techniques can ensure that credit decisions enhance shareholder value.
Copyright 2005 by Thomson Learning, Inc.