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CORPORATE FINANCE

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ABHIJEET CHANDRA
Vinod Gupta School of Management, IIT KHARAGPUR

Lecture 33: Credit Management - I

CONCEPTS COVERED

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⮚ Cash Management Process

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⮚ Credit Management

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 Cash Management
Cash Management Process
Cash and Accounts Receivables
INFLOWS Contingency Funds
Bank Loans

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Corporate Cash Management Policy on Dividends

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Payment of Current Liabilities
OUTFLOWS Dividends
Investment of Surplus Funds

Adapted from: Vishwanath (2021)

 Cash Management
Cash Management Process

Business Operations:
Receipts of Cash/Collections
Requirements of Funds

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Requirements of Funds: Deficit Borrow
Information and Control

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Surplus Invest

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Payments of Cash/Outflows

Adapted from: Pandey (2021)

 Cash Management
Cash Inflow Timeline

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Sales Order Issue of Mailing of Receipt of Deposit of Receipt of Updating
Order Receipt Invoices Cheque(s) Cheque(s) Cheque(s) Fund(s) Accounting

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Intimation Records

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Issue of Date of Mailing of Receipt of Deposit of Loss of Updating
Purchase Accounting
Order Invoice Cheque(s) Cheque(s) Cheque(s) Fund(s) Records

Adapted from: Vishwanath (2021)

Cash Management
Float
• The cash balance shown in the books of accounts of the company and the
balance in the books of the bank need not coincide.
• The reason could be that the bank has not collected the cheques presented
by the company or the customers have not yet presented the cheques issued
by the company.

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• As soon as the cheques are deposited in the bank, the company debits the

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cash account. But the bank credits the account only when the amount is

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realized from the bank of the customer.
• This time lag is called deposit float.
The deposit float is the time lag between drawing of the cheque by the customer and
the receipt of funds by the company. The deposit float consists of mail float, processing
float and check clearance float shown as follows.
Cash Management
Float
The deposit float is the time lag between drawing of the cheque by the customer and the
receipt of funds by the company. The deposit float consists of mail float, processing float
and check clearance float shown as below.

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Credit Management
Why a firm should have a credit policy?
• A significant component of current assets: sundry debtors/accounts receivables/trade
debtors
• Investment in trade debtors/accounts receivables depends on:
(a) The (average) credit sales, and

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(b) The (average) collection period

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• A firm’s average investment in accounts receivables is:

𝑫𝒂𝒊𝒍𝒚 𝒄𝒓𝒆𝒅𝒊𝒕 𝒔𝒂𝒍𝒆𝒔 × 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒄𝒐𝒍𝒍𝒆𝒄𝒕𝒊𝒐𝒏

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𝒑𝒆𝒓𝒊𝒐𝒅
e.g., a firm’s credit sales (daily average) is Rs. 10 Lakh and the average collection period
is 45 days. Then:
Credit Management
Why a firm should have a credit policy?
• The volume of credit sales is a function of total sales and the percentage of credit sales to
total sales.
• Collection period depends on a firm’s credit policies and its relations with debtors. Both
volume of credit sales and collection period defines the investment required for WC.

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• A finance manager can contribute the volume of credit sales and collection period (and
consequently, investments in accounts receivables):

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(a) Credit standards,

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(b) Credit terms, and
(b) Collection efforts
 Credit Management
Why a firm should have a credit policy?
• Credit standards: the criteria to decide the creditworthy customers to whom credit sales can
be made. A firm with customer-base where they pay slowly, requires higher investments in
accounts receivables. Likely to be exposed to default risk.
• Credit terms: the extent to which credit is offered to the customers of credit sales. A liberal
credit terms means higher investments in accounts receivables.

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• Collection efforts: deployment of resources to get cash from credit sales customers. It

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implies the actual collection period. A short collection period → Lower AR.

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A firm can have the following credit policy:
• Lenient credit policy: sell good to customers on liberal credit terms
and extend longer credit period. Higher investments in AR
• Stringent credit policy: credit offered to highly selective customers
(with high credit standards) and shorter credit period.
 Credit Management
Why a firm offers credit to its customers?
• Competition: Customer acquisition in a highly competitive market.
• Company’s bargaining power: a firm with better products, monopoly, brand image, size,
financial position has more bargaining power, hence no or less credit.
• Industry requirements: Some sectors cannot do without credit, e.g., manufacturing.

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• Relations with dealers: Credit extended to build long-term relationship/ to reward
loyalty.

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• Marketing strategy: To attract/retain customers, specially for new

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products; when company wishes to push weaker products/services.
• Transit delays: A forced reason for extended credit. Companies
anticipating delays offer longer credit terms to offset the economic
impacts on business operations.
Adapted from: Pandey and Bhat (2021)
 Credit Management
Optimal Credit Policy
• A marginal cost-benefits analysis: the value of the firm is maximum when the marginal rate
of return on investments equals the marginal cost of funds required.

Marginal cost of
capital (rWACC)
Cost of Funds and Returns (%)

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Marginal rate of
Optimum return (ri)
Investment
in
Receivables
Stringent ← Credit Policy →Liberal
CONCLUSION

• Cash management involves handling of cash inflows and cash outflows in an

efficient manner so as to minimize the time gap between the two.

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• Management of receivables depends on industry and sector to which a

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company belongs. Some sectors require stringent credit management while
others manage with liberal policies.

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• Credit management is undertaken with relevant credit standards, credit
terms
and collection efforts to minimize cost of funds required for investment in
accounts receivables.
REFERENCES

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⮚ Corporate Finance, 2nd ed. (2012), Clayman et al. Wiley

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⮚ Financial Management, 14th ed (2021), Pandey, Pearson

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