20130708 wcm optimum credit policy

7/28/2019 20130708 WCM Optimum Credit Policy

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Optimum Credit Policy

By

Rahul SasidharanMGT 1105131


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When a firm sells goods and services:

(1) it can be paid in cash immediately

or

(2) it can wait for a time to be paid byextending credit to its customers.

Granting credit is investing in a customer,

an investment tied to the sale of a product orservice.


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Components of

Credit Policy

A firms credit policy is

composed of:

Terms of sale

Credit analysis

Collection policy


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Term of Sales

Conditions under which afirm extends credit to

customersCredit PeriodCash Discount

Credit Instrument


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Credit Analysis

The process ofdetermining the

likelihood that thecustomer will or will not

pay


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Collection Policy

The procedures that a firmfollows to make sure thatpayments are duly paid

against accounts recievables


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-Terms of Sales-

Credit Period

The duration of the time period allowed to acustomer to pay the credit offered.

Factors in deciding extend: The probability of the customer not pay.ing.

The size of the account. The extent to which goods are perishable.

Lengthening the credit period generallyincreases sales


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The discount offered in the purchase price to

induce timely payment5/8net 30; 2/10net 30

Means

The customer can avail 5% discount if he pays in

8 days and;avail 2% discount paying back in 10 days In anyof these two cases net 30 is unconditionally the

deadline or the maximum allowable credit period

-Terms of Sales-

Cash Discount


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The basic evidence of indebtedness in a credit transaction

Invoice: Most credit is offered on open accountthe invoice is the only

credit instrument.Promissory notes: They are IOUs that are signed after the delivery ofgoodsCommercial drafts: They call for a customer to pay a specific amountby a specific date. The draft is sent to the customers bank, when thecustomer signs the draft, the goods are sent.Bankers acceptances: They allow a bank to substitute itscreditworthiness for the customer, for a fee.

Conditional sales contracts: They let the seller retain legal ownershipof the goods until the customer has completed payment.

-Terms of Sales-

CreditInstrument


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Collection PolicyNo credit Credit


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The Decision to Grant Credit: Risk and Information

)C(PQ 000 The only cashflow of the first

strategy is The expectedcash flows of thecredit strategy are:

'

0

'

0PQh

0 1

'

0

'

0QC

We incur costs up

front

and get paid in 1

period by h% of ourcustomers.


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The Decision to GrantCredit: Risk and

Information )C(PQNPV 000cash = The NPV of thecash onlystrategy is

)r(1

PQhQCNPV

B

'

0

'

0'

0

'

0credit +

+=

The NPV of

the creditstrategy is

The decision to grant credit depends onfour factors:

1. The delayed revenues from granting credit,

2. The immediate costs of granting credit,

3. The probability of repayment,

4. The discount rate,

'

0

'

0QP'

0

'

0QCh

Br


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Optimal Credit Policy

At the optimal amount of credit, theincremental cash flows from increased

sales are exactly equal to the carryingcosts from the increase in accounts

CarryingCosts

Total costs

C*

Costs

in

Rupees

Level of creditextended

Opportunity costs


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Optimal Credit Policy

Trade Credit is more likely to be grantedif:

1. The selling firm has a cost advantageover other lenders.

2. The selling firm can engage in pricediscrimination.

3. The selling firm can obtain favourable

tax treatment.4. The selling firm has no establishedreputation for quality products orservices.

5. The selling firm perceives a long-term


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Collection PolicyCollection refers to obtaining payment onpast-due accounts.

Collection Policy is composed of

The firms willingness to extend credit asreflected in the firms investment in

receivables.

Collection Effort


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Average Collection Period

Measures the average amount of timerequired to collect an account receivable.

saledailyAverage

receivaAccountsperiodcollectionAverage =

For example, a firm with averagedaily sales of $20,000 and an

investment in accounts receivable of$150,000 has an average collectionperiod of days7.5

day20,000Rs

150,000Rs=


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Accounts Receivable

Aging Schedule Shows receivables by age of account.

The aging schedule is often augmented by the

payments pattern.

The payments pattern describes the laggedcollection pattern of receivables.

The longer an account has been unpaid, the

less likely it is to be paid.


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Collection Effort Most firms follow a protocol for customers that are past

due:

1. Send a delinquency letter.

2. Make a telephone call to the customer.

3. Employ a collection agency.

4. Take legal action against the customer.

There is a potential for a conflict of interest between thecollections department and the sales department.

You need to strike a balance between antagonizing acustomer and being taken advantage of by a deadbeat.


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Factoring

The sale of a firms accounts receivable toa financial institution (known as a factor).

The firm and the factor agree on the basiccredit terms for each customer.

Customerssendpayment to

the factor

The factor pays an agreed-upon percentage of the

accounts receivable to thefirm. The factor bears the

risk of nonpayingcustomers

Firm

Factor

CustomerGoods


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Summary1. The components of a firms optimum credit

policy are the terms of sale, the credit analysis,and the collection policy.

2. The decision to grant credit is a straightforwardNPV problem.

3. Additional information about the probability ofcustomer default has value, but must beweighed against the cost of the information.

4. The optimal amount of credit is a function of theconditions in which a firm finds itself.

5. The collection policy is the firms method fordealing with past-due accountsit is an integralpart of the decision to extend credit.


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Thank you

20130708 wcm optimum credit policy

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