Credit management

Credit Management

1

www.pace2race.com

Put your queries on www.financeclubb.com

Session Outline • Receivables

• Receivables Management

• Factors Determining Credit Policy

• Credit Evaluation

• Financing of Receivables

• Control of Receivables

2


Receivables

3

• 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

4

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.

5


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?

6


Illustration

7


Five C’s of Credit Analysis

8

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

9

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

10

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

11

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

12


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

13


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.

14


Control of Receivables

• Days’ Sales Outstanding

• Ageing Schedule

• Collection Matrix

15


Collection Matrix

16

% 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?

17


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