credit management

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  1. Credit Management
      1. Effects of offering credit:
      2. Two types:
      3. Terms of sale:
      4. Cash discounts
      5. Industry trends
      6. How to decide how much credit to offer?
      7. Factors to consider
      8. The Optimal Credit Policy
      9. Profile of an ideal credit extending company:
    1. Tools for Credit Management
      1. Days Sales outstanding (DSO)
      2. Aging Schedule
    2. Financing Trade Credits
  2. see also : 

 

 

Credit Management

 

The decision by a firm to either (a) sell items just for cash, or (b) offer trade credit to its customers. 

 

 

Effects of offering credit:

lowering of prices to the customers....so the level of sales should increase.  Although the fixed amount of money that the customer owes you stays fixed, because you allow them to spread that payment out over time, the net present value of that cost is decreased to the customer.  So, they should be able to buy more from you because your prices just became cheaper. 

 

Two types:

1. Trade credit - includes about 1/6th of all assets of industrial firms (in accounts receivables) A/R and accounts payables (A/P)

2. consumer credit

 

Terms of sale:

1/10 net 30 ....means 1% discount for paying in 10 days, net due in 30 days

 

Cash discounts

the 1% cash discount is offered to give customers an incentive to hurry up their payment.  You need to do an NPV analysis to see if this makes sense for your firm. 

 

Industry trends

each industry has typical standards for offering credit

 

How to decide how much credit to offer?

need to consider:

1.  what is likelyhood that you will get paid back

2.  how big is the customer, ie. how important are they to your business

 

Factors to consider

 

a. the probability of getting paid

b. the delayed revenues from offering credit (are they higher than if you dont offer credit?)

c. the current costs of offering credit (does it take extra work to offer credit?  credit check, for example)

d. what is the right discount rate to use to evaluate the net present value of the cash flows?

 

 

The Optimal Credit Policy

 

There is a trade off decision that you need to make:  should you continue to add more sales by offering more credit?  But, what about the additional cost of bad sales, and running a credit department?  At the optimum level, you should have a balance between the cost of "carrying" more credit, with the "opportunity costs" of missing out on extra sales from not offering more credit.

 

 

Reasons for offering Credit:

1.  The selling firm is relatively new, or if the buying firm can not accurately predict the quality of the product before it is shipped.  In this case, the industry standard may be selling firms to extend credit to buyers so that they have a chance to inspect the merchandise before paying.  This is common in the furniture trade, as well as other industries. 

 

2.If the selling firm can reduce taxes by extending credit...by spreading a fixed tax bill results in posititve NPV.

 

3. more...

 

Profile of an ideal credit extending company:

High tax bracket, repeat customers, excess capacity, low variable costs, able to raise prices slightly to cover the cost of offering credit. 

 

 

 

Tools for Credit Management

 

Days Sales outstanding (DSO)

This ratio determines the average collection period for a firm, or the days that sales are in receivables.   It is one of the many useful "turnover ratios"in financial statement analysis 

 

Like all turnover ratios, this one is Sales / assets.   In this case, the assets are A/R (accounts receivables). 

 

To find the days, just take 365, and divide it by the turnover ratio...that will tell you the DSO (or average collection period) for the firm.

 

This tool is commonly used by outside analysts to determine the efficiency of the company, or how well they are using their investment in A/R to generate sales.

 

 

Aging Schedule

 

This tool is mostly used internally in a company to monitor the daily / monthly outstanding balances of A/R.   They watch for patterns over time, and compare one year vs. the next to see how the company is operating compared to other similar time frames. 

 

 

Financing Trade Credits

 

how to finance accounts receivable  

 

 

 

see also : 

 

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