Copyright 1998 by Harcourt Brace &Company Chapter 6 Credit Policy and Collections Order Order Sale...

Copyright Copyright 1998 by Harcourt Brace &Company 1998 by Harcourt Brace &Company

Chapter 6Chapter 6Credit Policy and CollectionsCredit Policy and Collections

OrderOrder Order Order Sale Sale Cash Cash PlacedPlaced Received Received Received Received AccountsAccounts Collection Collection < Inventory > < < Inventory > < ReceivableReceivable > < Float > > < Float >

Time ==>Time ==> Accounts Disbursement Accounts Disbursement

< Payable > < Float >< Payable > < Float > Invoice Invoice Payment Payment CashCash Received Sent PaidReceived Sent Paid

OrderOrder Order Order Sale Sale Cash Cash PlacedPlaced Received Received Received Received AccountsAccounts Collection Collection < Inventory > < < Inventory > < ReceivableReceivable > < Float > > < Float >

Time ==>Time ==> Accounts Disbursement Accounts Disbursement

< Payable > < Float >< Payable > < Float > Invoice Invoice Payment Payment CashCash Received Sent PaidReceived Sent Paid


ObjectivesObjectives

Specify advantages of NPV in evaluating credit policy Specify advantages of NPV in evaluating credit policy alternativesalternatives

Calculate the NPV of alternative credit policies and Calculate the NPV of alternative credit policies and select the best policyselect the best policy

Identify the 3 major traditional measures of collection Identify the 3 major traditional measures of collection patterns, calculate them, and understand their flawspatterns, calculate them, and understand their flaws

Calculate and interpret uncollected balance Calculate and interpret uncollected balance percentages and relate to traditional measurespercentages and relate to traditional measures

Describe present corporate credit policy practicesDescribe present corporate credit policy practices List and explain the major differences encountered List and explain the major differences encountered

when extending credit internationallywhen extending credit internationally


Evaluate Changes in Credit PolicyEvaluate Changes in Credit Policy

Credit term change decision variablesCredit term change decision variables– effect on dollar profitseffect on dollar profits

– sales effectsales effect

– receivables effectreceivables effect

– return on investment effectreturn on investment effect

84% can estimate:84% can estimate:– default probabilitydefault probability

– credit limitscredit limits

– opportunity cost of funds invested in receivablesopportunity cost of funds invested in receivables

– company’s overall cost of capitalcompany’s overall cost of capital


Incremental Profit vs NPVIncremental Profit vs NPV

Financial statement approachFinancial statement approach NPV approachNPV approach


Changing Credit Terms, EQ 6.1Changing Credit Terms, EQ 6.1

ZZNN = =

[(1+g)S[(1+g)SEE](1-d](1-dNN)P)PNN(1-b(1-bNN) / (1 + iDP) / (1 + iDPNN)) PV discount pmtsPV discount pmts

+ [(1+g)S+ [(1+g)SEE](1-P](1-PNN)(1-b)(1-bNN) / (1 + iCP) / (1 + iCPNN)) PV non-discount pmtsPV non-discount pmts

- VCR [(1+g)S- VCR [(1+g)SEE]] PV variable cost pmtsPV variable cost pmts

- EXP- EXPNN[(1+g)S[(1+g)SEE] / (1 + iCP] / (1 + iCPNN)) PV credit expense pmtsPV credit expense pmts

ZZNN = =

[(1+g)S[(1+g)SEE](1-d](1-dNN)P)PNN(1-b(1-bNN) / (1 + iDP) / (1 + iDPNN)) PV discount pmtsPV discount pmts

+ [(1+g)S+ [(1+g)SEE](1-P](1-PNN)(1-b)(1-bNN) / (1 + iCP) / (1 + iCPNN)) PV non-discount pmtsPV non-discount pmts

- VCR [(1+g)S- VCR [(1+g)SEE]] PV variable cost pmtsPV variable cost pmts

- EXP- EXPNN[(1+g)S[(1+g)SEE] / (1 + iCP] / (1 + iCPNN)) PV credit expense pmtsPV credit expense pmts


Changing Credit Terms, EQ 6.2Changing Credit Terms, EQ 6.2

ZZEE = =

SSEE(1-d(1-dEE)P)PEE(1-b(1-bEE) / (1 + iDP) / (1 + iDPEE)) PV discount pmtsPV discount pmts

+ S+ SEE(1-P(1-PEE)(1-b)(1-bEE) / (1 + iCP) / (1 + iCPEE)) PV non-discount pmtsPV non-discount pmts

- VCR (S- VCR (SEE)) PV variable cost pmtsPV variable cost pmts

- EXP- EXPEE S SEE / (1 + iCP / (1 + iCPEE)) PV credit expense pmtsPV credit expense pmts

ZZEE = =

SSEE(1-d(1-dEE)P)PEE(1-b(1-bEE) / (1 + iDP) / (1 + iDPEE)) PV discount pmtsPV discount pmts

+ S+ SEE(1-P(1-PEE)(1-b)(1-bEE) / (1 + iCP) / (1 + iCPEE)) PV non-discount pmtsPV non-discount pmts

- VCR (S- VCR (SEE)) PV variable cost pmtsPV variable cost pmts

- EXP- EXPEE S SEE / (1 + iCP / (1 + iCPEE)) PV credit expense pmtsPV credit expense pmts


Changing Credit Terms, EQ 6.3, Changing Credit Terms, EQ 6.3, 6.46.4

EQ 6.3 EQ 6.3 Z = ZZ = ZNN - Z - ZEE

Decision Rule:Decision Rule:

IF IF Z > 0 then Accept policy changeZ > 0 then Accept policy change

IF IF Z < 0 then Reject policy changeZ < 0 then Reject policy change

EQ 6.4 EQ 6.4 NPV = NPV = Z / iZ / i

EQ 6.3 EQ 6.3 Z = ZZ = ZNN - Z - ZEE

Decision Rule:Decision Rule:

IF IF Z > 0 then Accept policy changeZ > 0 then Accept policy change

IF IF Z < 0 then Reject policy changeZ < 0 then Reject policy change

EQ 6.4 EQ 6.4 NPV = NPV = Z / iZ / i


Monitoring CollectionsMonitoring Collections

Receivables turnoverReceivables turnover– least favored techniqueleast favored technique

Days sales outstanding, DSODays sales outstanding, DSO– ranked almost as high as aging schedulesranked almost as high as aging schedules

Aging schedulesAging schedules– ranked as most favored techniqueranked as most favored technique


ProblemProblem

All three traditional measures have a All three traditional measures have a serious flawserious flaw– All three are influenced by sales trendsAll three are influenced by sales trends

– Choice of averaging period impacts turnover Choice of averaging period impacts turnover and DSOand DSO

Increasing sales tends to:Increasing sales tends to:– improve aging schedulesimprove aging schedules

– worsen DSO and turnoverworsen DSO and turnover


SolutionSolution

Payment or Balance Fraction ApproachPayment or Balance Fraction Approach


Collection ProceduresCollection Procedures

Typical collection effortTypical collection effort– initial contact within 10 days of delinquencyinitial contact within 10 days of delinquency

– then reminder letter followed by phone callthen reminder letter followed by phone call

– sales force notifiedsales force notified

– last resort, reference to collection agency/legal actionlast resort, reference to collection agency/legal action

Collection agencyCollection agency– Phase 1 - computer generated collection letter, when accounts are 45 to Phase 1 - computer generated collection letter, when accounts are 45 to

90 days past due90 days past due

– Phase 2 - commissioned collectors usedPhase 2 - commissioned collectors used

Companies tend to be more aggressive the larger the Companies tend to be more aggressive the larger the receivables balancereceivables balance

Companies understand the good-will tradeoff when Companies understand the good-will tradeoff when selecting collection methodsselecting collection methods


International Credit ManagementInternational Credit Management

Credit policy analysisCredit policy analysis– lengthening terms increases exchange rate risklengthening terms increases exchange rate risk

– also increases default riskalso increases default risk

– harder to get D&B reportsharder to get D&B reports

– harder to get bank credit informationharder to get bank credit information

Modifying monitoring and collectionsModifying monitoring and collections– legal remedies for late payment or nonpayment differ by legal remedies for late payment or nonpayment differ by

countrycountry


SummarySummary

This chapter developed the framework for applying the This chapter developed the framework for applying the NPV model to credit policy decisionsNPV model to credit policy decisions

The NPV approach was applied to changes in credit The NPV approach was applied to changes in credit standards, the credit period, cash discountsstandards, the credit period, cash discounts

Traditional monitoring tools include aging, DSO and Traditional monitoring tools include aging, DSO and receivables turnoverreceivables turnover

Improved monitoring measureImproved monitoring measure– uncollected balance percentageuncollected balance percentage

– a reliable and unbiased measure of customer payment behaviora reliable and unbiased measure of customer payment behavior

Collection procedures were reviewedCollection procedures were reviewed The chapter concluded with a look at benchmarking The chapter concluded with a look at benchmarking

and the impact of foreign salesand the impact of foreign sales

Copyright 1998 by Harcourt Brace &Company Chapter 6 Credit Policy and Collections Order Order Sale...

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