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If credit is granted, the next problem is to set a collection policy. This requires tact and
judgment. You want to be firm with the truly delinquent customer, but you don™t want to
offend the good one by writing demanding letters just because a check has been delayed in
the mail. You will find it easier to spot troublesome accounts if you keep a careful aging
schedule of outstanding accounts.

What happens when firms cannot pay their creditors?
A firm that cannot meet obligations may try to arrange a workout with its creditors to
enable it to settle its debts. If this is unsuccessful, the firm may file for bankruptcy, in
which case the business may be liquidated or reorganized. Liquidation means that the
firm™s assets are sold and the proceeds used to pay creditors. Reorganization means that the
firm is maintained as an ongoing concern, and creditors are compensated with securities in
the reorganized firm. Ideally, reorganization should be chosen over liquidation when the
firm as a going concern is worth more than its liquidation value. However, the conflicting
interests of the different parties can result in violations of this principle.

www.nacm.org/ National Association of Credit Management
Related Web www.dnb.com/ Dun & Bradstreet™s site; the premier guide to corporate credit decisions
www.ny.frb.org/pihome/addpub/credit.html The Federal Reserve Bank of New York™s guide to
Links credit management
www.creditworthy.com/ Useful tips and online resources for credit management
www.ftc.gov/bcp/conline/pubs/credit/scoring.htm A discussion of the credit scoring process
http://bankrupt.com/ Resources for firms that have made some bad decisions

terms of sale collection policy workout
Key Terms open account aging schedule liquidation
credit analysis bankruptcy reorganization
credit policy

1. Trade Credit Rates. Company X sells on a 1/20, net 60, basis. Customer Y buys goods with
Quiz an invoice of $1,000.

a. How much can Company Y deduct from the bill if it pays on Day 20?
b. How many extra days of credit can Company Y receive if it passes up the cash discount?
c. What is the effective annual rate of interest if Y pays on the due date rather than Day 20?

2. Terms of Sale. Complete the following passage by selecting the appropriate terms from the
following list (some terms may be used more than once): acceptance, open, commercial,
trade, the United States, his or her own, note, draft, account, promissory, bank, banker™s, the

Most goods are sold on ________ ________. In this case the only evidence of the debt is a
record in the seller™s books and a signed receipt. When the order is very large, the customer
may be asked to sign a(n) ________ ________, which is just a simple IOU. An alternative
is for the seller to arrange a(n) ________ ________ ordering payment by the customer. In
order to obtain the goods, the customer must acknowledge this order and sign the document.
This signed acknowledgment is known as a(n) ________ ________. Sometimes the seller
may also ask ________ ________ bank to sign the document. In this case it is known as a(n)
________ ________.
3. Terms of Sale. Indicate which firm of each pair you would expect to grant shorter or longer
credit periods:

a. One firm sells hardware; the other sells bread.
b. One firm™s customers have an inventory turnover ratio of 10; the other™s customers have
turnover of 15.
c. One firm sells mainly to electric utilities; the other to fashion boutiques.
4. Payment Lag. The lag between purchase date and the date at which payment is due is known
as the terms lag. The lag between the due date and the date on which the buyer actually pays
is termed the due lag, and the lag between the purchase and actual payment dates is the pay
lag. Thus
Pay lag = terms lag + due lag

State how you would expect the following events to affect each type of lag:

a. The company imposes a service charge on late payers.
b. A recession causes customers to be short of cash.
c. The company changes its terms from net 10 to net 20.

5. Bankruptcy. True or false?

a. It makes sense to evaluate the credit manager™s performance by looking at the proportion
of bad debts.
b. When a company becomes bankrupt, it is usually in the interests of the equityholders to
seek a liquidation rather than a reorganization.
c. A reorganization plan must be presented for approval by each class of creditor.
d. The Internal Revenue Service has first claim on the company™s assets in the event of
e. In a reorganization, creditors may be paid off with a mixture of cash and securities.
f. When a company is liquidated, one of the most valuable assets to be sold is often the tax-
loss carry-forward.

6. Trade Credit Rates. A firm currently offers terms of sale of 3/20, net 40. What effect will
the following actions have on the implicit interest rate charged to customers that pass up the
cash discount? State whether the implicit interest rate will increase or decrease.

a. The terms are changed to 4/20, net 40.
b. The terms are changed to 3/30, net 40.
c. The terms are changed to 3/20, net 30.

Practice 7. Trade Credit and Receivables. A firm offers terms of 2/15, net 30. Currently, two-thirds
of all customers take advantage of the trade discount; the remainder pay bills at the due date.
Problems a. What will be the firm™s typical value for its accounts receivable period?
Credit Management and Collection 247

b. What is the average investment in accounts receivable if annual sales are $20 million?
c. What would likely happen to the firm™s accounts receivable period if it changed its terms
to 3/15, net 30?

8. Terms of Sale. Microbiotics currently sells all of its frozen dinners cash on delivery but be-
lieves it can increase sales by offering supermarkets 1 month of free credit. The price per
carton is $50 and the cost per carton is $40.

a. If unit sales will increase from 1,000 cartons to 1,060 per month, should the firm offer
the credit? The interest rate is 1 percent per month, and all customers will pay their bills.
b. What if the interest rate is 1.5 percent per month?
c. What if the interest rate is 1.5 percent per month, but the firm can offer the credit only
as a special deal to new customers, while old customers will continue to pay cash on de-

9. Credit Decision/Repeat Sales. Locust Software sells computer training packages to its
business customers at a price of $101. The cost of production (in present value terms) is $95.
Locust sells its packages on terms of net 30 and estimates that about 7 percent of all orders
will be uncollectible. An order comes in for 20 units. The interest rate is 1 percent per month.

a. Should the firm extend credit if this is a one-time order? The sale will not be made un-
less credit is extended.
b. What is the break-even probability of collection?
c. Now suppose that if a customer pays this month™s bill, it will place an identical order in
each month indefinitely and can be safely assumed to pose no risk of default. Should
credit be extended?
d. What is the break-even probability of collection in the repeat-sales case?

10. Bankruptcy. Explain why equity can sometimes have a positive value even when compa-
nies petition for bankruptcy.
11. Credit Decision. Look back at Example 3. Cast Iron™s costs have increased from $1,000 to
$1,050. Assuming there is no possibility of repeat orders, and that the probability of suc-
cessful collection from the customer is p = .9, answer the following:

a. Should Cast Iron grant or refuse credit?
b. What is the break-even probability of collection?

12. Credit Analysis. Financial ratios were described earlier. If you were the credit manager, to
which financial ratios would you pay most attention?
13. Credit Decision. The Branding Iron Company sells its irons for $50 apiece wholesale. Pro-
duction cost is $40 per iron. There is a 25 percent chance that a prospective customer will
go bankrupt within the next half year. The customer orders 1,000 irons and asks for 6
months™ credit. Should you accept the order? Assume a 10 percent per year discount rate, no
chance of a repeat order, and that the customer will pay either in full or not at all.
14. Credit Policy. As treasurer of the Universal Bed Corporation, Aristotle Procrustes is wor-
ried about his bad debt ratio, which is currently running at 6 percent. He believes that im-
posing a more stringent credit policy might reduce sales by 5 percent and reduce the bad
debt ratio to 4 percent. If the cost of goods sold is 80 percent of the selling price, should Mr.
Procrustes adopt the more stringent policy?
15. Credit Decision/Repeat Sales. Surf City sells its network browsing software for $15 per
copy to computer software distributors and allows its customers 1 month to pay their bills.
The cost of the software is $10 per copy. The industry is very new and unsettled, however,
and the probability that a new customer granted credit will go bankrupt within the next

month is 25 percent. The firm is considering switching to a cash-on-delivery credit policy
to reduce its exposure to defaults on trade credit. The discount rate is 1 percent per month.

a. Should the firm switch to a cash-on-delivery policy? If it does so, its sales will fall by 40
b. How would your answer change if a customer which is granted credit and pays its bills
can be expected to generate repeat orders with negligible likelihood of default for each
of the next 6 months? Similarly, customers which pay cash also will generate on average
6 months of repeat sales.

16. Credit Policy. A firm currently makes only cash sales. It estimates that allowing trade credit
on terms of net 30 would increase monthly sales from 200 to 220 units per month. The price
per unit is $101 and the cost (in present value terms) is $80. The interest rate is 1 percent per
a. Should the firm change its credit policy?
b. Would your answer to (a) change if 5 percent of all customers will fail to pay their bills
under the new credit policy?
c. What if 5 percent of only the new customers fail to pay their bills? The current customers
take advantage of the 30 days of free credit but remain safe credit risks.

17. Credit Analysis. Use the data in Example 3. Now suppose, however, that 10 percent of Cast
Iron™s customers are slow payers, and that slow payers have a probability of 30 percent of
Problems defaulting on their bills. If it costs $5 to determine whether a customer has been a prompt
or slow payer in the past, should Cast Iron undertake such a check? Hint: What is the ex-
pected savings from the credit check? It will depend on both the probability of uncovering
a slow payer and the savings from denying these payers credit.
18. Credit Analysis. Look back at the previous problem, but now suppose that if a customer de-
faults on a payment, you can eventually collect about half the amount owed to you. Will you
be more or less tempted to pay for a credit check once you account for the possibility of par-
tial recovery of debts?
19. Credit Policy. Jim Khana, the credit manager of Velcro Saddles, is reappraising the com-
pany™s credit policy. Velcro sells on terms of net 30. Cost of goods sold is 85 percent of sales.
Velcro classifies customers on a scale of 1 to 4. During the past 5 years, the collection ex-
perience was as follows:

Defaults as Average Collection
Percentage Period in Days for
Classification of Sales Nondefaulting Accounts
1 0 45
2 2 42
3 10 50
4 20 80

The average interest rate was 15 percent. What conclusions (if any) can you draw about Vel-
cro™s credit policy? Should the firm deny credit to any of its customers? What other factors
should be taken into account before changing this policy?
20. Credit Analysis. Galenic, Inc., is a wholesaler for a range of pharmaceutical products. Be-
fore deducting any losses from bad debts, Galenic operates on a profit margin of 5 percent.
For a long time the firm has employed a numerical credit scoring system based on a small
number of key ratios. This has resulted in a bad debt ratio of 1 percent.
Credit Management and Collection 249

Galenic has recently commissioned a detailed statistical study of the payment record of
its customers over the past 8 years and, after considerable experimentation, has identified
five variables that could form the basis of a new credit scoring system. On the evidence of
the past 8 years, Galenic calculates that for every 10,000 accounts it would have experienced
the following default rates:

Number of Accounts

Credit Score under Proposed System Defaulting Paying Total
Better than 80 60 9,100 9,160
Worse than 80 40 800 840
Total 100 9,900 10,000

By refusing credit to firms with a poor credit score (worse than 80) Galenic calculates that
it would reduce its bad debt ratio to 60/9,160, or just under .7 percent. While this may not
seem like a big deal, Galenic™s credit manager reasons that this is equivalent to a decrease of
one-third in the bad debt ratio and would result in a significant improvement in the profit

a. What is Galenic™s current profit margin, allowing for bad debts?
b. Assuming that the firm™s estimates of default rates are right, how would the new credit
scoring system affect profits?
c. Why might you suspect that Galenic™s estimates of default rates will not be realized in
d. Suppose that one of the variables in the proposed new scoring system is whether the cus-
tomer has an existing account with Galenic (new customers are more likely to default).
How would this affect your assessment of the proposal? Hint: Think about repeat sales.

1 To get the cash discount, you have to pay the bill within 10 days, that is, by May 11. With
Solutions to
the 2 percent discount, the amount that needs to be paid by May 11 is $20,000 — .98 =
Self-Test $19,600. If you forgo the cash discount, you do not have to pay your bill until May 21, but
on that date, the amount due is $20,000.
Questions 2 The cash discount in this case is 5 percent and customers who choose not to take the dis-
count receive an extra 50 “ 10 = 40 days credit. So the effective annual interest is

( )
discount 365/extra days credit
Effective annual rate = 1 + “1
discounted price

() 5 365/40
= 1+ “ 1 = .597, or 59.7%
In this case the customer who does not take the discount is effectively borrowing money at
an annual interest rate of 59.7 percent. This is higher than the rate in Example 21.1 because
fewer days of credit are obtained by forfeiting the discount.
3 The present value of costs is still $1,000. Present value of revenues is now $1,100. The
break-even probability is defined by
p — 100 “ (1 “ p) — 1,000 = 0

which implies that p = .909. The break-even probability is higher because the profit margin
is now lower. The firm cannot afford as high a bad debt ratio as before since it is not mak-
ing as much on its successful sales. We conclude that high-margin goods will be offered


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