Credit management

Credit Management
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Session Outline
• Receivables
• Receivables Management
• Factors Determining Credit Policy
• Credit Evaluation
• Financing of Receivables
• Control of Receivables
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Receivables
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• It Involves an Element of
Risk
• Cash Payment will be
made in future
• Increase Sales
• Strategy to face
competition
• Cost of Financing
• Administrative Cost
• Collection Costs
• Cost of default
Characteristics Objectives Cost of Maintaining
• It is amount/Debt which is receivable for the goods or Services provided on Credit
• Also known as Trade, Debtors, Sundry Debtors, Trade, Receivables, Book Debts

Receivables Management
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Maintain Receivables at a level at which there is a trade-off between Profitability &
Cost
• Determining the Level of
Credit Sales
• Determining of the Credit
Standards
• Determining of the Credit
Terms
• Rate of cash discount
This requires the finance
manager to determine as to
how risky it is to
advance credit to a particular
party.
This requires finance
manager to follow up
debtors and decide
about a suitable credit
collection policy. It involves
both laying down of credit
policies
and execution of such
policies.
Credit Policy Credit Analysis Control of Receivables

Factors Determining Credit Policy
• The effect of credit on the volume of sales;
• Credit terms;
• Cash discount;
• Policies and practices of the firm for selecting credit
customers.
• Paying practices and habits of the customers.
• The firm’s policy and practice of collection.
• The degree of operating efficiency in the billing, record
keeping and adjustment function,
• other costs such as interest, collection costs and bad debts
etc.
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Illustration
XYZ Corporation is considering relaxing its present credit policy and is in the process
of evaluating two proposed policies. Currently, the firm has annual credit sales of `
50 lakhs and accounts receivable turnover ratio of 4 times a year. The current level of
loss due to bad debts is ` 1,50,000. The firm is required to give a return of 25% on
the investment in new accounts receivables. The company’s variable costs are 70% of
the selling price. Given the following information, which is the better option?
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Illustration
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Five C’s of Credit Analysis
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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 customer

Numerical Credit Rating Index
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Factor Factor Rating Factor
weight 5 4 3 2 1 score
Past payment 0.30 √ 1.20
Net profit margin 0.20 √ 0.80
Current ratio 0.20 √ 0.60
Debt-equity ratio 0.10 √ 0.40
Return on equity 0.20 √ 1.00
Rating index 4.00

Risk Classification Scheme
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Risk Class Description
1 Customers with no risk of default
2 Customers with negligible risk of default (default rate less
than 2 percent)
3 Customers with little risk of default (default rate between 2
percent and 5 percent)
4 Customers with some risk of default (default rate between 5
percent and 10 percent)
5 Customers with significant risk of default (default rate in
excess of 10 percent)

Decision Tree Analysis
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Rev – Cost
– Cost
p (Revenue – Cost) – (1 – p) Cost

Illustration
ABC Company is considering offering 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 offering credit, given the
above information, is:
0.8 (1,200 – 800) – 0.2 (800) = Rs.160
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Errors in Credit Evaluation
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
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Financing Receivables
• Pledging: This refers to the use of a firm’s receivable to secure
a short term loan. A firm’s receivables can be termed as its
most liquid assets and this serve as prime collateral for a
secured loan.
• Factoring: Factoring refers to out right sale of accounts
receivables to a factor or a financial agency.
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Control of Receivables
• Days’ Sales Outstanding
• Ageing Schedule
• Collection Matrix
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Collection Matrix
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% of Receivables January February March April May June
Collected During the Sales Sales Sales Sales Sales
Month of sales 13 14 15 12 10 9
First following month 42 35 40 40 36 35
Second following month 33 40 21 24 26 26
Third following month 12 11 24 19 24 25
Fourth following month - - - 5 4 5

Illustration
Mosaic Limited has current sales of ` 15 lakh per year. Cost of sales is
75 per cent of sales and bad debts are one per cent of sales. Cost of
sales comprises 80 per cent variable costs and 20 per cent fixed costs,
while the company’s required rate of return is 12 per cent. Mosaic
Limited currently allows customers 30 days’ credit, but is considering
increasing this to 60 days’ credit in order to increase sales.
It has been estimated that this change in policy will increase sales by
15 per cent, while bad debts will increase from one per cent to four
per cent. It is not expected that the policy change will result in an
increase in fixed costs and creditors and stock will be unchanged.
Should Mosaic Limited introduce the proposed policy?
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Illustration
• New level of sales will be 15,00,000×1.15 = ` 17,25,000
• Variable costs are 80% ×75% = 60% of sales
• Contribution from sales is therefore 40% of sales
x 60% (11,540)
24,460

Summary
• The important dimensions of a firm’s credit policy are :
credit standards, credit period, cash discount, and
collection effort
• In general, liberal credit standards tend to push sales
up by attracting more customers. However, this is
accompanied by a higher incidence of bad debt loss, a
larger investment in receivables, and a higher cost of
collection. Stiff credit standards have opposite effects.
• Three broad approaches are used for credit evaluation
: traditional credit analysis, numerical credit scoring
risk classification.

Summary
• The traditional approach to credit analysis calls for
assessing a prospective customer in terms of the five Cs
of credit, viz. character, capacity, capital, collateral, and
conditions.
• Three methods are commonly employed for monitoring
accounts receivable : days’ sales outstanding, ageing
schedule, and collection matrix.
20

Credit management

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