Credit Management

Principles of Corporate FinanceBrealey and Myers Sixth Edition

Slides by

Matthew Will Chapter 30

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Topics Covered

Terms of Sale Commercial Credit Instruments Credit Analysis The Credit Decision Collection Policy Bankruptcy

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Terms of Sale

Terms of Sale - Credit, discount, and payment terms offered on a sale.

Example - 5/10 net 30

5 - percent discount for early payment

10 - number of days that the discount is available

net 30 - number of days before payment is due

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Terms of Sale

A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier.

We can calculate the implicit cost of this loan.

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Terms of Sale

A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier.

We can calculate the implicit cost of this loan

( )Effective annual rate

1 + - 1discountdiscounted price

365 / extra days credit=

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Terms of Sale

Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given?

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Terms of Sale

Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given?

45.4%or .454,=1-+1

1-+1

rate annual Effective

365/50

955

credit days 365/extra

price discounteddiscount

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Credit Instruments

Terminology open account promissory note commercial draft sight draft time draft trade acceptance banker’s acceptance

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Credit Analysis

Credit Analysis - Procedure to determine the likelihood a customer will pay its bills.

Credit agencies, such as Dun & Bradstreet provide reports on the credit worthiness of a potential customer.

Financial ratios can be calculated to help determine a customer’s ability to pay its bills.

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Credit Analysis

Numerical Credit Scoring categories The customer’s character The customer’s capacity to pay The customer’s capital The collateral provided by the customer The condition of the customer’s business

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Credit Analysis

Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time.

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Credit Analysis

Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time.

Altman Z Score formula

Z = 3.3EBIT

total assets+ 1.0

sales

total assets+.6

market value of equity

total book debt

+ 1.4retained earnings

total assets+ 1.2

working capital

total assets

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Credit Analysis

Example - If the Altman Z score cut off for a credit worthy business is 2.7 or higher, would we accept the following client?

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Credit Analysis

Example - If the Altman Z score cut off for a credit worthy business is 2.7 or higher, would we accept the following client?

EBIT

total assets

sales

total assets

market equity

book debt

=

=

=

1 2

1 4

9

.

.

.

retained earnings

total assets

working capital

total assets

=

=

.

.

4

12

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Credit Analysis

Example - If the Altman Z score cut off for a credit worthy business is 2.7 or higher, would we accept the following client?

A score above 2.7 indicates good credit.

Firm' s Z Score

( . . ) ( . . ) ( . . ) ( . . ) ( . . ) .3 3 12 1 0 1 4 6 9 1 4 4 1 2 12 3 04x x x x x+ + + + =

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Credit Analysis

Credit analysis is only worth while if the expected savings exceed the cost. Don’t undertake a full credit analysis unless the

order is big enough to justify it. Undertake a full credit analysis for the doubtful

orders only.

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The Credit Decision

Credit Policy - Standards set to determine the amount and nature of credit to extend to customers.

Extending credit gives you the probability of making a profit, not the guarantee. There is still a chance of default.

Denying credit guarantees neither profit or loss.

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The Credit Decision

The credit decision and its probable payoffs

Refuse credit

Offer credit

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The Credit Decision

The credit decision and its probable payoffs

Refuse credit

Offer credit

Customer pays = p

Customer defaults = 1-p

Payoff = 0

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The Credit Decision

The credit decision and its probable payoffs

Refuse credit

Offer credit

Customer pays = p

Customer defaults = 1-p

Payoff = Rev - Cost

Payoff = - Cost

Payoff = 0

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The Credit Decision

Based on the probability of payoffs, the expected profit can be expressed as:

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The Credit Decision

Based on the probability of payoffs, the expected profit can be expressed as:

p x PV(Rev - Cost) - (1 - p) x (PV(cost)

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The Credit Decision

Based on the probability of payoffs, the expected profit can be expressed as:

The break even probability of collection is:

p x PV(Rev - Cost) - (1 - p) x (PV(cost)

p =PV(Cost)

PV(Rev)

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Collection Policy

Collection Policy - Procedures to collect and monitor receivables.

Aging Schedule - Classification of accounts receivable by time outstanding.

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Collection Policy

Sample aging schedule for accounts receivable

$298,000$58,000$40,000$200,000Total

30,00021,0004,0005,000Omega

*****

*****

*****

5,0005,00000Beta

10,0000010,000AlphaOwed

Total

Overdue Month

1 thanMore

Overdue

Month1

Yet Due

NotAmount

Name

sCustomer'