CORPORATE FINANCE

UNIT II
CREDIT MANAGEMENT
Credit Management is the process of deciding which
customers to extend credit to and evaluating those customers'
creditworthiness over time. It involves setting credit limits for
customers, monitoring customer payments and collections, and
assessing the risks associated with extending credit to
customers
 Definition of Receivables
Receivables, also regarded as accounts receivable, are debts
owed to a firm by its customers for goods or services used or
delivered but not yet paid for.
Receivables are created by expanding the line of credit to
customers and are listed as current assets on the company's
balance sheet. They are considered as liquid assets since they
can be used as collateral to secure a loan to help meet short-
term obligations.
Receivables are part of the working capital of a company.
Effectively handling receivables means promptly following up
with any consumers who have not paid and eventually
reviewing payment plans if necessary. This is critical as it
provides additional capital to fund operations and reduces the
net debt of the organization
• To boost cash flow, a company can reduce the credit terms of its
accounts receivable or take longer to pay its accounts receivable.
This lowers the company's cash conversion time, or how long it
takes to turn capital assets, such as inventory, into capital for
operations.
What are Credit Policy Variables?
Credit policy variables are an essential feature of every credit policy.
These variables impact the credit policy directly or indirectly. Since
the variables have the power to make or break a credit policy they are
considered indispensable while forming and executing the credit
policy. Management of credit policies requires efficient handling of
credit policy variables.
THE FOUR TYPES OF CREDIT POLICY VARIABLES ARE AS
FOLLOWS −
• CREDIT STANDARDS
Standards of Credit Policy refer to the offering of credit to particular
customers and it is purely institutional in character. A company may decide
to grant credit to a company willingly while it can hold the offer even when
the customer is very credit-diligent.
When the standard of a credit policy is liberal the company offers credit to
many customers without considering their credit rating. As is obvious, this
increases the sales and may also increase profitability but it is very risky in
nature. As the liberal policies extend credit to doubtful customers, the chances
of bad debt increase, and it may hamper the long-term profitability of a
company.
• CREDIT PERIOD
Another credit policy variable that impacts the policy directly is the duration
of time that the company offers to the customer to pay for the goods and
services availed on credit. It is also called the credit period. The credit period
may depend on the industry and nature of customers. However, a good
company that knows its customers should be able to offer a credit period that
is optimum yet restrictive in nature.
In a liberal credit policy, the duration to pay back the accounts receivables
is longer. So, the companies offering a longer credit period enjoy more
sales as the customers buy more from the company because they get
extended time to pay back. However, a long credit tenure may increase
the chances of defaults by the customers too.
CASH DISCOUNTS
Cash discounts are offered to customers who pay back the accounts
receivable prior to the last date of the credit period. It enhances the
collection of the accounts receivable and hence also increases the chances
of sales and profitability. Discounts in credit policy depend on the nature
of the business and the industry. While some industries, such as textiles
and real estate offer large discounts on early payment, the discounts in
automobiles and FMCG may be less in quantity.
Customers usually love to avail discounts on purchased goods and
services. So, offering discounts may reduce the period a company takes to
pay for the goods and services. This allows the company to enjoy more
flexibility and profit in the longer term.
COLLECTION EFFORTS
A company that sells products or services in credit must have a credit
policy that includes a particular form of collection efforts. Without any
effort to collect the credits, the companies may face more bad debts and
losses. So, in order to gain more profit, the companies must employ a
strict collection effort for recovering the credits granted to their
customers.
CONCLUSION
Longer credit tenures require the companies to invest more in accounts
receivables and although the chances of profits are higher, the
lengthening of credit periods also increases the chances of bad debts. So
a company has to be careful in this regard.
Q1. Standard Sports Company dealing in sports goods, has an annual sales of
Rs.50 lakhs and are currently extending 30 days credit to tlie dealers. It is felt
that sales can pick up considerably if the dealers are willing to carry increased
stocks, but the company is, therefore, considering shifts in credit policy. The
following information is available:
The average collection period is 30 days. Fixed Costs : Rs. 6 lakh per annum.
Costs : Variable costs : 80% on sales, Required (pre-tax) return on investment :
20%.
On the basis of the above incremental contribution under the various alternative
credit policies over the present level, policy B should be adopted.

Discussion - If the tracler offers a cash discount @ 2% if payment is made

within 10 days of the date of invoice. If this collection period is reduced from
60 days to 30 days, it is hoped 50% of customers will take the discount benefit.
Assume Rs. 25,00,000 average investment in receivables and net profit in 30
days is Rs. 54.000 and in 60 days. Additional investment needed is Rs. 2,33,334
and profit will be Rs. 80,500. Should the company give this discount'?
Cost of Cash discount - - Rs. 25,00,000 * 0.50 * 0.02
233,334/2 = 116,667
The amount of Rs. 1,16,667 is freed up and suppose trader wants 14% rate of
return, additional earnings will be Rs.l,16,667 * 0.14 = Rs. 16,333. The cost of
discount is higher than the additional earnings. So the discount should not be
offered.
Marginal analysis is an examination of the associated costs and
potential benefits of specific business activities or financial
decisions. The goal is to determine if the costs associated with
the change in activity will result in a benefit that is sufficient
enough to offset them
Marginal analysis is an examination of the additional benefits of
an activity compared to the additional costs incurred by that same
activity. Companies use marginal analysis as a decision-making
tool to help them maximize their potential profits. Marginal
refers to the focus on the cost or benefit of the next unit or
individual, for example, the cost to produce one more widget or
the profit earned by adding one more worker.
CREDIT EVALUATION OF INDIVIDUAL ACCOUNTS
After credit policy is finalized the next step is execution, execution of
credit policy involves 2 steps
1. Evaluation of credit applicants
2. Financing of investments in receivables
The first step in credit policy implementation is to find the credit
worthiness of the applicants. This is to ensure that they conform to
the firm's credit standards. The credit worthiness of customers
Involves
: a) Collecting Credit Information; b) Credit Investigation; and C)
Credit Granting Decision.
 A firm may use discriminant analysis in credit scoring models.
Discriminant analyses for credit scoring are divided into two
sections. They are as follows −
• Simple Discriminant Analysis
• Multiple Discriminant Analysis Models.

Discriminant models are objective methods of finding the differences

between good and bad customers. By applying discriminant analysis,
the lending firms can discriminate good credit customers from the
bad ones.
Simple Discriminant Analysis Model
As mentioned above, the simple discriminant analysis model is an
objective method to separate the bad credit customers from the good
ones. The lenders often look for a solid method that can identify bad
customers via using data from the customer’s financial statements. In
that way, using simple discriminant analysis goes a long way in
providing a dependable solution to the lenders.
Simple discriminant analysis models are objective.
For example, their empirical analysis may show that the ratio of
EBDIT (Earnings before depreciation, interest, and tax) to sales
is a good discriminating factor to separate bad customers from
the good ones.
However, to use such a model, the cut-off EBDIT to sales ratio
must be obtained.
To do this, first, the good and bad customers are arranged by
their EBDIT to sales ratios.
Secondly, a cut-off point is selected to differentiate the array into
two parts. This differentiation must be done with minimum
misclassifications. The cut-off point has to be selected by visual
inspection. Now, the lenders can offer credit to those customers
who are above the cut-off point.
Instead of using only one factor as mentioned above, the lenders
can use two factors to make the model more accurate.
For example, two ratios EBDIT to sales and cash flow to sales ratios
can be used to discriminate the bad customers and the good ones. A
combination of these two factors can be plotted on a graph for
paying and non-paying customers.
A straight line can separate the two factors maintaining a minimum
misclassification. The straight line will indicate how much
importance to be paid to each of the ratios. This will be given by the
discriminant index that can be selected from the graph.
Furthermore, the discriminant index will also indicate which
customers are good and which are not. So, depending on the simple
discriminant analysis model, the lenders can differentiate between
Multiple-Discriminant Analysis Model
The multiple-discriminant analysis model offers a composite
score to each customer and depending on the score, lenders may
decide which is the minimum score to consider for separating
the good customers from the bad ones. The simple discriminant
analysis model mentioned above uses only two factors.
However, in practical terms, there may be many factors that
affect the analysis of credit scores. These factors will interact
with each other.
To include such interactions which may not be excluded from
simple discriminant analysis, the multiple-discriminant analysis
model gives due weight age to each factor that may impact the
credit scoring model.
Depending on the attributes of the firms, Altman predicted the
potential bankruptcy of firms via a multiple-discriminant
analysis index.
The function derived by Altman was −
• NWC = Net Working Capital
TA = Total Assets
• RE = Retained Earnings
• EBIT = Earnings before interest and taxes
• MV = Market value of equity
• S = Sales
• D = Book value of debt
Conclusion
Discriminant analysis is an effective method for multivariate
analysis to extract relevant information from huge amounts of data.
Loan processing speed has increased rapidly due to this scoring
system.