CREDIT AND COLLECTION POLICY

Introduction
 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.
Credit Policy

 A firm’s credit policy is composed of:

Terms of the sale
Credit analysis
Collection policy
Terms of Sale
 A term of sale is the agreed method by which
the sale will be processed.
 “terms of sale” refers to the period for which credit
is granted, the cash discount, and the type of credit
instrument
 typical credit terms for accounts receivable are
2/10, net 30. Note that this implies a significant
cost to late payment
 credit terms (and their effect on sales) determine
the profitability of extending credit
Credit Analysis
 firms gather information to evaluate likelihood of
payment:
 financialstatements
 credit reports on customer payment history with other
firms
 banks

 customer’s payment history with the firm

Credit Analysis
 typical credit worthiness evaluation criteria (the 5
C’s)
 character (willingness to pay)
 capacity (ability to pay from operating cash flow)

 capital (ability to pay from capital reserves)

 collateral (pledged asset in case of default)

 conditions (economic conditions of customer’s line of

business)
Credit Analysis
 systems have been developed based on these and
similar criteria
Collection Policy
 “collection” refers to obtaining payment of past due
accounts
 collection may involve
 sending past-due delinquency notices
 calling the customer

 employing a collection agency

 taking legal action against the customer

The Cash Flows of Granting Credit
Credit sale Customer Firm Bank credits
is made mails cheque deposits firm’s
cheque account

Time

Cash collection

Accounts receivable
Terms of the sale
 The terms of sale is composed of
Credit Period
Cash Discounts
Credit Instruments
 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
 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.
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.
$970

0 10 30
Other customers will pay on day 30 and forgo the discount.
$1,000

0 10 30
The Interest Rate Implicit in 3/10 net 30
A customer that forgoes the 3% discount to pay on day 30 is
borrowing $970 for 20 days and paying $30 interest:
+$970 -$1,000

0 10 30

$1,000 $1,000
$970  (1  r ) 20 365

(1  r ) 20 365 $970
365
 $1,000  20
r    1  0.7435  74.35%
 $970 
 Credit Instruments
 Most credit is offered on open account—the 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 customer’s
bank, when the customer signs the draft, the goods are sent.
 Banker’s 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.
 The significant difference
between the two is that the
invoice is issued prior to the
payment while the receipt is
Invoice

issued after the payment.

Simple Promissory Note
Commercial Drafts
 Demand Draft
Commercial Drafts
 Sight Draft
Banker’s Acceptance
The Decision to Grant Credit: Risk and Information

 Consider a firm that is choosing between two alternative

credit policies:
 Everybody else pays cash
 Offering their customers credit.

• The only cash flow of the first strategy is Q0  ( P0  C 0 )

• The expected cash flows of the credit strategy are:

 C0' Q0' h  Q0' P0'

0 1
We incur costs up …and get paid in 1 period
front… by h% of our customers.
The Decision to Grant Credit: Risk and Information

•The NPV of the cash only strategy is

NPVcash  Q0  ( P0  C 0 )
•The NPV of the credit strategy is
h  Q ' '
0 P0
NPVcredit  C0Q0 
' '

(1  rB )
The decision to grant credit depends on four factors:
1. The delayed revenues from granting credit, P0'Q0'
2. The immediate costs of granting credit, C0' Q0'
3. The probability of repayment, h
4. The discount rate, rB
 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.
Example of the Decision to Grant Credit
No Credit Net 30
Quantity sold 1,000 1,300
Selling price $500 $500
Unit cost $400 $425
Probability of payment 100% 95%
Credit period (days) 0 30
Discount rate p.a. 10%
The NPV of cash only:  1,000  ($ 500  $ 400 )  $ 100,000
The NPV of Net 30:
1,300  $500  0.95
 1,300  $425  30 / 365
 $60,181.58
(1.10)
 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
1,300  P0'  0.95
$100,000  1,300  $425 
(1.10) 30 / 365

($ 100,000  1,300  $425)  (1.10) 30 / 365  1,300  P0'  0.95

($ 100, 000  1,300  $ 425)  (1 . 10 ) 30 / 365

P0'   $532.50
1,300  0.95
Seatwork Decision to Grant Credit
CASH CREDIT

Quantity sold 7000 7000

Selling price 530 530

Unit cost 500 500
Probability of 100% 98%
payment
Discount rate 2%
 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:
$0
NPVdefault  C  Q  (1  h) 
' '

(1  rB )
0 0

 C0'  Q0'  (1  h)
In our earlier example, with a credit price of $500, we would be
willing to pay $26,000 for a perfect credit screen.

C 0'  Q0'  (1  h )  $400  1,300  (1  0.95)  $26,000

 Optimal Credit Policy

Costs in Total costs

dollars
Carrying
Costs

Opportunity costs

C* 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.
 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 favorable 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.
 Credit Analysis
 Credit Information
 Financial Statements
 Credit Reports on Customer’s Payment History with Other Firms
 Banks
 Customer’s Payment History with the Firm
 Credit Scoring:
 The traditional 5 C’s of credit
 Character
 Capacity
 Capital
 Collateral
 Conditions
 Some firms employ sophisticated statistical models
 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 C’s.
 Credit scoring is used for business customers by chartered
banks. Scoring for small business loans is a particularly
attractive application because the technique offers the
advantages of objective analysis.
 FICO, originally Fair, Isaac and Company, is a data analytics
company based in San Jose, California focused on credit
scoring services.
 FICO score, a measure of consumer credit risk, has become a
fixture of consumer lending in the United States.
 Collection Policy
 Collection refers to obtaining payment on past-due
accounts.
 Collection Policy is composed of

 The firm’s willingness to extend credit as reflected

in the firm’s investment in receivables.
 Collection Effort
 Average Collection Period
 Measures the average amount of time required to collect
an account receivable.
Accounts receivable
Average collection period 
Average daily sales

• 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

$150,000
 7.5 days
$20,000 day
Significance and Interpretation

 Like receivables turnover ratio, average

collection period is of significant importance
when used in conjunction with liquidity ratios.
 A short collection period means prompt
collection and better management of
receivables. A longer collection period may
negatively affect the short-term debt paying
ability of the business in the eyes of analysts.
 Whether a collection period is good or bad, depends
on the credit terms allowed by the company. For
example, if the average collection period of a
company is 50 days and the company allows credit
terms of 40 days then the average collection period
is worrisome. On the other hand, if the company’s
credit terms are 60 days then the average collection
period of 50 days would be considered very good.
 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.
Other Aspects of Credit Policy/Factoring
 The sale of a firm’s accounts receivable to a
financial institution (known as a factor).
 The firm and the factor agree on the basic credit
terms for each customer.
The factor pays an
agreed-upon percentage
of the accounts receivable
Customers send to the firm. The factor
payment to the bears the risk of nonpaying
factor customers
Factor

Customer Firm
Goods
 Factoring

 Factoring 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.
 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.
Credit Limits
 Purpose and advantages
 Serve as guides to credit management and control.
 Through its use, before the determination of credit
limits, there is the need for careful investigation and
comprehensive analysis of the elements composing a
given risk.
 It is an overall device for the control of credit
extensions.
 Credit limits aid in reducing the cost, of credit
management and in enhancing its efficiency.
 Limits also work to the advantage of debtors. It serves
as a check against reckless buying spree which if
unchecked, could ruin the lives of debtors and as such
suffer the disgrace of being labelled as poor debtors.
Principles of Controlled Credit
 Only after a thorough investigation of the credit
worthiness of the customer seeking credit may credit
be granted.
 Each new customer should be made acquainted with
the terms and conditions as promulgated and
implemented by the business firm with respect to
terms of payment; discounts, if any; credit period;
and credit limit.
 It is necessary that the first reminder be sent
immediately (i.e. The next day after bills become
past due)
 Continued use of the credit privilege should be
suspended in respect to slow paying customers.
Such privilege may be given back to them only
after they have paid their existing indebtedness.
 Decisions and actions should be characterized by
firmness but short of being rude and arrogant.
 When it becomes absolutely necessary, the services
of collection agencies must be sought or legal
services enlisted as the case may be.
5 Cs of a Bad Credit
Meaning of 5Cs
1. COMPLACENCY: “I don’t need to watch this
debtor, they always paid on time.”
2. CARELESSNESS: being sloppy and unorganized
among loan files of the clients.
3. COMMUNICATION: first breakdown between the
clients and the lending officer.
4. CONTINGENCIES: lenders have one of the hardest
job as they need to be correct 99.5% of the time.
5. COMPETITION: it causes lender to strange things.
COMPLACENCY
 It stems from the attitude, “I don’t need to watch
this borrower; they have always paid on time.”
 This blinds lenders from seeing the need to
monitor the company which may end up with a
nasty surprise when the default comes.
 Complacency can come from an overreliance on
past performance of the company, guarantors, or
the economy.
 Some may also look at the net worth of the
sponsors of the credit and think there is no need to
monitor the credit.
CARELESSNESS
 One of the most popular forms of carelessness is
sloppy, unorganized loan files with inadequate
documentation. In some cases, collateral is not
properly perfected, resulting in the lender’s
collateral position being compromised.
 Sometimes, loan officers will fail to document
conversations with borrowers and then are caught
reconstructing the file at the last minute as the bank
is taking the customer to court to recover the
loan. Or they may leave items out of loan
documents that should have been in there to protect
the lender.
COMMUNICATION
 Communication breakdown may be a simple
problem, or it can bring down an entire
institution. The first breakdown may be between
the officer and the borrower.
 This can lead to a startled lender, when a seemingly
good credit all of the sudden is incapable of
making payments. It is important to have good
relationships with the borrower that fosters
communication between your borrower and you as
the officer.
 Remember, you should have a commanding and
current knowledge of your borrower.
CONTIGENCIES

 Lenders have one of the hardest jobs as

they need to be correct 99.5% of the
time. Once your losses begin to creep up
over that ½% level, it could begin to
impair your capital. Truly, commercial
lending has one of the smallest margins of
error of any profession. Imagine what
would happen in baseball if you had to
get a hit that often to be successful!
 Lending is risk analysis. We are to look at every bad
thing that could occur and then decide on how likely
any of those things can happen. A lack of attention
to a downside risk can hurt the ability of the loan to
get repaid if the economy slows down, occupancy
drops or company revenues fall. This is why it is
important to stress test the credit at underwriting in
applying breakeven analysis, increase the loan
interest rate, raise the cap rate, and also reduce
company revenues to see how the credit will perform.
COMPETITION
 Competition causes lenders to do strange
things. Too often, credit decisions are based
upon what the institution down the street is doing
rather than concentrating on the merits and risks
of the loan in front of them.
 Unfortunately, this often leads to loosening credit
standards down to the lowest common
denominator. When the losses begin to roll in, at
least you will have company with other lenders
who are in the same boat.
 A competitive euphoria is a sickness that may cause
the institution to lower the price or seek a reduced
covenant or collateral position just to get the
deal. Oftentimes, the results of these closings are
touted as the credit union having a stronger market
share than its peers. But higher market share with
poor credits is not a way to build your shop.