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McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
Corporate Finance
Ross - Westerfield - Jaffe
Sixth Edition
29
Chapter Twenty Nine
Credit Management
Prepared by

Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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Executive Summary
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 by extending
credit to its customers.
Granting credit is investing in a customer, an
investment tied to the sale of a product or service.
This chapter examines the firms decision to grant
credit.
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Chapter Outline
29.1 Terms of the Sale
29.2 The Decision to Grant Credit:
Risk and Information
29.3 Optimal Credit Policy
29.4 Credit Analysis
29.5 Collection Policy
29.6 Other Aspects of Credit Policy
29.7 Summary & Conclusions
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Introduction
A firms credit policy is composed of:
Terms of the sale
Credit analysis
Collection policy
This chapter discusses each of the components of
credit policy that makes up the decision to grant
credit.
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The Cash Flows of Granting Credit
Credit sale
is made
Customer
mails
cheque
Firm
deposits
cheque
Bank credits
firms
account
Accounts receivable
Cash collection
Time
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29.1 Terms of the Sale
The terms of sale of composed of
Credit Period
Cash Discounts
Credit Instruments

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Credit Period
Credit periods vary across industries.
Generally a firm must consider three factors in
setting a credit period:
The probability that the customer will not pay.
The size of the account.
The extent to which goods are perishable.
Lengthening the credit period generally increases
sales
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Cash Discounts
Often part of the terms of sale.
Tradeoff between the size of the discount and the
increased speed and rate of collection of
receivables.
An example would be 3/10 net 30
The customer can take a 3% discount if he pays within 10
days.
In any event, he must pay within 30 days.
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The Interest Rate Implicit in 3/10 net 30
A firm offering credit terms of 3/10 net 30 is essentially
offering their customers a 20-day loan.
To see this, consider a firm that makes a $1,000 sale on day 0
Some customers will pay on day 10 and take the discount.
Other customers will pay on day 30 and forgo the discount.
0 10 30
$970
0 10 30
$1,000
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0 10 30
+$970
-$1,000
A customer that forgoes the 3% discount to pay on day 30 is
borrowing $970 for 20 days and paying $30 interest:
365 20
) 1 (
000 , 1 $
970 $
r +
=
970 $
000 , 1 $
) 1 (
365 20
= + r
% 35 . 74 7435 . 0 1
970 $
000 , 1 $
20
365
= =
|
.
|

\
|
= r
The Interest Rate Implicit in 3/10 net 30
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Credit Instruments
Most credit is offered on open accountthe invoice is the
only credit instrument.
Promissory notes are IOUs that are signed after the delivery
of goods
Commercial drafts call for a customer to pay a specific
amount by a specific date. The draft is sent to the customers
bank, when the customer signs the draft, the goods are sent.
Bankers acceptances allow a bank to substitute its
creditworthiness for the customer, for a fee.
Conditional sales contracts let the seller retain legal
ownership of the goods until the customer has completed
payment.
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29.2 The Decision to Grant Credit: Risk
and Information
Consider a firm that is choosing between two
alternative credit policies:
In God we trusteverybody else pays cash.
Offering their customers credit.
) (
0 0 0
C P Q The only cash flow of the first strategy is
The expected cash flows of the credit strategy are:
'
0
'
0
P Q h
0 1
'
0
'
0
Q C
We incur costs up
front
and get paid in 1 period
by h% of our customers.
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29.2 The Decision to Grant Credit: Risk
and Information
) (
0 0 0
C P Q NPV
cash
=
The NPV of the cash only strategy is
) 1 (
'
0
'
0
'
0
'
0
B
credit
r
P Q h
Q C NPV
+

+ =
The NPV of the credit strategy is
The decision to grant credit depends on four factors:
1. The delayed revenues from granting credit,
2. The immediate costs of granting credit,
3. The probability of repayment, h
4. The discount rate, r
B
'
0
'
0
Q P
'
0
'
0
Q C
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Example of the Decision to Grant Credit
A firm currently sells 1,000 items per month on a
cash basis for $500 each.
If they offered terms net 30, the marketing
department believes that they could sell 1,300 items
per month.
The collections department estimates that 5% of
credit customers will default.
The cost of capital is 10% per annum.
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Example of the Decision to Grant Credit
The NPV of cash only:
000 , 100 $ ) 400 $ 500 ($ 000 , 1 = =
No Credit Net 45
Quantity sold 1,000 1,300
Selling price $500 $500
Unit cost $400 $425
Probability of payment 100% 95%
Credit period (days) 0 30
Discount rate p.a. 10%
The NPV of Net 30:
58 . 181 , 60 $
) 10 . 1 (
95 . 0 500 $ 300 , 1
425 $ 300 , 1
365 / 30
=

+ =
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Example of the Decision to Grant Credit
How high must the credit price be to make it
worthwhile for the firm to extend credit?
The NPV of Net 30 must be at least as big as
the NPV of cash only:
365 / 30
'
0
) 10 . 1 (
95 . 0 300 , 1
425 $ 300 , 1 000 , 100 $

+ =
P
95 . 0 300 , 1 ) 10 . 1 ( ) 425 $ 300 , 1 000 , 100 ($
'
0
365 / 30
= + P
50 . 532 $
95 . 0 300 , 1
) 10 . 1 ( ) 425 $ 300 , 1 000 , 100 ($
365 / 30
'
0
=

+
= P
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The Value of New Information about
Credit Risk
The most that we should be willing to pay for new
information about credit risk is the present value of
the expected cost of defaults:
) 1 (
) 1 (
0 $
) 1 (
'
0
'
0
'
0
'
0
h Q C
r
h Q C NPV
B
default
=
+
+ =
In our earlier example, with a credit price of $500, we would
be willing to pay $26,000 for a perfect credit screen.
000 , 26 $ ) 95 . 0 1 ( 300 , 1 400 $ ) 1 (
'
0
'
0
= = h Q C
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Future Sales and the Credit Decision
Do not
give credit
Give
credit
Customer pays
h = 100%
Customer pays
(Probability = h)
Customer
defaults
(Probability = 1 h)
Give
credit
Do not
give credit
Our first decision:
We refuse further
sales to deadbeats.
We face a more certain credit
decision with our paying
customers:
Information is
revealed at the
end of the first
period:
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29.3 Optimal Credit Policy
Carrying
Costs
Total costs
C
*
Costs in
dollars
Level of credit extended
At the optimal amount of credit, the incremental cash
flows from increased sales are exactly equal to the
carrying costs from the increase in accounts receivable.
Opportunity costs
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29.3 Optimal Credit Policy
Trade Credit is more likely to be granted if:
1. The selling firm has a cost advantage over other lenders.
2. The selling firm can engage in price discrimination.
3. The selling firm can obtain favourable tax treatment.
4. The selling firm has no established reputation for
quality products or services.
5. The selling firm perceives a long-term strategic
relationship.
The optimal credit policy depends on the
characteristics of particular firms.
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Organizing the Credit Function
Firms that run strictly internal credit operations are self-
insured against default risk.
An alternative is to buy credit insurance through an
insurance company.
In Canada, exporters may qualify for credit insurance
through the Export Development Corporation (EDC).
Large corporations commonly extend credit through a
wholly owned subsidiary called a captive finance company.
Securitization occurs when the selling firm sells its accounts
receivable to a financial institution.
During 1991--92 recession, some Canadian companies
tightened their credit-granting rules to offset the higher
probability of customer bankruptcy.

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29.4 Credit Analysis
Credit Information
Financial Statements
Credit Reports on Customers Payment History with Other Firms
Banks
Customers Payment History with the Firm
Credit Scoring:
The traditional 5 Cs of credit
Character
Capacity
Capital
Collateral
Conditions
Some firms employ sophisticated statistical models
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Credit Scoring
Credit scoring refers to the process of:
(1) calculating a numerical rating for a customer based on
information collected,
(2) granting or refusing credit based on the result.
Financial Institutions have developed elaborate statistical
models for credit scoring. This approach has the advantage
of being objective as compared to scoring based on
judgments on the 5 Cs.
Credit scoring is used for business customers by Canadian
chartered banks. Scoring for small business loans is a
particularly attractive application because the technique
offers the advantages of objective analysis.
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29.5 Collection Policy
Collection refers to obtaining payment on past-due
accounts.
Collection Policy is composed of
The firms willingness to extend credit as reflected in the
firms investment in receivables.
Collection Effort
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Average Collection Period
Measures the average amount of time required to
collect an account receivable.
sales daily Average
receivable Accounts
period collection Average =
For example, a firm with average daily sales of
$20,000 and an investment in accounts receivable
of $150,000 has an average collection period of
days 5 . 7
day 000 , 20 $
000 , 150 $
=
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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 lagged
collection 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 the collections department and the sales
department.
You need to strike a balance between antagonizing
a customer and being taken advantage of by a
deadbeat.
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29.6 Other Aspects of Credit Policy/Factoring
The sale of a firms accounts receivable to a
financial institution (known as a factor).
The firm and the factor agree on the basic credit
terms for each customer.

Firm
Factor
Customer
Customers send
payment to the
factor
The factor pays an agreed-
upon percentage of the
accounts receivable to the
firm. The factor bears the
risk of nonpaying
customers
Goods
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Factoring
Factoring in Canada is conducted by independent
firms where main customers are small businesses.
What factoring does is remove receivables from
the balance sheet and so, indirectly, it reduces the
need for financing.
Firms financing their receivables through a
chartered bank may also use the services of a
factor to improve the receivables collateral value.
This is called maturity factoring with assignment
of equity.
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Credit Management in Practice
To make monitoring easy, treasury credit staff call
up customer information from a central database.
The system also provides collections staff with a
daily list of accounts due for a telephone call with a
complete history of each account.
Credit analysis uses an early warning system that
examines the solvency risk of existing and new
commercial accounts. The software scores the
accounts based on financial ratios.
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29.7 Summary & Conclusions
1. The components of a firms credit policy are the terms of
sale, the credit analysis, and the collection policy.
2. The decision to grant credit is a straightforward NPV
problem.
3. Additional information about the probability of customer
default has value, but must be weighed against the cost of
the information.
4. The optimal amount of credit is a function of the conditions
in which a firm finds itself.
5. The collection policy is the firms method for dealing with
past-due accountsit is an integral part of the decision to
extend credit.