Transcript Short-Term Financial Management

SHORT-TERM
FINANCIAL MANAGEMENT
Chapter 6 – Credit Policy & Collections
2
Chapter 6 Agenda
CREDIT POLICY & COLLECTIONS
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.
Cash Flow Timeline
3
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.
Credit Policy & Collections
4


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.
Credit Policy & Collections
5

Strategic changes to Credit Policy are considered
when:
 Sales
volume and/or profits can be enhanced.
 Receivables
performance is unsatisfactory.
 Competitors
change credit terms.
Credit Policy & Collections
6

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.
Credit Policy & Collections
7

Credit Managers can predict the impact from
credit policy changes on
 Sales
 Default
probabilities
 Delinquency
Value Maximizing Decisioning
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

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.
Changing Credit Terms
9

Before we said our goal is to
design a credit policy that
maximizes NPV.
Variables
Terms (all sales are credit sales)
Sales Growth Rate (g)
Annual Credit Sales


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.
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)
Changing Credit Terms
10



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.
Variables
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)
Z=
+
–
–
PV of Sales To Discount Takers
PV of Sales to Non-Discount Takers
Variable Operating Costs
PV of Credit/Collection Costs
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)
Modeling Z
11

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.
Modeling Z
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
Before, we calculated the NPV from a single sale, using the
following formula.
NPV 

S  EXP  S 
1  iCP
 VCR  S 
Now, we will model the NPV of a single average day’s sales
(Z):
Z 
S (1  d ) p (1  b )
(1  iDP )

S (1  p )( 1  b )
(1  iCP )
 VCR ( S ) 
EXP ( S )
(1  iCP )
Modeling Credit Terms
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Variables
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
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 )
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.
1
Variable Cost Ratio (VCR)
Collection/Credit Exp (EXP) at CP
Bad Debt Expense Ratio (b) at CP
Annual Cost of Capital (i)
Modeling Credit Terms Illustrative
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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.
Variables
Terms (all sales are credit sales)
Terms
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 )
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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%
Changing Credit Terms
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
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
Decision Rule:
If Delta Z > 0  Accept policy change
If Delta Z = 0  Indifferent about policy change
If Delta Z < 0  Reject policy change
The aggregate NPV is calculated from the daily NPV (Z):

NPV = Z / i
Modeling Changes to Credit Terms
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ZE =
ZE =
Existing
Policy
ZN =
ZN =
New
Policy
SE(1-dE)pE(1-bE) / (1 + iDPE)
+ SE(1-pE)(1-bE) / (1 + iCPE)
‐ VCR (SE)
‐ EXPE (SE) / (1 + iCPE)
 PV of Discounted Invoices
 PV of Non-Discounted Invs
 Variable Cost Pmts
 PV of Credit Expense Pmts
[(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)
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).
Credit Policy Modeling Example
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Lengthening Credit Period (no cash discount)


Offer net-60 rather than net-30 terms.
Variables
Terms (all sales are credit sales)
Current Terms (E)
Proposed Terms
(N)
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
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
DSO - Non-Discount Takers (CP )
Credit Policy Modeling Example
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Lengthening Credit Period (no cash discount)


Offer net-60 rather than net-30 terms.

First, calculate ZE.
Variables
Terms (all sales are credit sales)
Current Terms (E)
Proposed Terms
(N)
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
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
DSO - Non-Discount Takers (CP )
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
Credit Policy Modeling Example
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Lengthening Credit Period (no cash discount)


Offer net-60 rather than net-30 terms.

Now, calculate ZN.
Variables
Terms (all sales are credit sales)
Current Terms (E)
Proposed Terms
(N)
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
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
DSO - Non-Discount Takers (CP )
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
Credit Policy Modeling Example
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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
Another Modeling Example
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Introduce Cash Discount


Offer 2/10, net-30 rather than net-30 terms.
Variables
Terms (all sales are credit sales)
Current Terms (E)
Proposed Terms
(N)
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
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
DSO - Non-Discount Takers (CP )
Another Modeling Example
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Introduce Cash Discount


Offer 2/10, net-30 rather than net-30 terms.

First, calculate ZE.
Variables
Terms (all sales are credit sales)
Current Terms (E)
Proposed Terms
(N)
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
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
DSO - Non-Discount Takers (CP )
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
Another Modeling Example
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Introduce Cash Discount


Offer 2/10, net-30 rather than net-30 terms.

Now, calculate ZN.
Variables
Terms (all sales are credit sales)
Current Terms (E)
Proposed Terms
(N)
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
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
DSO - Non-Discount Takers (CP )
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
Another Modeling Example
24
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
Competitor Reaction
25



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).
Monitoring Receivables
26

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:
Accounts
receivable

Days Sales Outstanding (DSO).

Accounts Receivable Turnover.

Aging Schedules (organizes A/R into categories-next slide).
DSO 
( Annual credit sales / 365 )
Credit Policy & Collections
27

Last time we said the Credit Policy includes:
Credit Standards
1.

Create a profile of the minimally acceptable credit-worthy customer.
Credit Terms
2.

Define how long the customer has to pay and/or the offering of Cash
Discounts.
Credit Limits
3.

Determine the amount of cumulative credit offered to a single
customer and/or group of customers.
Collection Process (Chapter 6)
4.

Determine how and when past-due accounts are handled.
Collection Procedures
28


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.
Trends in Receivables
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