CREDIT MANAGEMENT

By Prof Sameer Lakhani

OUTLINE Terms of Payment Credit Policy Variables Credit Evaluation Credit Granting Decision Control of Accounts Receivable Credit Management in India

TERMS OF PAYMENT
Cash Terms - Cash in advance is generally insisted upon when goods are made to order. In such a case, the seller would like to finance production and eliminate marketing risks. Cash on delivery is often demanded by the seller if it is in a strong bargaining position and/or the customer is perceived to be risky. Open Account - Credit sales are generally on open account. This means that the seller first ships the goods and then sends the invoice (bill). The credit terms (credit period, cash discount for prompt payment, the period of discount and so on) are stated in the invoice which is acknowledged by the buyer. Cash Discount Firms generally offer cash discount to induce customers to make prompt payment. For example, credit terms of 2/10, net 30 mean that a discount of 2 percent is offered if the payment is made by the tenth day; otherwise, the full payment is due by the thirteenth day. Consignment - When goods are sent on consignment, they are merely shipped but not sold to the consignee. The consignee acts as the agent of the seller (consignor). The title of the goods is retained by the seller till they are sold by the consignee to a third party.

CREDIT POLICY VARIABLES The important dimensions of a firms credit policy are: Credit standards Credit period Cash discount Collection effort These variables are related and have a bearing on the level of sales, bad debt loss, discounts taken by customers, and collection expenses

CREDIT STANDARDS Liberal Sales Bad debt loss Investment in receivables Collection costs Higher Higher Larger Stiff Lower Lower Smaller

Higher

Lower

IMPACT ON RESIDUAL INCOME OF RELAXATION

RI = [S(1 V) - S bn] (1 t ) k I where RI = change in residual income S = increase in sales V = ratio if variable costs to sales bn = bad debt loss ratio on new sales t = corporate tax rate

I = increase in receivables investment Where I = S * ACP * V

IMPACT ON RESIDUAL INCOME OF RELAXATION

RI = [S(1 V) - S bn] (1 t ) k I On the right hand side of the Eq S (1-V), measures the increase in gross profit (defined here as sales minus variable costs) on account of incremental sales, S b, reflects the bad debt loss on incremental sales, [S(1 V) - S bn] (1 t ) represents the post-tax profit arising from increase in sales after considering bad debt losses, and k I measures the post-tax opportunity cost of additional funds locked in receivables.

EXAMPLE
The current sales of Pioneer Company are Rs. 100 million. The company classifies its customers into 4 credit categories, 1 through 4. Credit rating diminishes as one goes from category 1 to category 4. (Customer in category 1 have the highest credit rating and customers in category 4 have the lowest credit rating). Pioneer presently extends unlimited credit to customers in categories 1 and 2, limited credit to customers in category 3, and no credit to customers in category 4. As a result of this credit policy, the company is foregoing sales to the extent of Rs. 10 million to customers in category 4. The firm is considering the adoption of a more liberal credit policy under which customers in category 3 would be extended unlimited credit and customers in category 4 would be extended limited credit. Such relaxation would increase the sales by Rs. 15 million on which bad debt losses would be 10 percent. The contribution margin ratio, (1-V), for the firm is 20 percent, the average collection period, ACP, is 40 days, and the post-tax cost of funds, k, is 10 percent. The tax rate for Pioneer is 40 percent. Given the above information, the effect of relaxing the credit policy on residual income would be :

EXAMPLE Pioneer Limited is considering relaxing its credit standards. S = Rs.15 million, bn = 0.10, V = 0.80, ACP = 40 days, k = 0.10, t = 0.4 RI = [15,000,000 (1 0.80) 15,000,000 x 0.10] (1 0.4) 15,000,000 0.10 x 360 = Rs.766,667 Since the impact of change in credit standards on net profit is positive, the proposed change is desirable. x 40 x 0.80

The credit period refers to the length of time customers are allowed to pay for their purchases. It generally varies from 15 days to 60 days. When a firm does not extend any credit, the credit period would obviously be zero. If a firm allows 30 days, say, of credit, with no discount to induce early payments, its credit terms are stated as 'net 30'. Longer Shorter Sales Higher Lower Investment in receivables Bad debts Larger Higher Smaller Lower

CREDIT PERIOD

Since the effects of lengthening the credit period are similar to that of relaxing the credit standards, we may estimate the effect on residual income of change in credit period by using the same formula: Impact on Residual Income of Longer Credit Period

INCREASE IN RECEIVABLES INVESTMENT

I = (ACPn ACP0) S0 + V (ACPn) 360 where: I 360 S

= increase in receivables investment

ACPn = new average collection period (after lengthening the credit period) ACP0 = old average collection period V S = ratio of variable cost to sales = increase in sales

INCREASE IN RECEIVABLES INVESTMENT

I = (ACPn ACP0) S0 + V (ACPn) 360 360 S

On the right hand side of Eq the first term represents the incremental investment in receivables associated with existing sales and the second term represents the investment in receivables arising from incremental sales. It may be noted that the incremental investment in receivables arising from existing sales is based on the value of sales, whereas the investment in receivables arising from new sales is based on the variable costs associated with new sales. The difference exists because the firm would have collected the full sales price on the old receivables earlier in the absence of credit policy change, whereas it invests only the variable costs associated with new receivables.

EXAMPLE
Zenith Corporation currently provides 30 days of credit to its customers. Its present level of sales is Rs. 50 million. The firm's cost of capital is 10 percent and the ratio of variable costs to sales is 0.85. Zenith is considering extending its credit period to 60 days. Such an extension is likely to push sales up by Rs. 5 million. The bad debt proportion on additional sales would be 8 percent. The tax rate for Zenith is 40 percent.

RI = [5,000,000 x 0.15 5,000,000 x 0.08] (0.6) 0.10 (60 30) x 50,000,000 + 0.85 x 60 x 5,000,000 360 360 = [750,000 400,000] (0.6) 0.10 [4,166,667 + 708,333] = 277,500

LIBERALISING THE CASH DISCOUNT POLICY

Firms generally offer cash discounts to induce customers to make prompt payments. The percentage discount and the period during which it is available are reflected in the credit terms. For example, credit terms of 2/10, net 30 mean that a discount of 2 percent is offered if the payment is made by the tenth day; otherwise the full payment is due by the thirtieth day. Liberalizing the cash discount policy may mean that the discount percentage is Increased and/or the discount period is lengthened. Such an action tends to enhance sales (because the discount is regarded as price reduction), reduce the average collection period (as customers pay promptly), and increase the cost of discount. The effect of such an action on residual income may be estimated by the following formula:

RI = [S(1 V) - DIS] (1 t ) + k I

LIBERALISING THE CASH DISCOUNT POLICY RI = [S(1 V) - DIS] (1 t ) + k I

Where S is increase in sales, V is the ratio of variable cost to sales, K is the cost of capital, I is the savings in receivables investment, DIS is the increase in discount cost.

EXAMPLE
The present credit terms of Progressive Company are 1/10, net 30. Its sales are Rs. 80 million, its average collection period, ACP, is 20 days, its variable costs to sales ratio, V, is 0.85, and its cost of capital, k, is 10 percent. The proportion of sales on which customers currently take discount, p, is 0.5. Progressive is considering relaxing its discount terms to 2/10, net 30. Such a relaxation is expected to increase sales by Rs. 5 million, reduce the ACP to 14 days, and increase the proportion of discount sales to 0.8. Progressive's tax rate is 40 percent. Given the above information, the effect of relaxing the discount policy on residual income would be: [ 5,000,000 (0.15) 9,60,000] (1-0.4) + 0.10 * 1,168,055 = Rs 9194 DIS = 0.8(80,000,000+5,000,000)0.02 - 0.5*80,000,000*0.01 = 9,60,000 I = (20-14) * 80,000,000 - 0.85 * 5,000,000 *14 = 1,168,055 360 360 Since the impact of change in discount policy on residual income is negative, it is not desirable to change the discount terms from 1/10, net 30 to 2/10, net 30.

DECREASING THE RIGOUR OF COLLECTION PROGRAMME

A rigorous collection programme tends to decrease sales, shorten the average collection period, reduce bad debt percentage, and increase the collection expense. A lax collection programme, on the other hand, would push sales up, lengthen the average collection period, increase the bad debt percentage, and perhaps reduce the collection expense. The effect of decreasing the rigour of collection programme on residual income may be estimated as follows:

where RI is the change in residual income, S is the increase in sales, V is the variable costs to sales ratio, BD is the increase in bad debt cost, t is the tax rate, k is the cost of capital, and I is the increase in investment in receivable. Where BD = bn (So + S) boSo I = (ACPn ACP0) S0 + V (ACPn) S

RI = [S(1 V) - BD] (1 t ) k I

EXAMPLE

ABC Company is considering relaxing its collection effort. Its sales are Rs. 40 million, its average collection period, ACP, is 20 days, its variable costs to sales ratio, V, is 0.80, its cost of capital, k, is 12 percent, and its bad debt ratio is 0.05. The relaxation in collection effort is expected to push sales up by Rs. 5 million, increase the average collection period to 40 days, and raise the bad debt ratio to 0.06. ABC's tax rate is 40 percent. Given the above information, the effect of relaxing the collection effort on residual effect Since the on residual income would be: [5,000,000 * (0.2) 7,00,000](0.6) 0.12 (2,666,666) = -Rs 1,40,000 BD = bn (So + S) boSo BD =0.06 (40,000,000 + 5,000,000) (0.05 * 40,000,000) = Rs 7,00,000 S0 + V (ACPn) 360 0.80 * 40 * 5,000,000 = Rs 2,666,666 S
income is negative, it is not worthwhile to relax the collection effort.

I = (ACPn ACP0)

360 I = [(40-20) * 40,000,000 +

ERRORS IN CREDIT EVALUATION

In assessing credit risks, two types of errors occur : Type I error Type II error A good customer is misclassified as a poor credit risk A bad customer is misclassified as a good credit risk

Type I error leads to loss of profit on sales to good customers who are denied credit. Type I1 error results in bad debt losses on credit sales made to risky customers. While misclassification errors cannot be eliminated wholly, a firm can mitigate their occurrence by doing proper credit evaluation. Three broad approaches are used for credit evaluation, viz., traditional credit analysis, numerical credit scoring, and discriminant analysis

TRADITIONAL CREDIT ANALYSIS Five Cs of Credit Character : The willingness of the customer to honour his obligations Capacity Capital Collateral : The operating cash flows of the customer : The financial reserves of the customer : The security offered by the customer

Conditions : The general economic conditions that affect the customer

TRADITIONAL CREDIT ANALYSIS

To get information on the five C's, a firm may rely on the following: Financial Statements : The following ratios seem particularly helpful in this context: current ratio, acid-test ratio, debt-equity ratio, EBIT to total assets ratio, and return on equity. Bank References: The banker of the prospective customer may be another source of Information. Experience of the Firm: If the firm had previous dealings with the customer, then it is worth asking: How prompt has the customer been in making payments? How well has the customer honoured his word in the past? Where the customer is being approached for the first time, the impression of the company' sales personnel is useful. Prices and Yields on Securities: For listed companies, valuable inferences can be derived from stock market data. Higher the price-earnings multiple and lower the yield on bonds, other things being equal, lower will be the credit risk. Exhibit 28.1 shows a logic that the credit analyst may employ to process credit-related information. For the sake of simplicity, only three C's, viz., character, capacity, and capital are considered. For judging a customer on these dimensions, the credit analyst may use quantitative measures (like financial ratios) and qualitative assessments (like 'trustworthy').

TRADITIONAL CREDIT ANALYSIS

Should credit be granted?

Strong

Character

Weak

Capacity

Capacity

Strong
Capital

Weak
Capital

Strong
Capital

Weak
Capital

Strong
Excellent risk

Weak

Strong Weak
Fair risk

Strong

Weak

Strong

Weak
Dangerous risk

Doubtful risk

How much credit should be granted ?

SEQUENTIAL CREDIT ANALYSIS

The full logic of Exhibit 28.1 may be redundant for certain customers. For example, if the character of a customer is found weak, it may be pointless to conduct the credit investigation further. Hence, sequential credit analysis is a more efficient method. In this analysis, investigation is carried further if the benefit of such analysis outweighs its cost. To illustrate, consider three stages of credit analysis: review of the past payment record, detailed internal analysis, and credit investigation by an external agency. The credit analyst proceeds from stage one to stage two only if there is no past payment history and hence a detailed internal credit analysis is warranted. Likewise, the credit analyst goes from stage two to stage three only if internal credit analysis suggests that the customer poses a medium risk and hence there is a need for external credit analysis.

NUMERICAL CREDIT SCORING

In traditional credit analysis, customers are assigned to various risk classes somewhat judgmentally on the basis of the five Cs of credit. Credit analysts may, however, want to use a more systematic numerical credit scoring system. Such a system may involve the following steps:

NUMERICAL CREDIT RATING INDEX

1. Identify factors relevant for credit evaluation.

2. Assign weights to these factors that reflect their relative importance. 3.Rate the customer on various factors, using a suitable rating scale (5 point or 7 point scale) 4. For each factor multiply the factor rating with the factor weight to get the factor score. 5.Add all the factor scores to get the overall customer rating Index. 6. Based on the rating Index classify the customer. Exhibit illustrates the use of this procedure for assigning a rating index.

F actor

F actor w eight 0.30 0.20 0.20 0.10 0.20

R ating 3 2

F actor score 1.20 0.80 0.60 0.40 1.00 4.00

Past paym ent N et profit m argin C urrent ratio D ebtequity ratio R eturn on equity

R ating index

DISCRIMINANT ANALYSIS
The nature of this analysis may be discussed with the help of a simple example. ABC Company manufactures gensets for industrial customers. It considers the following financial ratios of its customers as the basic determinants of creditworthiness: current ratio and return on net worth. The plot of its customers on a graph of these two I variables is shown in Exhibit 28.3 +s represent customers who have paid their dues and 0s represent customers who have defaulted. The straight line seems to separate the +s from the 0s-while it may not be possible to completely separate the +s and 0s with the help of a straight line, the straight line does a fairly good job of segregating the two groups. The equation for this straight line is Z = 1 Current ratio + 0.1 Return on equity Since this is the line which discriminates between the good customers (those who pay) and the bad customers (those who default), a customer with a Z score of more than 3 is deemed creditworthy and a customer with a Z score of less than 3 is considered not creditworthy. Of course, the higher the Z score, the stronger the credit rating. In the foregoing discussion we considered a Z function of two variables. In most of the practical applications a Z function of several variables is considered.

DISCRIMINANT ANALYSIS
Z = 1 Current ratio + 0.1 Return on equity
Current + ratio + + + + + + + + + + + + + +

Return on equity

RISK CLASSIFICATION SCHEME

On the basis of information and analysis in the credit investigation process, customers may be classified into various risk categories. A simple risk classification scheme is shown in Exhibit 28.4.
Risk Class 1 2 3 4 5 Description Customers with no risk of default Customers with negligible risk of default (default rate less than 2 percent) Customers with little risk of default (default rate between 2 percent and 5 percent) Customers with some risk of default (default rate between 5 percent and 10 percent) Customers with significant risk of default (default rate in excess of 10 percent)

Each firm would have to develop a risk classification scheme appropriate to its needs and circumstances.

CREDIT GRANTING DECISION

Once the creditworthiness of a customer has been assessed the next question is: Should the credit be offered? If there is no possibility of a repeat order, the situation may be represented by a decision tree as shown in Exhibit 28.5. In Exhibit 28.5, p is the probability that the customer pays his dues, (1-p) is the probability that the customer defaults, REV is the revenue from sale, COST is the cost of goods sold. The expected profit8 for the action 'offer credit' is
Expected Pre-tax Profit p (Revenue Cost) (1 p) Cost

to Cus p

ys r pa me

Rev Cost

ffe O Re f

cre r
us e

dit

Custome

r default

(1 p)

Cost

0
cred it

EXAMPLE ABC Company is considering offering credit to a customer. The probability that the customer would pay is 0.8 and the probability that the customer would default is 0.2. The revenues from the sale would be Rs.1,200 and the cost of sale would be Rs.800. The expected profit from offering credit, given the above information, is: 0.8 (1,200 800) 0.2 (800) = Rs.160 If the expected profit of the course of action 'offer credit' is positive, it is desirable to extend credit, otherwise not.

DECISION TREE FOR GRANTING CREDIT

s 5 Pay p = 0.9 1
it red rc ffe O
Def ault s (1 p1 ) = 0.05

s Pay .9 =0 p1 it red c ffer O

De fau (1 lts p 1)= 0. 1

REPEAT ORDER
What happens when there is a possibility of a repeat order? Exhibit 28.6 illustrates this situation. PQR Company is considering extending credit to a customer who is expected to place a repeat order. (The repeat order, of course, would be accepted only if the customer does not default on the first order.) One thing about this situation needs to be emphasized. Once the customer pays for the first order, the probability that he would default on the second order is less than the probability of his defaulting on the first order. In the case shown in Exhibit 28.6, for example, the probability of default decreases from 0.1 to 0.05. The expected profit of offering credit in this case, ignoring the time value of money, is:
Expected profit on Probability of payment + and repeat order Initial order Expected profit on x repeat order

[ p1(REV1 COST1) (1-p1) COST1] + p1 x [ p2 (REV2 COST2) (1-p2) COST2] [0.9 (2000-1500) 0.1(1500)] + 0.9 [0.95 (2000-1500) 0.05 (1500)] = 660

CONTROL OF ACCOUNTS RECEIVABLES

Days Sales Outstanding : The days sales outstanding (DSO, hereafter) at a given time 't' to a customer. may be defined as the ratio of accounts receivable outstanding at that time to average daily sales figure during the preceding 30 days,60 days,90 days or some relevant period. DSOt = Accounts receivables at time t' Average daily sales To illustrate the calculation of this measure, consider the monthly sales and month-end accounts receivable for a company:

CONTROL OF ACCOUNTS RECEIVABLES

Looking at the DSO we see that it decreased slightly over last year, suggesting that collections improved a little. According to this method, accounts receivable are deemed to be in control if the DSO is equal to or less than a certain norm. If the value of DSO exceeds the specified norm, collections are considered to be slow. Ageing Schedule :The ageing schedule (AS) classifies outstanding accounts receivables at a given point of time into different age brackets. An illustrative AS is given below.

The actual AS of the firm is compared with some standard AS to determine whether accounts receivable are in control. A problem is indicated if the actual AS shows a greater proportion of receivables, compared with the standard AS, in the higher age groups.

COLLECTION MATRIX
The average collection period and the ageing schedule have traditionally been very popular measures for monitoring receivables. However, they suffer from a limitation in that they are influenced by the sales pattern as well as the payment behavior of the customers. If sales are increasing, the average collection period and the ageing schedule will differ from what they would be if sales are constant. This holds even when the payment behavior of customers remains unchanged. The reason is simple: a greater portion of sales is billed currently. Similarly, decreasing sales lead to the same results. The reason here is that a smaller portion of sales is billed currently. In order to study correctly the changes in payment behavior of customers, it is helpful to look at the pattern of collections associated with credit sales. Exhibit 28.7 shows an illustrative collection matrix. From

the collection pattern, one can judge whether the collection is improving, stable, or deteriorating.
Percentage of ReceivablesJanuary Collected During the Sales M onth of sales First following month Second follow ing month Third following month Fourth following month 13 42 33 12 February M arch Sales Sales 14 35 40 11 15 40 21 24 April Sales 12 40 24 19 5 M ay Sales 10 36 26 24 4

June Sales 9 35 26 25 5

SUMMING UP
The important dimensions of a firms credit policy are : credit standards, credit period, cash discount, and collection effort In general, liberal credit standards tend to push sales up by attracting more customers. However, this is accompanied by a higher incidence of bad debt loss, a larger investment in receivables, and a higher cost of collection. Stiff credit standards have opposite effects. Three broad approaches are used for credit evaluation : traditional credit analysis, numerical credit scoring, and discriminant analysis. The traditional approach to credit analysis calls for assessing a prospective customer in terms of the five Cs of credit, viz. character, capacity, capital, collateral, and conditions. Three methods are commonly employed for monitoring accounts receivable : days sales outstanding, ageing schedule, and collection matrix.

SOLVED PROBLEMS
Apex Limited classifies its customers into five risk categories, 1 through 5. Presently Apex extends unlimited credit to customers in categories 1 through 3, limited credit to customers in category 4, and no credit to customers in category 5. Due to this policy, the company is foregoing sales of Rs 3 million to customers in category 4 and Rs 6 million to customers in category 5. Apex is considering the adoption of a more liberal credit policy under which customers in category 4 would be extended unlimited credit and customers in category 5 would be extended limited credit. Such relaxation would increase sales by Rs 9,000,000 on which bad debt losses would be 10 percent. The contribution margin ratio (1-V) for Apex is 20 percent. The average collection period, ACP, is 50 days and the post tax cost of funds, k, is 12 percent. The tax rate for Apex is 40 percent.What will be the effect of relaxing the credit policy on residual Income? Solution The effect of relaxing the credit policy on residual income would be:

SOLVED PROBLEMS
Manish Corporation currently provides 45 days of credit to its customers. Its present sales are Rs 80 million. The firm's cost of capital is 13 percent and the ratio of variable costs to sales is 0.75. Manish is considering extending its credit period to 60 days, Such an extension is likely to push sales up by Rs 20 million. The bad debt proportion on additional sales would be 10 percent. The tax rate for Manish is 35 percent.What will be the effect of lengthening the credit period on the residual income of Manish? Solution The effect of lengthening the credit period on the residual income of Manish would be:

SOLVED PROBLEMS
The present credit terms of Multimedia Company are 2/15, net 45. Its sales are Rs 200 million, its average collection period, ACP, is 30 days, its variable costs to sales ratio, V, is 0.80, and its cost of capital, k, is 12 percent. The proportion of sales on which customers currently take discount, po, is 0.5. Multimedia is considering relaxing its discount terms to 3/15, net 45. Such a relaxation is expected to increase sales by Rs 10 million, reduce the ACP to 27 days, and increase the proportion of discount sales to 0.6. Multimedia's tax rate if 40 percent. What will be the effect of liberalizing the cash discount on residual income is: Solution The effect of liberalizing the cash discount on residual income is:

SOLVED PROBLEMS
Vibgyor Limited is considering relaxing its collection effort. Its sales are Rs 100 million, its average collection period, ACP, is 30 days, its variable costs to sales ratio, V, is 0.75, its cost of capital, k, is 14 percent, and its bad debt ratio, bo, is 0.04. Vibgyor's tax rate is 30 percent. The relaxation in collection effort is expected to push sales up by Rs 10 million, increase the average collection period to 40 days, and raise the bad debts ratio to 0.05. What will be the effect of relaxing the collection effort on residual income? Solution Given the above information, the effect of relaxing the collection effort on residual income would be.

SOLVED PROBLEMS
Vineeta Enterprises sells on terms 2/10, net 45. Annual sales are Rs 90 million. 30 percent of its customers pay on the 10th day and take the discount. If accounts receivable average of Rs 12 million, what is the average collection period (ACP) on non-discount sales?

SOLVED PROBLEMS
The following information is available for Avinash Company:

Required: (a) Calculate the daily sales outstanding (DSO) at the end of each quarter for averaging periods of 30 days and 60 days. (b) Draw up the ageing schedules (AIS) at the end of each quarter using the age brackets 0-31, 31-60, and 61-90 days.

SOLVED PROBLEMS
Solution (a)The DSO is as shown below:

(b)(b) The ageing schedule is as follows:

UNSOLVED PROBLEMS
28.6 Sabet Company sells on terms 1/5, net 15. The total sales for the year are Rs.10 million. The cost of goods sold is Rs. 7.5 million. Customers accounting for 30 percent of sales take discount and pay on the fifth day, while others take an average of 25 days to pay. Calculate a) The Average Collection period. b) The Average Investment in receivables. Solution: a) 30% of sales are collected on the 5th day and 70% of sales are collected on the 25th day. So, ACP = 0.3 x 5 + 0.7 x 25 = 19 days Rs.10,000,000 Value of receivables = 360 = Rs.527,778 (b) Investment in receivables = 0.7 x 527,778 = Rs.395,833 x 19

UNSOLVED PROBLEMS
28.8 The financial manager of a firm is wondering whether credit should be granted to a new customer who is expected to make a repeat purchase. On the basis of credit evaluation, the financial manager feels that the probability that the customer will pay is 0.85 and the probability that the customer will default is 0.15. Once the customer pays for the first purchase, the probability that he will pay for the repeat purchase increases to 0.95. The revenues from the sale will be Rs. 10,000 and the cost of sale would be Rs. 8,500-these figures apply to both the initial and repeat purchase. Should credit be granted? Solution : The decision tree for granting credit is as follows:

The expected profit from granting credit, ignoring the time value of money, is: Expected profit on + Probability of payment x Expected profit on Initial order and repeat order repeat order {0.85(1500) - 0.15(8500)} + 0.85 {0.95(1500) - 0.05(8500)}

MINI CASE
Multitech Limited, set up by a few technocrats in the mid 1990s, enjoyed a fairly healthy growth rate till two years ago. Intense competition in the last few years has slowed down the growth rate considerably. The present sales of Multitech is Rs. 800 million. In a recent executive committee meeting, Jeevan Reddy, the marketing director, argued for relaxing the credit policy of Multitech to stimulate sales increase. Gautam Singhvi, the finance director, promised to consider this request favorably, provided the relaxation in credit policy had a positive impact on residual income. The present credit policies of Multitech are as follows: Credit Standards Multitech classifies its customers into 4 categories, 1 through 4. Credit rating diminishes as one goes from category 1 to category 4. Customers in category 1 have the highest credit rating whereas customers in category 4 have the lowest credit rating. Currently Multitech extends unlimited credit to customers in categories 1 and 2, limited credit to customers in category 3, and no credit to customers in category 4. Credit Period Multitech provides 30 days of credit to its customers who are deemed eligible for credit under its credit standards.

MINI CASE
You have recently joined Multitech as a financial analyst and Gautam Singhvi has asked you to examine the effect of relaxing credit standards, extending the credit period, and providing more generous cash discount. After talking to executives in the marketing, production, and finance departments you have gathered the following information . Presently the proportion of credit sales and cash sales are 0.7 and 0.3. 50 percent of the customers (by value) who are granted credit avail of cash discount. The contribution margin ratio for Multitech is 20 percent, the tax rate for Multitech is 30 percent, the post-tax cost of capital for Multitech is 12 percent, and the average collection period (ACP) on credit sales is 20 days. If the company extends unlimited credit to customers in category 3 and limited credit to customers in category 4, the sales of the company would increase by Rs. 50 million on which the bad debt losses would be 12 percent. The ACP, however, will remain unchanged at 20 days.

MINI CASE
If the company extends its credit period from 30 days to 60 days, its sales to customers who are granted credit will increase by Rs. 40 million. Further, the percentage of customers who will avail of cash discount will decrease to 20 percent. The ACP, as result of the extension of the credit period, will increase to 50 days. If the company relaxes its discount terms to 2/10 net 30, its sales to customers who are granted credit will increase by Rs. 20 million. Further, the percentage of credit customers who will avail of cash discount will increase to 70 percent and the ACP will decrease to 16 days. a. What will be the effect of relaxing the credit standards on residual income? b. What will be the effect of extending the credit period on residual income? c. What will be the effect of relaxing the cash discount policy on residual income? Examine the impact of these credit policy changes one at a time.

SOLUTION - MINI CASE

SOLUTION - MINI CASE

SOLUTION - MINI CASE