# Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 31
CREDIT POLICY
In this hand out we shall discuss the following topics:
Cash discounts
o  Cost of discount
o  Shortening average collection period
Credit instrument
Analyzing credit policy
o  Revenue effect
o  Cost effect
o  Cost of debt
o  Probability of default
Evaluating client worthiness
Optimal credit policy
Collection policy
One Example of debtors management
Cash Discounts:
Cash discounts are offered by the seller to buyer in order to improve its operating cycle and this involves
some cost ­ that is the discount cost of receiving early payment. This discount is conditional subject to
payment within a stipulated period of time which is generally much shorter than normal credit period.
For example, term of "3/10, net 45" means that discount of 3% is available only if the payment is received
within first ten days of delivering goods otherwise, full invoice value will be payable by the debtor on 45th
day.
There's a cost of credit for seller. By availing a discount for early payment the buyer is often not in a
position to ignore the cash discount.
Let's see cost of discount to seller with the help of an example.
For example, the sale terms are 2/10 net 30 for a transaction in the amount of Rs. 100,000/-.
If buyer gives up discount, he pays Rs. 100,000/- on 30th day, and will loose Rs. 2,000/- (100,000 x 2%).
Look, foregoing Rs 2,000/- may look small but let's annualize it and express it in %age:
2,000/98,000 = 0.020408
Note this is for 20 days.
For computing the loss of not taking discount on annual basis,
We will have 365/20 = 18.25 - 20-days period in one year.
Effective annual rate (EAR) = (1.020408)18.25 = 44.58%
This is only for Rs 2000 on Rs 100,000/-. You can well imagine the business activity that runs in million of
rupees.
Discounts also, for seller, shorten the average collection period (ACP).
Shortening ACP:
A firm has 30 days collection period and it is offering terms of 2/10, net 30 and estimates that around 50%
customers will avail this opportunity by paying within 10 days. Remaining 50% will pay after 30 days. Now
the ACP will be as follows:
50% x 10 days + 50% x 30 days = 20 days
If average sales are rs.2 million per month, then receivable Rs 2 million x 1/3 = 666,666.00
Credit Instrument
The formal evidence of indebtedness is invoice or dispatch note.
When seller is supposed to dispatch goods invoice may or may not accompany goods, but may accompany a
dispatch note on which buyer acknowledges the receipt of goods upon arrival at buyer's premises.
Analyzing Credit Policy:
When a firm allows credit to its customers there are some effects that should be considered.
First, allowing credit to customers means that the revenues to the firm will be delayed. A firm may charge
higher prices to the customers for allowing them on credit and this will result in increased sales. Total
revenues may increase but still the company will receive it late.
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Corporate Finance ­FIN 622
VU
Secondly, if the company allows credit to customers and then offers cash discounts for early payment from
debtors it will incur cost of discount. In other words, it is reducing its profits.
After allowing credit to parties the firm must arrange some loans to finance its short term operations. Such
finances do carry a handsome interest rate and this need to be considered.
Increasing sales by allowing generous credit to customers also increased the probability of default and thus
Evaluating client worthiness:
A firm who is in process of granting credit to the customers should also consider the business character of
the customer. There are several ways that could guide the business as far as the credit worthiness of the
client and help decide whether to extend credit or not.
The following methods to evaluate the credit worthiness are widely used in business:
Financial statements of vendor
Market reputation
Banks
Previous payment record
Financial strength
Capacity
General economic conditions in vendors industry
We have discussed the credit policy and the question arises here that what should be the optimal credit
policy?
The trade off between allowing credit or not is a matter which we cannot quantify exactly. We can only
outline a optimal credit policy. Thus far, we have identified the following costs associated with granting
credit to the customers:
a) The return on receivables
b) The losses from customers' default ­ bad debts
c) The collection and credit management cost
If a firm has very rigid credit policy then the cost associated will be low. Resultantly, there will be shortage
of credit (extended to customers) and the cost will incur in terms of opportunity cost. This opportunity cost
is the extra profit from sales due to the fact that credit was declined. (One way of increasing return is to
allow credit to customers or also called investment in debtors). This cost is reduced as credit period is
increased.
Optimal Credit Level
Total Cost
Carrying Cost
Opportunity
Cost
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Corporate Finance ­FIN 622
VU
The total of carrying cost and the opportunity cost of credit policy is called the total credit cost curve. There
is a point on the total cost curve where the total credit cost curve is minimized. This point corresponds to
the optimal amount of credit or investment in receivables.
If the firm extends more credit than the minimum level the additional net cash flow from new customers
will not cover the carrying costs of the investment in receivables. If the level of receivables is below this
limit then the firm is forgoing profit opportunities.
In general the cost and benefits from extending credit will depend on the characteristics of particular firms
and industries. For example, it is likely that firms with excess capacity, lower operational costs and repeat
customers will extend credit more than other firms.
Collection Policy:
This is the last item in designing credit policy. This phase encompasses:
·
The company must keep track of average collection period (ACP). The monitoring of ACP will
also consider seasonal effects.
·
Aging schedule: a compilation of accounts receivable by the age of each account.
·
Collection effort for overdue or delinquent accounts.
To keep track of payment by customers most firms will monitor outstanding accounts. The ACP should not
be more than allowed to individual customers. However, the seasonal effects should also be considered
while monitoring the ACP. In seasonal times ACP will fluctuate but there should not be abnormal increase
in average period.
To monitor the un-wanted stretches in ACP, the firm can use the aging analysis. Under this analysis, each
customer receivable age is determined using the invoice date or processing date. Normally, the age is
determined in three or four categories set up on time basis. For example, if a customer account shows a
debit balance of Rs. 550,000/- on any specific date it can be broken down on aging basis like as follows:
Days
0 ­ 30
31- 60
61 ­ 90 > 90
75,000
150,000
200,000 125,000
If the firm in above example allows 60 days credit to this customer, then you can calculate that Rs.
325,000/- (sum of last two columns) is delinquent or overdue amount, which has a definite cost. This type
of analysis helps identify the overdue accounts and then efforts are directed to recover such amounts.
Collection effort is not just limited to send a letter or calling the client but there are some sensitive points
involved. A situation where a customer is source of substantial source of sales or a major client and loss of
which would be colossal, then it would be in firms interest not to press for recovery even if it over due.
However, the recovery process should be handled by the sales team and there must be sense of strong
relationship with the client. For normal clients we can use reminder, phone or send a representative for
quick collection.
In extreme circumstances, the company has to refuse additional supplies until the previous balance is paid
or even a legal action can be initiated for recovery. But it should be noted that there's a significant legal cost
involved in litigation.
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