Credit and Inventory Management_2003

7/30/2019 Credit and Inventory Management_2003

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Optimal Credit Policy

&

Credit Analysis

Group 10Chan Wing Lam, Heather 10012257Chiu Mei Ting, Macy 10017082Hui Ka Wing, Francesca 10011854

Leung Pui Wah, Sanita 10009388


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Agenda1. Optimal Credit Policy

What is Credit?

The Total Credit Cost Curve

Organizing the Credit Function

2. Credit Analysis When should credit be granted in following two cases?

i) one-time saleii) repeat business

Source of Credit Information

Credit evaluating and scoring


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What is Credit? Definition:A firm extends credit to customers to

allow some delay in payment


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Optimal Credit Policy The optimal amount of credit is found at the point at which

incremental

cash flow fromincreased sales

incremental costs ofcarrying the increase in

investment in accountreceivables


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Optimal Credit Policy Carrying cost:

1. The required return onreceivables2. The losses from bad debt3. The costs of managing creditand credit collection*

Positively related to the amount

of credit extended

*Expenses associated withrunning the credit department


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Optimal Credit Policy Opportunity Cost: the lost sales resulting from

refusing credit. These costs go down when credit isgranted.

Negatively related to the amount of credit extended:Higher opportunity cost

Decrease in quantity sold

Loss of extra potential profit from credit sales


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(Optimal Credit Cost Curve)


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Optimal amount of credit: the point at which total

credit cost is minimized



`


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To the right:

amount of credit > optimum (minimum) credit Additional new cash flow from customer




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To the left:

amount of credit < optimum(minimum) credit Forgoing valuable profit opportunities




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Optimal Credit Policy Factors affecting the cost and benefit from extending

credit

1. Excess capacity2. Low variable operating cost(less sensitive to the operating cyclemore capital to support the credit policy)

3. Repeat customers

The firm credits more liberally than other firms


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Organizing Credit Function 2 Ways to organize the Credit Function (to allow the

firm to achieve a lower overall cost of debt)

1. Running a credit department itself

2. Contract out all or part of the creditfunction to a factor, an insurance companyor a captive finance company


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Credit Analysis Definition: the process of deciding whether or not to

extend credit to a particular customer

Step 2

Determine credit worthiness

Step 1

Gather relevant information


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Importance of Credit Analysis

reduce the substantial potentiallosses on receivables

Importance of CreditAnalysisReduce the substantial

potential losses on receivables


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Credit Analysis When should Credit

Be Granted? (One-Time Sales) A One-Time Sale: New customer buys one unit on credit at the price

of P per unit

1. When credit is refused Customer will not make purchase

2. When credit is granted

(1-x): probability to pay on due date

x: probability to default

R: required return on receivables

v: variable cost

NVP = -v + (1 x) P/ (1 + R)


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Be Granted? (One-Time Sales)

For example, for Locust Software, this NPV is:NPV = -$20 + (1-x) X 49/ 1.02

With , say, a 20 percent rate of default, this works out to be:

NPV = -$20 + .80 X 49/ 1.02 = $18.43 >/= 0

So, the firm grants the credit.

NVP = -v + (1 x) P/ (1 + R)


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Be Granted? (One-Time Sales)Maximum Acceptable Default Probability

For a new customer, the creditmay be granted even if a defaultprobability is high.

The firm risks its variable costand stands to gain the full price.


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With probability (1-x), the firm has a permanent newcustomer NPV of extending credit:

For Locust, this is:NPV = -$20 + (1-x) X (49 -20)/.02

= -$20 + (1-x) X 1,450 Even if the probability of default is 90 percent, the NPV is:

NPV = -$20 + .10 X 1,450 = $125


Be Granted? (Repeat Business)

NPV = -v + (1-x)(P-v)/ R


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Be Granted? (Repeat Business) The firm should grant credit to

almost anyone

The most important is tocontrol the amount of creditinitially offered in order tolimit the potential loss

The amount of credit canincrease with time


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Source of Credit InformationFinancial statement

(balance sheet + income statement

financial ratio)

Banks

Credit reports(about the customers payment

history with other firms)

Customers paymenthistorywith the firm

Source of CreditInformation


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Credit Scoring Credit Scoring: the process of calculating a numerical

ratingfor a customer based on information collected

Rate on each of the five Cs of Credit and then add them up(1 very poor; 10 very good)

In most cases, firm will the credit only when the score > 30


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Organizing Credit Function

Factor: may have full responsibility for creditchecking, authorization, and collection


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Organizing Credit Function Captive finance company: simply a wholly owned

subsidiarythat handle the credit function for theparent company

To separatethe production and financing of the firmsproduct for management, financing and reporting

e.g., The finance subsidiary can borrow in its own

name, using its receivables as collateral, and thesubsidiary often carries a better credit rating than theparent

Credit and Inventory Management_2003

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