Chapter 6Credit Policy and Collections

OrderOrder Order Order Sale Sale Payment Sent Cash Payment Sent 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 Received Payment Sent Cash DisbursedInvoice Received Payment Sent Cash Disbursed

OrderOrder Order Order Sale Sale Payment Sent Cash Payment Sent 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 Received Payment Sent Cash DisbursedInvoice Received Payment Sent Cash Disbursed

Evaluate Changes in Credit Policy•Credit term change decision variables

•effect on dollar profits•sales effect• receivables effect• return on investment effect

•84% can estimate:•default probability•credit limits•opportunity cost of funds invested in receivables•company’s overall cost of capital

Changing Credit Terms, EQ 6.1 (P. 196)

NPV Average Daily Sales NPV Average Daily Sales

= PV of Sales to discount-takers= PV of Sales to discount-takers

+ PV of Sales to non-discount takers+ PV of Sales to non-discount takers

- Variable Operating Costs- Variable Operating Costs

- PV of Variable Credit and Collection Costs- PV of Variable Credit and Collection Costs

NPV Average Daily Sales NPV Average Daily Sales

= PV of Sales to discount-takers= PV of Sales to discount-takers

+ PV of Sales to non-discount takers+ PV of Sales to non-discount takers

- Variable Operating Costs- Variable Operating Costs

- PV of Variable Credit and Collection Costs- PV of Variable Credit and Collection Costs

Changing Credit Terms, Equation 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 paymentsPV discount payments

+ [(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 paymentsPV discount payments

+ [(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

Existing Credit Terms, Equation 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

-EXPEXPEE SSEE / (1 + iCP / (1 + iCPEE)) PV credit expense pmtsPV credit expense pmts

(correct this in your textbook)(correct this in your textbook)

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

-EXPEXPEE SSEE / (1 + iCP / (1 + iCPEE)) PV credit expense pmtsPV credit expense pmts

(correct this in your textbook)(correct this in your textbook)

Changing Credit Terms, Equation 6.3, 6.4

Equation 6.3 Equation 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 IndifferentZ = 0 then Indifferent

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

Equation 6.4 Equation 6.4 NPV = NPV = Z / iZ / i

Equation 6.3 Equation 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 IndifferentZ = 0 then Indifferent

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

Equation 6.4 Equation 6.4 NPV = NPV = Z / iZ / i

Assignment

•AJ Group’s CEO Mr. Ananta Jalil asked you make a recommendation to the executive policy committee on whether the company should tighten its credit standards. The marketing department estimates that annual sales will drop by BDT 15 million from the present level of BDT 200 million. The VCR is 0.60 and it will not change, and the credit and collection expenses will increase from 1.25 percent to 1.50 percent under the proposal. The bad debt expense rate on both existing and incremental sales is estimated to be 10 percent. The DSO of 30 days is not expected to change. The company’s annual cost of capital is 18 percent.

a. Calculate the decision’s 1-day change in value.

b. Calculate the decision’s NPV.

c. Do you recommend tightening the credit standards? Explain.

Monitoring Collections

DSO

365 ratio turnover Receivable /

sales/365)credit (

Receivable Accounts

CA

AnnualDSO

Spreadsheet containing sales and A/C receivable data

Aging Schedule

Monitoring Collections

•Receivables turnover• least favored technique

•Days sales outstanding, DSO• ranked almost as high as aging schedules

•Aging schedules• ranked as most favored technique

Problem

All three traditional measures have a serious flaw◦ All three are influenced by sales trends◦ Choice of averaging period impact turnover and DSO

Increasing sales tends to:◦ improve aging schedules◦ worsen DSO and A/C Receivable turnover

Solution: Uncollected balance percentage/ Payment pattern approach

Collection Procedures

Typical collection effort◦ initial contact within 10 days of delinquency◦ then reminder letter followed by phone call◦ sales force notified◦ last resort, reference to collection agency/legal action

Collection agency◦ Phase 1 - computer generated collection letter, when

accounts are 45 to 90 days past due◦ Phase 2 - commissioned collectors used

Companies tend to be more aggressive the larger the receivables balance

Companies understand the good-will tradeoff when selecting collection methods