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Financial Decisions
4a. Receivables Management
Credit granting
Instructor: A. Ashta
References: Ross, Westerfield Jordan: Ch. 17
Emery, Finnerty & Stowe: Ch. 23
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Why keep accounts receivables? Credit sales create accounts receivables
Accounts receivables cost money (interest)
So why grant credit? Financial intermediation
Cheaper than bank for customers, more profitable for than banks forsuppliers
Collateral
The inventory with a customer is more valuable to a supplier than tocustomers bank
Information costs
Easier for supplier to assess creditworthiness
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The Cash Flows from Granting Credit
Creditsale ismade
Customermailscheck
Firm depositscheck inbank
Bank creditsfirmsaccount
Cash collection
Accounts receivable
Time
Creditmanagement
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Components of Credit Policy
Terms of sale
Conditions under which a firm sells itsgoods and services for cash or credit.
Credit AnalysisThe process of determining the probability
that customers will or will not pay.
Collection PolicyProcedures followed by a firm in collectingaccounts receivable.
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Determinants of Length of Credit Period Product market competition
More competition means more credit offered
The size/ countervailing power of buyer
Customer type Wholesaler, retailer or final consumer
Credit risk
Perishability and collateral value
Consumer demand New customers require longer credit period
Cost, profitability and standardization
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Costs of Granting Credit
Opportunity costsare the lost sales from refusing credit. These costs godown when credit is granted.
Cost indollars
Amount of creditextended
Optimal
amountof credit
Total costs
Carrying costs
Opportunitycosts
Carrying costsarethe cash flows that
must be incurredwhen credit isgranted. They arepositively related tothe amount ofcredit extended.
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The Basic Credit Granting Decision
Credit should be granted if the NPV of granting credit is
positive.
The NPV of the Basic Credit Granting Decision
Let R = amount of sale
p = probability of payment
C= the firms investment in the sale r= the required return
t= time at which payment is expected
Cr
Rp
NPV t +
= )1(
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The Basic Credit Granting Decision
Mohawk Carpets is considering extending $5,000
of credit to a customer. Mohawk has invested
$3,750 in the sale and it estimates that the customer
has a 75% probability of making the payment.
The payment is due in 2 months, and the required
rate of return in 20% APY (Annual Percentage
Yield = compound return).
Should Mohawk grant credit to this customer?
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The Basic Credit Granting Decision
What is the minimum probability of payment
that Mohawk would require from thiscustomer?
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Try Emery, Finnerty, Wade Q.B1 SLSC wants to make a $ 200,000 credit purchase from
your firm.
Your investment in this credit sale is the 70% of cost ofsale.
You estimate that SLSC has a 95% probability of payingon time, which is in 3 months, and a 5% probability ofpaying nothing.
If the opportunity cost of funds is 18%, calculate theNPV of granting the credit.
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Credit Policy Decisions
Choice of credit terms
CBD; COD: net 30; or 2/10, net 30
Setting evaluation methods and creditstandards
Monitoring receivables
Taking actions for slow payments
Controlling & administering the firmscredit functions
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Sources of Credit Information
A credit application, including references
Applicants payment history
Information from sales representatives
Financial statements for recent years Reports from credit rating agencies
Dun & Bradstreet Credit Services
Credit bureau reports
Industry association credit files
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Character
Willingness to pay Capacity
Ability to pay
Capital Financial reserves
Collateral
Pledged assets
Conditions Relevant economic conditions
The five Cs of credit:
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Credit Scoring Models
These combine several financial variables to
create a single score or index. Credit is granted if the score is above a pre-
specified cut-off value.
Advantages: Easy to compute Easy to change standards
Avoids bias or discrimination
Requires large samples to calibrate.
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