5/10, net 50? Why is the rate higher?
The terms of sale define the amount of any credit but not the nature of the contract.
Repetitive sales are almost always made on open account and involve only an implicit
contract. There is simply a record in the sellerÔÇ™s books and a receipt signed by the buyer.
Agreement whereby sales are
Sometimes you might want a more formal agreement that the customer owes you
made with no formal debt
money. Where the order is very large and there is no complicating cash discount, the
customer may be asked to sign a promissory note. This is just a straightforward IOU,
worded along the following lines:
April 1, 2001
Sixty days after date, ABC, Inc., promises to pay to the order of the XYZ Company ten
thousand dollars ($10,000) for value received.
Such an arrangement is not common but it does eliminate the possibility of any sub-
sequent disputes about the amount and existence of the debt; the customer knows that
he or she may be sued immediately for failure to pay on the due date.
If you want a clear commitment from the buyer, it is more useful to have it before
you deliver the goods. In this case the common procedure is to arrange a commercial
draft. This is simply jargon for an order to pay.2 It works as follows. The seller prepares
a draft ordering payment by the customer and sends this draft to the customerÔÇ™s bank. If
2For example, a check is an example of a draft. Whenever you write a check, you are ordering the bank to
make a payment.
232 SECTION TWO
immediate payment is required, the draft is termed a sight draft; otherwise it is known
as a time draft. Depending on whether it is a sight or a time draft, the customer either
tells the bank to pay up or acknowledges the debt by adding the word accepted and a
signature. Once accepted, a time draft is like a postdated check and is called a trade ac-
ceptance. This trade acceptance is then forwarded to the seller, who holds it until the
payment becomes due.
If the customerÔÇ™s credit is for any reason suspect, the seller may ask the customer to
arrange for his or her bank to accept the time draft. In this case, the bank guarantees the
customerÔÇ™s debt and the draft is called a bankerÔÇ™s acceptance. BankerÔÇ™s acceptances are
often used in overseas trade. They are actively bought and sold in the money market, the
market for short-term high-quality debt.
If you sell goods to a customer who proves unable to pay, you cannot get your goods
back. You simply become a general creditor of the company, in common with other un-
fortunates. You can avoid this situation by making a conditional sale, so that ownership
of the goods remains with the seller until full payment is made. The conditional sale is
common in Europe. In the United States it is used only for goods that are bought on in-
stallment. In this case, if the customer fails to make the agreed number of payments,
then the equipment can be immediately repossessed by the seller.
There are a number of ways to find out whether customers are likely to pay their debts,
that is, to carry out credit analysis. The most obvious indication is whether they have
paid promptly in the past. Prompt payment is usually a good omen, but beware of the
Procedure to determine the
customer who establishes a high credit limit on the basis of small payments and then
likelihood a customer will pay
disappears, leaving you with a large unpaid bill.
If you are dealing with a new customer, you will probably check with a credit agency.
Dun & Bradstreet, which is by far the largest of these agencies, provides credit ratings
on several million domestic and foreign firms. In addition to its rating service, Dun &
Bradstreet provides on request a full credit report on a potential customer.
Credit agencies usually report the experience that other firms have had with your
customer, but you can also get this information by contacting those firms directly or
through a credit bureau.
Your bank can also make a credit check. It will contact the customerÔÇ™s bank and ask
for information on the customerÔÇ™s average bank balance, access to bank credit, and gen-
In addition to checking with your customerÔÇ™s bank, it might make sense to check
what everybody else in the financial community thinks about your customerÔÇ™s credit
standing. Does that sound expensive? Not if your customer is a public company. You
just look at the MoodyÔÇ™s or Standard & PoorÔÇ™s rating for the customerÔÇ™s bonds.3 You can
also compare prices of these bonds to the prices of other firmsÔÇ™ bonds. (Of course the
comparisons should be between bonds of similar maturity, coupon, and so on.) Finally,
you can look at how the customerÔÇ™s stock price has been behaving recently. A sharp fall
in price doesnÔÇ™t mean that the company is in trouble, but it does suggest that prospects
are less bright than formerly.
3 We described bond ratings in later.
Credit Management and Collection 233
FINANCIAL RATIO ANALYSIS
We have suggested a number of ways to check whether your customer is a good risk.
You can ask your collection manager, a specialized credit agency, a credit bureau, a
banker, or the financial community at large. But if you donÔÇ™t like relying on the judg-
ment of others, you can do your own homework. Ideally this would involve a detailed
analysis of the companyÔÇ™s business prospects and financing, but this is usually too ex-
pensive. Therefore, credit analysts concentrate on the companyÔÇ™s financial statements,
using rough rules of thumb to judge whether the firm is a good credit risk. The rules of
thumb are based on financial ratios. Earlier we described how these ratios are calcu-
lated and interpreted.
NUMERICAL CREDIT SCORING
Analyzing credit risk is like detective work. You have a lot of cluesÔÇ”some important,
some fitting into a neat pattern, others contradictory. You must weigh these clues to
come up with an overall judgment.
When the firm has a small, regular clientele, the credit manager can easily handle
the process informally and make a judgment about what are often termed the five Cs of
1. The customerÔÇ™s character
2. The customerÔÇ™s capacity to pay
3. The customerÔÇ™s capital
4. The collateral provided by the customer4
5. The condition of the customerÔÇ™s business
When the company is dealing directly with consumers or with a large number of
small trade accounts, some streamlining is essential. In these cases it may make sense
to use a scoring system to prescreen credit applications.
For example, if you apply for a credit card or a bank loan, you will be asked about
your job, home, and financial position. The information that you provide is used to cal-
culate an overall credit score. Applicants who do not make the grade on the score are
likely to be refused credit or subjected to more detailed analysis.
Banks and the credit departments of industrial firms also use mechanical credit scor-
ing systems to cut the costs of assessing commercial credit applications. One bank
claimed that by introducing a credit scoring system, it cut the cost of reviewing loan
applications by two-thirds. It cited the case of an application for a $5,000 credit line
from a small business. A clerk entered information from the loan application into a
computer and checked the firmÔÇ™s deposit balances with the bank, as well as the ownerÔÇ™s
personal and business credit files. Immediately the loan officer could see the applicantÔÇ™s
score: 240 on a scale of 100 to 300, well above the bankÔÇ™s cut-off figure. All that re-
mained for the bank was to check that there was nothing obviously suspicious about the
application. ÔÇťWe donÔÇ™t want to lend to set up an alligator farm in the desert,ÔÇŁ said one
Firms use several statistical techniques to separate the creditworthy sheep from the
impecunious goats. One common method employs multiple discriminant analysis to
4 For example, the customer can offer bonds as collateral. These bonds can then be seized by the seller if the
customer fails to pay.
5 Quoted in S. Hansell, ÔÇťNeed a Loan? Ask the Computer; ÔÇ˜Credit ScoringÔÇ™ Changes Small-Business Lend-
ing,ÔÇŁ The New York Times, April 18, 1995, sec. D, p. 1.
234 SECTION TWO
produce a measure of solvency called a Z score. For example, a study by Edward Alt-
man suggested the following relationship between a firmÔÇ™s financial ratios and its cred-
EBIT sales market value of equity
Z = 3.3 + 1.0 + .6
total assets total assets total book debt
retained earnings working capital
+ 1.4 + 1.2
total assets total assets
This equation did a good job at distinguishing the bankrupt and nonbankrupt firms.
Of the former, 94 percent had Z scores less than 2.7 before they went bankrupt. In con-
trast, 97 percent of the nonbankrupt firms had Z scores above this level.7
Consider a firm with the following financial ratios:
EBIT sales market equity
= .12 = 1.4 = .9
total assets total assets book debt
retained earnings working capital
= .4 = .12
total assets total assets
The firmÔÇ™s Z score is thus
(3.3 ├— .12) + (1.0 ├— 1.4) + (.6 ├— .9) + (1.4 ├— .4) + (1.2 ├— .12) = 3.04
This score is above the cutoff level for predicting bankruptcy, and thus would be con-
sidered favorably in terms of evaluating the firmÔÇ™s creditworthiness.
The nearby box describes how statistical scoring systems similar to the Z score can
provide timely first-cut estimates of creditworthiness. These assessments can streamline
the credit decision and free up labor for other, less mechanical tasks. The box notes that
these scoring systems can be used in conjunction with large databases on firms, such as
that of Dun & Bradstreet, to provide quick credit scores for thousands of firms.
WHEN TO STOP LOOKING FOR CLUES
We told you earlier where to start looking for clues about a customerÔÇ™s creditworthiness,
but we never said anything about when to stop. A detailed credit analysis costs money,
so you need to keep the following basic principle in mind:
Credit analysis is worthwhile only if the expected savings exceed the cost.
6EBIT is earnings before interest and taxes. E. I. Altman, ÔÇťFinancial Ratios, Discriminant Analysis and the
Prediction of Corporate Bankruptcy,ÔÇŁ Journal of Finance 23 (September 1968), pp. 589ÔÇ“609.
7 This equation was fitted with hindsight. The equation did slightly less well when used to predict bankrupt-
cies after 1965.
FINANCE IN ACTION
Americans Snap up Securities
Overseas at Record Pace
and bonds, and they often make long-term loans di-
Multinational Used to Bully Poor Countries.
rectly to corporations.
Maybe They Should Start Again
Of course the company will issue not just one policy,
Thus far we have pictured the financial manager as sell-
but thousands. Normally the incidence of fires ÔÇť aver-
ing securities directly to, and thereby raising money di-
ages out,ÔÇŁ leaving the company with a predictable obli-
rectly from, investors. But often there is a financial in-
gation to its policyholto its policyholders as a group. Of
termediary in between. A financial intermediary invests
course the insurance ders as a group. Of course the in-
primarily in financial assets. It provides financing to
surance company must charge enough for its policies
businesses, individuals, other organizations, and gov-
to cover selling and administrative costs, pay policy-
holdersÔÇ™ claims, and generate a profit for its stockhold-
ÔÇó Suppose a company wishes to borrow $250 million for 9
Suppose our company needs a loan for 9 years, not
months. It could issue a 9-month debt security to investors.
9 months. It could issue a bond directly to investors, or
ÔÇó But given the debtÔÇ™s short duration, it might be easier to
it could negotiate a 9-year loan with an insurance com-
arrange a 9-month bank loan.
ÔÇó In this case the bank raises money by taking deposits or
selling debt or stock to investors. It then lends the money
Ala. Notice how the insurance company raises the money to
on to the company. Of course the bank must charge inter-
make the loan: it sells stock,9 but most of its financing
est sufficient to cover its costs and to compensate its
comes from sale of insurance policies. Say you buy a
debtholders and stockholders.
fire insurance policy on your home.
Alb. You pay cash to the insurance company and get a finan-
Banks and their immediate relatives, such as savings
cial asset (the policy) in exchange. You receive no inter-
and loan companies, are the most familiar financial in-
est payments on this financial asset.
termediaries. But there are many others, such as insur-
But if a fire does strike, the company is obliged to cover the
damages up to the policy limit. This is the return on your in-
Box Head (bh1) That Is Long Enough to Make Two
or Three Lines or Four
Cash Paid You in Year
In the United States, insurance companies are more im-
You Pay 1 2 3 Rate of Return
portant than banks for the long-term financing of busi-
$1,100. $1,200. 20%
ness. They are massive investors in corporate stocks
This simple rule has two immediate implications:
1. DonÔÇ™t undertake a full credit analysis unless the order is big enough to justify it. If
the maximum profit on an order is $100, it is foolish to spend $200 to check whether
the customer is a good prospect. Rely on a less detailed credit check for the smaller
orders and save your energy and your money for the big orders.
2. Undertake a full credit analysis for the doubtful orders only. If a preliminary check
suggests that a customer is almost certainly a good prospect, then the extra gain from
a more searching inquiry is unlikely to justify the costs. That is why many firms use