short-term financial management chapter 6 – credit policy & collections
TRANSCRIPT
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SHORT-TERMFINANCIAL MANAGEMENT
Chapter 6 – Credit Policy & Collections
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CREDIT POLICY & COLLECTIONS
Chapter 6 Agenda
Calculate the net present value of proposed and existing credit policies, identify and utilize techniques used to assess collection patterns, and describe present corporate credit policy practices.
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Cash Flow Timeline
The cash conversion period is the time between when cash is received versus paid.
The shorter the cash conversion period, the more efficient the firm’s working capital.
The firm is a system of cash flows. These cash flows are unsynchronized and
uncertain.
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Credit Policy & Collections
Before, we developed strategies for extending
credit to individual customers.
Since a significant amount of cash can be tied up in A/R, in this chapter, we look at the:
Credit Policy decisions (portfolio management) that affect all customers, as well as
Collections practices and account receivable portfolio monitoring techniques.
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Credit Policy & Collections
Strategic changes to Credit Policy are considered when: Sales volume and/or profits can be
enhanced. Receivables performance is unsatisfactory. Competitors change credit terms.
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Credit Policy & Collections
Financial Managers consider the following variables:
1. Loosening or tightening credit standards.
2. Lengthening or shortening credit period.
3. Offering, reducing, or discontinuing cash discounts.
4. Imposing and/or enforcing late fees.
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Credit Policy & Collections
Credit Managers can predict the impact from credit policy changes on Sales Default probabilities Delinquency
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Value Maximizing Decisioning
Net Present Value (NPV) is the difference between the present value of the cash inflows and the present value of the cash outflows.
Credit managers select the credit policy that combines mutually-exclusive alternatives such that NPV is maximized.
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Changing Credit Terms
Before we said our goal is to design a credit policy that maximizes NPV.
There are a variety of decision variables that can be combined and/or altered to impact Z (NPV from one day’s average sales).
If the credit policy is changed, most variables will change.
Terms (all sales are credit sales)
Sales Growth Rate (g)
Annual Credit Sales
Daily Credit Sales (S)
Cash Discount Offered - % (d)
Customers Taking Discount - % (p)
DSO - Discount Takers (DP )
DSO - Non-Discount Takers (CP )
Variable Cost Ratio (VCR)
Collection/Credit Exp (EXP) at CP
Bad Debt Expense Ratio (b) at CP
Annual Cost of Capital (i)
Variables
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Changing Credit Terms
If we offer a cash discount, not all customers will take it.
The cash flow amounts for discount takers versus non-discount takers will vary, as will the timing of the cash flows.
Further, the bad debt experience for each could vary.
Z = PV of Sales To Discount Takers
+ PV of Sales to Non-Discount Takers
– Variable Operating Costs
– PV of Credit/Collection Costs
Terms (all sales are credit sales)
Sales Growth Rate (g)
Annual Credit Sales
Daily Credit Sales (S)
Cash Discount Offered - % (d)
Customers Taking Discount - % (p)
DSO - Discount Takers (DP )
DSO - Non-Discount Takers (CP )
Variable Cost Ratio (VCR)
Collection/Credit Exp (EXP) at CP
Bad Debt Expense Ratio (b) at CP
Annual Cost of Capital (i)
Variables
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Modeling Z
The model assumes: All sales are sold on trade credit. All variables can be estimated with accuracy. The bad debt loss rate applies, evenly, to:
New and existing customers. Customers taking and customers not taking the cash
discounts, if offered. Other than the change in receivables, no new fixed
assets or inventory is required. The VCR does not change.
If the Credit Manager prefers, adjustments to these model decisions can be incorporated.
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Modeling Z
Before, we calculated the NPV from a single sale, using the following formula.
Now, we will model the NPV of a single average day’s sales (Z):
)1(
)()(
)1(
)1)(1(
)1(
)1()1(
iCP
SEXPSVCR
iCP
bpS
iDP
bpdSZ
SVCRiCP
SEXPSNPV
1
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Modeling Credit Terms
Z = S(1-d)p(1-b) / (1 + iDP) PV of Sales To Discount
Takers
+ S(1-p)(1-b) / (1 + iCP) PV of Sales To Non-Discount
Takers
‐ VCR(S) Variable Operating Costs1
‐ EXP(S) / (1 + iCP) PV of Credit/Collection Costs
1 Assume that the firm has excess capacity and will have no increase in fixed costs or fixed assets as a result of the policy change.
Terms (all sales are credit sales)
Sales Growth Rate (g)
Annual Credit Sales
Daily Credit Sales (S)
Cash Discount Offered - % (d)
Customers Taking Discount - % (p)
DSO - Discount Takers (DP )
DSO - Non-Discount Takers (CP )
Variable Cost Ratio (VCR)
Collection/Credit Exp (EXP) at CP
Bad Debt Expense Ratio (b) at CP
Annual Cost of Capital (i)
Variables
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Modeling Credit Terms Illustrative
Z = S(1-d)p(1-b) / (1 + iDP) + S(1-p)(1-b) / (1 + iCP) ‐ VCR(S) ‐ EXP(S) / (1 + iCP)
($13,699)(1-.02)(.75)(1-.05)/[1+(.14/365)(12)]+ ($13,699)(1-.75)(1-.05) / [1+(.14/365)(45)] ‐ (.70)($13,699) ‐ (.02)($13,699) / [1+(.14/365)(45)]
= $9,521 + $3,198 - $9,589 - $269 = $2,861
Can compare to other options. Note: rounding impacts results on this slide.
Terms (all sales are credit sales) 2/10, Net 30
Sales Growth Rate (g)
Annual Credit Sales $5,000,000
Daily Credit Sales (S) $13,698.63
Cash Discount Offered - % (d) 2%
Customers Taking Discount - % (p) 75%
DSO - Discount Takers (DP ) 12
DSO - Non-Discount Takers (CP ) 45
Variable Cost Ratio (VCR) 70.00%
Collection/Credit Exp (EXP) at CP 2.00%
Bad Debt Expense Ratio (b) at CP 5.00%
Annual Cost of Capital (i) 14.00%
Variables Terms
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Changing Credit Terms
If credit terms are already offered, the NPV of the
existing terms ( ZE ) can be compared to
combinations of new terms ( ZN ):
Z = ZN – ZE
The aggregate NPV is calculated from the daily NPV (Z):
NPV = Z / i
Decision Rule:If Delta Z > 0 Accept policy changeIf Delta Z = 0 Indifferent about policy changeIf Delta Z < 0 Reject policy change
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ZN = [(1+g)SE](1-dN)pN(1-bN) / (1 + iDPN) + [(1+g)SE](1-pN)(1-bN) / (1 + iCPN) ‐ VCR [(1+g)SE] ‐ EXPN[(1+g)SE] / (1 + iCPN)
ZN = New Policy
Modeling Changes to Credit Terms
ZE = SE(1-dE)pE(1-bE) / (1 + iDPE) PV of Discounted
Invoices
+ SE(1-pE)(1-bE) / (1 + iCPE) PV of Non-Discounted
Invs
‐ VCR (SE) Variable Cost Pmts
‐ EXPE (SE) / (1 + iCPE) PV of Credit Expense
Pmts
This analysis assumes policy changes will increase (or decrease) sales and incorporates (g) sales growth, where SN = (1+g)(SE). Note you would include a decrease in sales with (1-g)(SE).
ZE = Existing Policy
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Credit Policy Modeling Example
Lengthening Credit Period (no cash discount) Offer net-60 rather than net-30 terms.
Terms (all sales are credit sales) Net 30 Net 60
Sales Growth Rate (g) 16.66667%
Annual Credit Sales $30,000,000 $35,000,000
Daily Credit Sales (S) $82,191.78 $95,890.41
Cash Discount Offered - % (d) Not Offered Not Offered
Customers Taking Discount - % (p) N/A N/A
DSO - Discount Takers (DP ) N/A N/A
DSO - Non-Discount Takers (CP ) 50 75
Variable Cost Ratio (VCR) 70.00% No Change
Collection/Credit Exp (EXP) at CP 2.00% 2.50%
Bad Debt Expense Ratio (b) at CP 5.00% 6.00%
Annual Cost of Capital (i) 14.00% No Change
VariablesProposed Terms
(N)Current Terms (E)
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Credit Policy Modeling Example
Lengthening Credit Period (no cash discount) Offer net-60 rather than net-30 terms.
First, calculate ZE.
ZE = SE(1-dE)pE(1-bE) / (1 + iDPE)+ SE(1-pE)(1-bE) / (1 + iCPE)‐ VCR (SE) ‐ EXPE (SE) / (1 + iCPE)
($82,192)(1-0)(1-.05) / [1 + (.14/365)(50)]‐ (0.70)($82,192)‐ (0.02)($82,192) / [1 + (.14/365)(50)]
= $76,613 - $57,534 - $1,613= $17,466
Terms (all sales are credit sales) Net 30 Net 60
Sales Growth Rate (g) 16.66667%
Annual Credit Sales $30,000,000 $35,000,000
Daily Credit Sales (S) $82,191.78 $95,890.41
Cash Discount Offered - % (d) Not Offered Not Offered
Customers Taking Discount - % (p) N/A N/A
DSO - Discount Takers (DP ) N/A N/A
DSO - Non-Discount Takers (CP ) 50 75
Variable Cost Ratio (VCR) 70.00% No Change
Collection/Credit Exp (EXP) at CP 2.00% 2.50%
Bad Debt Expense Ratio (b) at CP 5.00% 6.00%
Annual Cost of Capital (i) 14.00% No Change
VariablesProposed Terms
(N)Current Terms (E)
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Credit Policy Modeling Example
ZN = [(1+g)SE](1-dN)pN(1-bN) / (1 + iDPN)+ [(1+g)SE](1-pN)(1-bN) / (1 + iCPN) ‐ VCR [(1+g)SE] ‐ EXPN[(1+g)SE] / (1 + iCPN)
($95,890)(1-0)(1-.06) / [1 + (.14/365)(75)] ‐ (0.70)($95,890) ‐ (0.025)($95,890) / [1 + (.14/365)(75)]
= $87,616 - $67,123 - $2,330= $18,163
Lengthening Credit Period (no cash discount) Offer net-60 rather than net-30 terms.
Now, calculate ZN.
Terms (all sales are credit sales) Net 30 Net 60
Sales Growth Rate (g) 16.66667%
Annual Credit Sales $30,000,000 $35,000,000
Daily Credit Sales (S) $82,191.78 $95,890.41
Cash Discount Offered - % (d) Not Offered Not Offered
Customers Taking Discount - % (p) N/A N/A
DSO - Discount Takers (DP ) N/A N/A
DSO - Non-Discount Takers (CP ) 50 75
Variable Cost Ratio (VCR) 70.00% No Change
Collection/Credit Exp (EXP) at CP 2.00% 2.50%
Bad Debt Expense Ratio (b) at CP 5.00% 6.00%
Annual Cost of Capital (i) 14.00% No Change
VariablesProposed Terms
(N)Current Terms (E)
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Lengthening Credit Period (no cash discount) Offer net-60 rather than net-30 terms
Compare results:
Z = ZN – ZE
Z = $18,163 – $17,466 = $697
∆Z > 0, so accept policy change
Calculate the aggregate NPV:
NPV = Z / i
NPV = $697 / (0.14/365) = $1,816,997
Credit Policy Modeling Example
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Another Modeling Example
Introduce Cash Discount Offer 2/10, net-30 rather than net-30 terms.
Terms (all sales are credit sales) Net 30 2/10, Net 30
Sales Growth Rate (g) 3%
Annual Credit Sales $20,000,000 $20,600,000
Daily Credit Sales (S) $54,794.52 $56,438.36
Cash Discount Offered - % (d) Not Offered 2%
Customers Taking Discount - % (p) N/A 40%
DSO - Discount Takers (DP ) N/A 10
DSO - Non-Discount Takers (CP ) 35 No Change
Variable Cost Ratio (VCR) 60.00% No Change
Collection/Credit Exp (EXP) at CP 4.00% No Change
Bad Debt Expense Ratio (b) at CP 3.00% 2.50%
Annual Cost of Capital (i) 12.00% No Change
Proposed Terms (N)
Variables Current Terms (E)
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Terms (all sales are credit sales) Net 30 2/10, Net 30
Sales Growth Rate (g) 3%
Annual Credit Sales $20,000,000 $20,600,000
Daily Credit Sales (S) $54,794.52 $56,438.36
Cash Discount Offered - % (d) Not Offered 2%
Customers Taking Discount - % (p) N/A 40%
DSO - Discount Takers (DP ) N/A 10
DSO - Non-Discount Takers (CP ) 35 No Change
Variable Cost Ratio (VCR) 60.00% No Change
Collection/Credit Exp (EXP) at CP 4.00% No Change
Bad Debt Expense Ratio (b) at CP 3.00% 2.50%
Annual Cost of Capital (i) 12.00% No Change
Proposed Terms (N)
Variables Current Terms (E)
Another Modeling Example
Introduce Cash Discount Offer 2/10, net-30 rather than net-30 terms.
First, calculate ZE.
ZE = SE(1-dE)pE(1-bE) / (1 + iDPE)+ SE(1-pE)(1-bE) / (1 + iCPE)‐ VCR (SE) ‐ EXPE (SE) / (1 + iCPE)
($54,795)(1-.03) / [1+(.12/365)(35)]‐ (0.60)($54,795)‐ (0.04)($54,795) / [1 + (.12/365)(35)]
= $52,546 - $32,877 - $2,167= $17,502
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Another Modeling Example
Introduce Cash Discount Offer 2/10, net-30 rather than net-30 terms.
Now, calculate ZN.
ZN = [(1+g)SE](1-dN)pN(1-bN) / (1 + iDPN)+ [(1+g)SE](1-pN)(1-bN) / (1 + iCPN) ‐ VCR [(1+g)SE] ‐ EXPN[(1+g)SE] / (1 + iCPN)
($56,438)(1-.02)(.4)(1-.025)/[1+(.12/365)(10)]+ ($56,438)(1-.4)(1-.025) / [1+(.12/365)(35)] ‐ (0.60) ($56,438) ‐ (0.04)($56,438) / [1 + (.12/365)(35)]
= $21,500 + $32,641 - $33,863 - $2,231= $18,046
Terms (all sales are credit sales) Net 30 2/10, Net 30
Sales Growth Rate (g) 3%
Annual Credit Sales $20,000,000 $20,600,000
Daily Credit Sales (S) $54,794.52 $56,438.36
Cash Discount Offered - % (d) Not Offered 2%
Customers Taking Discount - % (p) N/A 40%
DSO - Discount Takers (DP ) N/A 10
DSO - Non-Discount Takers (CP ) 35 No Change
Variable Cost Ratio (VCR) 60.00% No Change
Collection/Credit Exp (EXP) at CP 4.00% No Change
Bad Debt Expense Ratio (b) at CP 3.00% 2.50%
Annual Cost of Capital (i) 12.00% No Change
Proposed Terms (N)
Variables Current Terms (E)
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Cash Discount Offer 2/10, net-30 rather than net-30 terms.
Compare results:
Z = ZN – ZE
Z = $18,046 - $17,502 = $544
∆Z > 0, so accept policy change
Calculate the aggregate NPV:
NPV = Z / i
NPV = $544 / (0.12/365) = $1,654,501
Another Modeling Example
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Sometimes, a firm has no competitive threat, regardless of terms offered.
Otherwise, competitors are likely to react to unilateral changes to credit policy by matching the terms.
This can be incorporated into the analysis.
A revised sales estimate would be made (quantity of pricing).
Competitor Reaction
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Monitoring Receivables
Nothing is more important than getting paid!
The diligent management of A/R is crucial to:
Accelerate collection of cash.
Reduce collection costs.
Increase likelihood of payment.
Credit Managers watch trends for:
Days Sales Outstanding (DSO).
Accounts Receivable Turnover.
Aging Schedules (organizes A/R into categories-next slide).
)365/( salescreditAnnual
receivableAccountsDSO
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Credit Policy & Collections
Last time we said the Credit Policy includes:
1. Credit Standards Create a profile of the minimally acceptable credit-worthy
customer.
2. Credit Terms Define how long the customer has to pay and/or the offering
of Cash Discounts.
3. Credit Limits Determine the amount of cumulative credit offered to a
single customer and/or group of customers.
4. Collection Process (Chapter 6) Determine how and when past-due accounts are handled.
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Collection Procedures
Firms try to strike the balance between collection activities and protecting the relationship with the customer. The typical collection effort includes:
Contact past due customer (letter or phone call) within 10 days of delinquency.
Notify the sales force of the delinquency.
As a last resort, refer the account to a collection agency, which can include legal action.
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Trends in Receivables