Credit Management
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will Chapter 30
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Topics Covered
Terms of Sale Commercial Credit Instruments Credit Analysis The Credit Decision Collection Policy Bankruptcy
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Terms of Sale
Terms of Sale - Credit, discount, and payment terms offered on a sale.
Example - 5/10 net 30
5 - percent discount for early payment
10 - number of days that the discount is available
net 30 - number of days before payment is due
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Terms of Sale
A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier.
We can calculate the implicit cost of this loan.
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Terms of Sale
A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier.
We can calculate the implicit cost of this loan
( )Effective annual rate
1 + - 1discountdiscounted price
365 / extra days credit=
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Terms of Sale
Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given?
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Terms of Sale
Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given?
45.4%or .454,=1-+1
1-+1
rate annual Effective
365/50
955
credit days 365/extra
price discounteddiscount
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Credit Instruments
Terminology open account promissory note commercial draft sight draft time draft trade acceptance banker’s acceptance
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Credit Analysis
Credit Analysis - Procedure to determine the likelihood a customer will pay its bills.
Credit agencies, such as Dun & Bradstreet provide reports on the credit worthiness of a potential customer.
Financial ratios can be calculated to help determine a customer’s ability to pay its bills.
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Credit Analysis
Numerical Credit Scoring categories The customer’s character The customer’s capacity to pay The customer’s capital The collateral provided by the customer The condition of the customer’s business
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Credit Analysis
Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time.
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Credit Analysis
Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time.
Altman Z Score formula
Z = 3.3EBIT
total assets+ 1.0
sales
total assets+.6
market value of equity
total book debt
+ 1.4retained earnings
total assets+ 1.2
working capital
total assets
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Credit Analysis
Example - If the Altman Z score cut off for a credit worthy business is 2.7 or higher, would we accept the following client?
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Credit Analysis
Example - If the Altman Z score cut off for a credit worthy business is 2.7 or higher, would we accept the following client?
EBIT
total assets
sales
total assets
market equity
book debt
=
=
=
1 2
1 4
9
.
.
.
retained earnings
total assets
working capital
total assets
=
=
.
.
4
12
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Credit Analysis
Example - If the Altman Z score cut off for a credit worthy business is 2.7 or higher, would we accept the following client?
A score above 2.7 indicates good credit.
Firm' s Z Score
( . . ) ( . . ) ( . . ) ( . . ) ( . . ) .3 3 12 1 0 1 4 6 9 1 4 4 1 2 12 3 04x x x x x+ + + + =
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Credit Analysis
Credit analysis is only worth while if the expected savings exceed the cost. Don’t undertake a full credit analysis unless the
order is big enough to justify it. Undertake a full credit analysis for the doubtful
orders only.
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The Credit Decision
Credit Policy - Standards set to determine the amount and nature of credit to extend to customers.
Extending credit gives you the probability of making a profit, not the guarantee. There is still a chance of default.
Denying credit guarantees neither profit or loss.
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The Credit Decision
The credit decision and its probable payoffs
Refuse credit
Offer credit
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The Credit Decision
The credit decision and its probable payoffs
Refuse credit
Offer credit
Customer pays = p
Customer defaults = 1-p
Payoff = 0
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The Credit Decision
The credit decision and its probable payoffs
Refuse credit
Offer credit
Customer pays = p
Customer defaults = 1-p
Payoff = Rev - Cost
Payoff = - Cost
Payoff = 0
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The Credit Decision
Based on the probability of payoffs, the expected profit can be expressed as:
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The Credit Decision
Based on the probability of payoffs, the expected profit can be expressed as:
p x PV(Rev - Cost) - (1 - p) x (PV(cost)
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The Credit Decision
Based on the probability of payoffs, the expected profit can be expressed as:
The break even probability of collection is:
p x PV(Rev - Cost) - (1 - p) x (PV(cost)
p =PV(Cost)
PV(Rev)
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Collection Policy
Collection Policy - Procedures to collect and monitor receivables.
Aging Schedule - Classification of accounts receivable by time outstanding.
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Collection Policy
Sample aging schedule for accounts receivable
$298,000$58,000$40,000$200,000Total
30,00021,0004,0005,000Omega
*****
*****
*****
5,0005,00000Beta
10,0000010,000AlphaOwed
Total
Overdue Month
1 thanMore
Overdue
Month1
Yet Due
NotAmount
Name
sCustomer'
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