9.18 Receivables and Credit Policy

The “investment” in Accounts Receivable can be measured by the opportunity cost of funds tied up in the receivables. The firm’s Credit Policy is thus of great importance. (You will recall that the ACP = [(Average Accounts Receivable) ÷ Credit Sales] × 360.)


Credit Policy Considerations

Customer Creditability depends on the “five Cs,” as noted below.

Character has to do with the firm’s reputation. Is it a company that has paid its obligations on time in the past? Does it have a bad name?

Capacity has to do with the company’s ability to pay its obligations. This has something to do with the company’s earnings and cash flow. It also has to do with the company’s balance sheet size and strength and, in particular, its liquidity ratios.

Capital is similar to capacity in that this too has to do with the company’s balance sheet strength, especially its leverage.

Collateral addresses whether the seller is able to take back any collateral should the buyer not honor its payment obligation. Is there any “gap” between the financial obligation and the worth of the collateral?

Conditions have to do with the Macro-economy and industry status. If conditions are deteriorating, what effect may this have on the buyer’s ability to pay its obligations?

The five Cs may be factored into a statistical model in order to come up with an objective assessment of the company’s creditworthiness.


Sources of Credit Information

Providing a customer with credit terms of sale presents the supplier with a risk that the customer may not pay, or may pay late, thereby causing the supplier increased internal financial costs relative to the sale of goods and services. Not providing a worthy customer with credit terms may result in lost sales. Companies must carefully analyze each customer’s creditability and monitor their financial situations on an ongoing basis.  This is often handled within the company’s accounts receivable department, often by a “credit analyst” who is dedicated to this responsibility. There are numerous means by which a supplier may inquire into a potential customer’s ability to warrant credit terms, rather than requiring cash payment no later than at the time of delivery.

There are various credit reporting agencies, which gather information and supply the information to interested parties for a fee. Some of these agencies include Dun & Bradstreet (“D & B”) and TRW. The reader may recognize these names as one and the same agencies that provide credit information of mortgagees and individuals who seek to finance a car purchase etc. A company’s credit score (see below) may also be obtained from a credit reporting agency.

Industry associations are often good sources of information. If a company gets “burned” by a customer, the company is likely to share that information with the trade association.  The trade association, which is supported by members’ dues, is charged with advancing the interests of its members. The association is thus a good receptacle and disseminator of relevant information.

Similarly, a supplier may garner information from the customer’s other suppliers.  Companies may be eager to assist one another under the premise that “what goes around comes around.” Naturally, if a supplier is competing for the same customer, or is in any manner at odds with the inquiring company, it may be quite unwilling to share any information whatsoever; this is very often the case. Nevertheless, any experience with the customer can be invaluable.

If the customer has a banking relationship, the bank may provide some information on the company. Banks often provide checking, international trade, and loan services to companies. The credit analyst must be wary of a bank who lends money to a company, as it may be reluctant to provide negative information to a supplier, which information could jeopardize its lending facility and its ability to be repaid. Still, banks will provide some information on its accounts, even if diluted.

The credit analyst, employed at the supplier’s firm, will often request an audited financial statement from the new customer. This will tell the analyst a great deal about the customer’s creditability. It will also enable the supplier to gauge the extent to which, in dollar terms, credit may be granted.

In the period during which a salesman wishes to sell to a new account, the credit (or accounts receivable) department must approve the sale and set credit terms and limits.  This is accomplished by gathering as much of the foregoing information as possible, and making a comprehensive assessment of the new customer’s financial status and credit worthiness. As a result, sales and credit departments have a built-in conflict of interest: the credit department wants to be completely assured of payment on terms, while the sales department is eager to sell.


Consumer Credit Scoring System

Most credit scoring systems employ Multiple Discriminant Analysis, a statistical procedure similar to regression, which inputs data relating to a debtor’s ability (and willingness) to pay down his debt. Credit worthiness is ranked or “scored.”  This serves to quantify one’s credit rating. A minimum score would be required in order to earn credit. Some inputs, used by Sears for consumer credit, include:

  • Home ownership (Use of some multiple or weight times one’s TIE ratio)
  • The TIE Ratio (Times Interest Earned Ratio = Earnings Before Interest and Taxes ÷ Interest Expense)
  • Current job tenure
  • Current debt load as a percent of annual income (X times debt ratio)
  • Credit history (personal loans, credit cards, etc.)

Problems for evaluating credit scores of corporations have to do with the fact that financial ratios are often incomparable due to varying accounting conventions. This is helpful, however, as a first step. A personal credit score in excess of 700 is considered very good; a perfect score would be 850. Unfortunately, credit scoring agencies do not share with the public their proprietary formulae for arriving at credit scores.


Terms of Sale/Credit

Companies typically extend credit to their customers by allowing the customer to pay for the goods received some time after delivery and receipt of the goods. The most common credit terms are “thirty days,” meaning that the customer agrees by accepting delivery that s/he will pay for the goods within thirty days of receipt.

Other common terms of sale include “2/10, net thirty.” This means that if the customer chooses to pay within ten days of receipt, s/he may take off 2% from the invoiced amount or, alternatively, pay the full invoice price within thirty days. For example, if the sale is for one million dollars, the customer may pay $980,000 within ten days of receipt of the goods. Whether it pays for the customer to take the discount or not is the subject of Cost of “Trade Credit” to be found below. Abuse of credit terms is clearly a risk with which the supplier must grapple; enforcement of terms of sale is one of the most difficult matters that a business confronts.


Collection Policy

Naturally, not all customers pay on time – or at all – in spite of the best efforts to gather and assess the customer’s creditability. It is therefore incumbent upon suppliers to have a policy to follow when the worst happens. How are “Past-due” accounts handled?

Many companies engage the services of an attorney or collection agency to assist in collecting on overdue accounts receivable. Short of this, telephone calls from salesmen, sales managers, or receivables managers can yield positive results. Passing along negative information to a customer’s other suppliers or trade association may or may not be fruitful. Calls to trade associations may yield helpful advice; in extreme cases, a bad debtor is punished by the entire trade who will not do business with the buyer unless it is for cash. This is a difficult situation because the industry does not want to ban the customer altogether, as doing so would cause the company to go out of business, resulting in the suppliers’ collectively (or individually) not getting paid their due.

In certain instances, a supplier will allow some customers to pay late with no consequences. Among the reasons for this liberality is the supplier’s interest in expanding market share to new accounts or entering new territories; the company may tolerate such lateness, knowing its longer-term goal of increased profits is attainable.


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Corporate Finance Copyright © 2023 by Kenneth S. Bigel is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

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