Notes in Fin

CREDIT MANAGEMENT
Ross (2010) stated that when a firm sells goods and services, it can demand cash on or
before the delivery date or it can extend credit to customers and allow some delay in
payment.  Granting credit is making an investment in a customer, an investment tied to
the sale of a product or service. Why do firms grant credit? Not all do, but the practice is
extremely common.
The obvious reason is that offering credit is a way of stimulating sales. The costs
associated with granting credit are not trivial. First, there is the chance that the customer
will not pay. Second, the firm has to bear the costs of carrying the receivables. The
credit policy decision thus involves a trade-off between the benefits of increased sales
and the costs of granting credit.
If a firm decides to grant credit to its customers, then it must establish procedures for
extending credit and collecting. The firm will have to deal with the
following components of credit policy:
1. Terms of sale: The terms of sale establish how the firm proposes to sell its
goods and services. A basic decision is whether the firm will require cash or will
extend credit. If the firm does grant credit to a customer, the terms of sale will
specify the credit period, the cash discount and discount period, and
the type of credit instrument.
2. Credit analysis: In granting credit, a firm determines how much effort to expend
trying to distinguish between customers who will pay and customers who will not
pay. Firms use a number of devices and procedures to determine the probability
that customers will not pay.
3. Collecting policy: After credit has been granted, the firm has the potential
problem of collecting the cash, for which it must establish a collection policy.
The Cash Flows From Granting Credit
Source: Ross, et al. (2010). Fundamentals of Corporate Finance. (9th Edition). New
York, NY: McGraw-Hill Irwin. p. 621
The Investments in Receivables
The investment in accounts receivable for any firm depends on the amount of credit
sales and the average collection period. For example, if a fi rm’s average collection
period, ACP, is 30 days, then, at any given time, there will be 30 days’ worth of sales
outstanding. If credit sales run $1,000 per day, the firm’s accounts receivable will then
be equal to 30 days x $1,000 per day = $30,000, on average.
As our example illustrates, a firm’s receivables generally will be equal to its average
daily sales multiplied by its average collection period: AR= Average daily sales x ACP
Thus, a firm’s investment in accounts receivable depends on factors that influence
credit sales and collections.
Terms of the Sale
The terms of a sale are made up of three distinct elements:
1. The period for which credit is granted (the credit period).
2. The cash discount and the discount period.
3. The type of credit instrument.
The easiest way to understand the terms of sale is to consider an example. Terms such
as 2/10, net 60 are common. This means that customers have 60 days from the invoice
date to pay the full amount; however, if payment is made within 10 days, a 2 percent
cash discount can be taken.
For example:
A buyer who places an order for $1,000, and assume that the terms of the sale are
2/10, net 60. The buyer has the option of paying $1,000 x (1- .02) = $980 in 10 days, or
paying the full $1,000 in 60 days. If the terms are stated as just net 30, then the
customer has 30 days from the invoice date to pay the entire $1,000, and no discount is
offered for early payment.
The Credit Period
The credit period is the basic length of time for which credit is granted. The credit
period varies widely from industry to industry, but it is almost always between 30 and
120 days. If a cash discount is offered, then the credit period has two components:
the net credit period and the cash discount period.
The net credit period is the length of time the customer has to pay. The cash discount
period is the time during which the discount is available. With 2/10, net 30, for example,
the net credit period is 30 days and the cash discount period is 10 days.
The Invoice Date is the beginning of the credit period. An invoice is a written account of
merchandise shipped to the buyer. For individual items, by convention, the invoice date
is usually the shipping date or the billing date, not the date on which the buyer receives
the goods or the bill.
ROG or receipts of goods. The credit period starts when the customer receives the
order. This might be used when the customer is in a remote location.
EOM or end of the month. All sales made during a particular month are assumed to be
made at the end of that month. This is useful when a buyer makes purchases
throughout the month, but the seller bills only once a month.
There are factors that influence the credit period. Many of these also influence our
customer’s operating cycles.
1. Perishability and collateral value: Perishable items have relatively rapid
turnover and relatively low collateral value. Credit periods are thus shorter for
such goods. For example, a food wholesaler selling fresh fruit and produce might
use net seven days. Alternatively, jewelry might be sold for 5/30, net four months.
2. Consumer demand: Products that are well established generally have more
rapid turnover. Newer or slow-moving products will often have longer credit
periods associated with them to entice buyers. Also, as we have seen, sellers
may choose to extend much longer credit periods for off-season sales (when
customer demand is low).
3. Cost, profitability, and standardization: Relatively inexpensive goods tend to
have shorter credit periods. The same is true for relatively standardized goods
and raw materials. These all tend to have lower markups and higher turnover
rates, both of which lead to shorter credit periods. However, there are
exceptions. Auto dealers, for example, generally pay for cars as they are
received.
4. Credit risk: The greater the credit risk of the buyer, the shorter the credit period
is likely to be (if credit is granted at all).
5. Size of the account: If an account is small, the credit period may be shorter
because small accounts cost more to manage, and the customers are less
important.
6. Competition: When the seller is in a highly competitive market, longer credit
periods may be offered as a way of attracting customers.
7. Customer type: A single seller might offer different credit terms to different
buyers. A food wholesaler, for example, might supply groceries, bakeries, and
restaurants. Each group would probably have different credit terms.
Cash discounts are often part of the terms of sale. One reason the discounts are
offered is to speed up the collection of receivables. This will have the effect of reducing
the amount of credit being offered, and the firm must trade this off against the cost of
the discount.
Cost of the Credit
To see why the discount is important, we will calculate the cost to the buyer of not
paying early. To do this, we will find the interest rate that the buyer is effectively paying
for the trade credit. Suppose the order is for $1,000. The buyer can pay $980 in 10 days
or wait another 20 days and pay $1,000. It is obvious that the buyer is effectively
borrowing $980 for 20 days and that the buyer pays $20 in interest on the “loan.” What
is the interest rate?
This interest is ordinary discount interest. With $20 in interest on $980 borrowed, the
rate is $20/980=2.0408%. This is relatively low but remember that this is the rate per 20-
day period. There are 365/20 = 18.25 such periods in a year, so, by not taking the
discount, the buyer is paying an effective annual rate (EAR) of:
EAR = (1+r)t - 1
EAR = 1.02040818.25 - 1 = 44.6%
From the buyer’s point of view, this is an expensive source of financing. Given that the
interest rate is so high here, it is unlikely that the seller benefits from early payment.
Ignoring the possibility of default by the buyer, the decision of a customer to forgo the
discount almost surely works to the seller’s advantage.
Credit Instruments
The credit instrument is the basic evidence of indebtedness. Most trade credit is offered
on an open account. This means that the only formal instrument of credit is the invoice,
which is sent with the shipment of goods and which the customer signs as evidence that
the goods have been received. Afterward, the firm and its customers record the
exchange on their books of account.