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CREDIT STANDARDS ∆RI = [∆S (1 – V) - ∆S bn] (1 – t) -k ∆I Where ∆RI = Change in residual income ∆S = increase in sales V = ratio of variables costs to sales bn = bad debt loss ratio on new sales t = corporate tax rate k = post tax cost of capital ∆t = increase in receivables investment.
CREDIT PERIOD∆S *ACP * V360 ∆S/360 = average daily change (increase) in sales. The divisor here can with equal justification be 365, rather than 360 ACP = average collection perid
CASH DISCOUNT ∆RI = [∆S (1 – V) - ∆DIS] (1 – t) + k∆I Where ∆S = Increase in sales V = ratio of variable cost to sales k = cost of capital ∆I = savings in receivables investment ∆DIS = increase in discount cost
COLLECTION EFFORT ∆RI = [∆S (1 – V) - ∆BD] (1 – t) + k∆I Where ∆RI = Change in residual income ∆S = Increase in sales V = ratio of variable cost to sales ∆BD = increase in bad debt cost t = tax rate k = cost of capital ∆I = savings in investment in receivables
Credit Evaluation Type I Error : A good customer misclassified as a poor credit risk. Type II Error: A bad customer misclassified as a good credit risk.
TRADITIONAL CREDITANALYSIS “Five C’s of credit”CharcterCapacityCapitalCollateralCondition Sources of informations about five cFinancial statementBank referencesExperiences of firm
Numerical Credit Scoring Identify factors relevant for credit evaluation Assign weights to these factors Rate the customer on various factors using suitable rating scale. Multiply weights with the rating scale. Add all score to get consumer rating index Based rating index classify customer Factor Facto Rating Factor r Score Past Payment Weigh 4 0.30 1.20 Net Profit t 0.20 4 0.80 Margin Rating 2.00 Index
Discriminant Analysis This technique is employed to construct better risk index. e.g. ABC company manufacture some product for industrial customer, they take two financial ratio into consideration, namely return on Equity and Current ratio. Current Ratio + + + + + + O O+ + O O O + O O O Return on Equity
CREDIT GRANTING DECISION P=Probability that customer pays his dues 1-P=The Probability that Customer can not Pays his dues. Revenue=Revenue from sale Cost =Cost of good sold
Formula P(Rev-cost)-(1-P)Cost Example ABC company is considering offering credit to a customer.the probability that customer would pay is 0.8 and the probability that customer would default is 0.2.The revenue from sale would be Rs 1200 and cost would be Rs.800Sol:- 0.8(1200-800)-0.2(800) = 160