TERMS OF PAYMENT

Cash Terms
Open Account
Consignment
Bill of Exchange
Letter of Credit

CREDIT POLICY VARIABLES

The important dimensions of a firms
credit policy are:
Credit standards
Credit period
Cash discount
Collection effort

CREDIT STANDARDS
Liberal
Sales

Stif

Higher

Bad debt loss

Higher

Investment
in receivables

Larger

Collection costs

Higher

Lower
Lower
Smaller
Lower

IMPACT ON RESIDUAL INCOME

OF Credit Standard
RELAXATION
RI = [S(1 V) - Sbn] (1 t ) k I
where RI = change in residual income
S = increase in sales
V

= ratio of variable costs to sales

bn = bad debt loss ratio on new sales

t
k
I

= corporate tax rate

= Post tax cost of capital
= increase in receivables investment

EXAMPLE
Pioneer Limited is considering relaxing its credit
standards.
S = Rs.15 million, bn = 0.10, V = 0.80,
ACP = 40 days, k = 0.10, t = 0.4
RI = [15,000,000 (1 0.80) 15,000,000 x 0.10] (1
0.4)
15,000,000
0.10 x
360
= Rs.766,667

x 40 x 0.80

CREDIT PERIOD
Longer
Sales
Investment in

Shorter

Higher
Larger

Lower
Smaller

receivables
Bad debts

Higher

Lower

IMPACT ON RESIDUAL
INCOME OF
LONGER CREDIT PERIOD

RI = [S(1 V) - Sbn] (1 t ) k I

INCREASE IN RECEIVABLES
INVESTMENT
S0
I = (ACPn ACP0)
360
I

where:

S
+ V (ACPn)
360

= increase in receivables investment

ACPn = new average collection period (after lengthening

the credit period)
ACP0 = old average collection period
V

= ratio of variable cost to sales

= increase in sales

EXAMPLE
Zenith Limited is considering extending its
credit period from 30 to 60 days.
S = Rs.50 million, S = Rs.5 million, V =
0.85, bn = 0.08, k = 0.10, t = 0.40
RI = [5,000,000 x 0.15 5,000,000 x 0.08] (0.6)
0.10 (60 30) x

+ 0.85 x 60 x

50,000,000
5,000,000
360
360
= [750,000 400,000] (0.6) 0.10 [4,166,667 + 708,333]

= 277,500

LIBERALISING THE CASH

DISCOUNT POLICY

RI = [S(1 V) - DIS] (1 t ) + k I

DECREASING THE RIGOUR

OF COLLECTION PROGRAMME

RI = [S(1 V) - DISs] (1 t ) k I

ERRORS IN CREDIT EVALUATION

In assessing credit risks, two types
of errors occur :
Type I error
A good customer is
misclassified as a
poor credit
risk
Type II error
A bad customer is
misclassified as a
good credit risk

TRADITIONAL CREDIT ANALYSIS

Five Cs of Credit
Character : The willingness of the
customer to honour
his
obligations
Capacity

: The operating cash flows of the

customer
Capital

: The financial reserves of the

customer
Collateral

: The security offered by the

customer
Conditions : The general economic
conditions that
affect the

NUMERICAL CREDIT RATING INDEX

( CREDIT SCORING)

RISK CLASSIFICATION SCHEME

CREDIT GRANTING DECISION

Expected Pre-tax Profit
p (Revenue Cost) (1 p) Cost

rp
e
m

r
e
f

i
d
e
cr

O
Ref
use

ays

Rev Cost

to
s
u
C
p
Custom
er defa
ults
Cost
(1 p
)

c re
dit

EXAMPLE
ABC Company is considering ofering credit
to a customer. The probability that the
customer would pay is 0.8 and the
probability that the customer would default
is 0.2. The revenues from the sale would be
Rs.1,200 and the cost of sale would be
Rs.800.
The expected profit from ofering credit,
given the above information, is:
0.8 (1,200 800) 0.2 (800) = Rs.160

CONTROL OF ACCOUNTS
RECEIVABLES
Days Sales Outstanding
Ageing Schedule
Collection Matrix

COLLECTION MATRIX