Notes in Fin

T 2.2. Credit Analysis

Credit Analysis
Ross (2010) stated that once a firm decides to grant credit to its customers, it must then
establish guidelines for determining who will and who will not be allowed to buy on
credit. Credit analysis refers to the process of deciding whether or not to extend credit
to a particular customer. It usually involves two steps: gathering relevant information
and determining creditworthiness.
When Should Credit Be Granted?
Imagine that a firm is trying to decide whether or not to grant credit to a customer. This
decision can get complicated. For example, note that the answer depends on what will
happen if credit is refused. Will the customer simply pay cash? Or will the customer not
make the purchase at all?
A new customer wishes to buy one unit on credit at a price of P per unit. If credit is
refused, the customer will not make the purchase.  Furthermore, we assume that, if
credit is granted, then, in one month, the customer will either pay up or default. The
probability of the second of these events is. In this case, the probability () can be
interpreted as the percentage of new customers who will not pay.
Our business does not have repeat customers, so this is strictly a one-time sale.
Finally, the required return on receivables is R per month, and the variable cost is v per
unit. The analysis here is straightforward. If the firm refuses credit, then the incremental
cash flow is zero. If it grants credit, then it spends v (the variable cost) this month and
expects to collect (1 – ) P next month. The NPV of granting credit is:
                                NPV = -v + (1 -    ) P / (1 + R)
For example: for Locust Software, the NPV is:
                                NPV = - $20 + (1 – ) x 49 / 1.02
With a 20 percent rate of default, this works out to be:
                                NPV = - $20 + .80 x 49 / 1.02 = $18.43
Therefore, credit should be granted. Notice that we have divided by (1 + R) here instead
of by R because we now assume that this is a one-time transaction. In granting credit
to a new customer, a firm risks its variable cost (v). It stands to gain a full price (P). For
a new customer, then, credit may be granted even if the default probability is high. For
example, the break-even probability, in this case, can be determined by setting the NPV
equal to zero and solving for :
                                NPV = 0 = - $20 + (1 – π) x 49 / 1.02
                                1 – π = $20/49 x 1.02
                                    = 58.4%
Locust should extend credit as long as there is a 1 – .584 = 41.6% chance or
better of collecting. This explains why firms with higher markups tend to have
looser credit terms.
58.4% is the maximum acceptable default probability for a new customer. If a returning,
cash-paying customer wanted to switch to a credit basis, the analysis would be
different, and the maximum acceptable default probability would be much lower.
Credit Information
If a firm wants credit information about customers, there are a number of sources.
Information sources commonly used to assess creditworthiness include the following:
1. Financial statements: A firm can ask a customer to supply financial statements
such as balance sheets and income statements. Minimum standards and rules of
thumb based on financial ratios like the ones we discussed in Module 2.
2. Credit reports about the customer’s payment history with other firms: Quite
a few organizations sell information about the credit strength and credit history of
business firms. Ratings and information are available for a large number of firms,
including very small ones. CMAP or Credit Management Association of the
Philippines provides the credit information of individual and corporate borrowers
of different credit institutions.
3. Banks: Banks will generally provide some assistance to their business
customers in acquiring information about the creditworthiness of other firms.
4. The customer’s payment history with the firm: The most obvious way to
obtain information about the likelihood of customers not paying is to examine
whether they have settled past obligations (and how quickly).
Credit Evaluation and Scoring
There are no magical formulas for assessing the probability that a customer will not pay.
In very general terms, the classic five Cs of credit are the basic factors to be
evaluated:
1. Character: The customer’s willingness to meet credit obligations.
2. Capacity: The customer’s ability to meet credit obligations out of operating cash
flows.
3. Capital: The customer’s financial reserves.
 4. Collateral: An asset pledged in the case of default.
5. Conditions: General economic conditions in the customer’s line of business.
Credit scoring is the process of calculating a numerical rating for a customer based on
information collected; credit is then granted or refused based on the result. For
example, a firm might rate a customer on a scale of 1 (very poor) to 10 (very good) on
each of the five Cs of credit using all the information available about the customer. A
credit score could then be calculated by totaling these ratings. Based on experience, a
firm might choose to grant credit only to customers with a score above, say, 30.
Because credit-scoring models and procedures determine who is and who is not
creditworthy, it is not surprising that they have been the subject of government
regulation. In particular, the kinds of background and demographic information that can
be used in the credit decision are limited.
Collection Policy
The collection policy is the final element in credit policy. Collection policy involves
monitoring receivables to spot trouble and obtaining payment on past-due accounts
(Ross, 2010).
Monitoring Receivables
To keep track of payments by customers, most firms will monitor outstanding
accounts. First of all, a firm will normally keep track of its average collection period
(ACP) through time. If a firm is in a seasonal business, the ACP will fluctuate during the
year; but unexpected increases in the ACP are a cause for concern. Either customer, in
general, is taking longer to pay, or some percentage of accounts receivable are
seriously overdue.
To see just how important timely collection of receivables is to investors, consider the
case of Art Technology Group (ATG), a company that provides Internet customer
relationship management and e-commerce software. In late 2000, ATG announced an
unusual sale of accounts receivable to a bank. The sale helped lower ATG’s reported
September days’ sales outstanding, an important indicator of receivables management.
However, after this information became public, investors became concerned about the
quality of the firm’s sales, and ATG’s stock sank 18 percent.
The aging schedule is a second basic tool for monitoring receivables. To prepare one,
the credit department classifies accounts by age. 2 Suppose a firm has $100,000 in
receivables. Some of these accounts are only a few days old, but others have been
outstanding for quite some time. The following is an example of an aging schedule:
Source: Ross, et al. (2010). Fundamentals of Corporate Finance. (9th Edition). New
York, NY: McGraw Hill
If this firm has a credit period of 60 days, then 25 percent of its accounts are late.
Whether or not this is serious depends on the nature of the fi rm’s collections and
customers. It is often the case that accounts beyond a certain age are almost never
collected. Monitoring the age of accounts is very important in such cases.
Collection Effort
 A firm usually goes through the following sequence of procedures for customers whose
payments are overdue:
1. It sends out a delinquency letter informing the customer of the past-due status of
the account.
2. It makes a telephone call to the customer.
3. It employs a collection agency.
4. It takes legal action against the customer.
At times, a firm may refuse to grant additional credit to customers until arrearages are
cleared up. This may antagonize a normally good customer, which points to a potential
conflict between the collections department and the sales department.
Synthesis:
Topic 2 discussed the basics of credit management and policy analysis. We developed
the cash flows from the decision to grant credit and showed how the credit decision can
be analyzed in an NPV setting. 
References: 
Lasher (2014). Practical Financial Management, (7th Edition). Philippines: Cengage
Learning Philippine Edition
Ross, et al. (2010). Fundamentals of Corporate Finance. (9th Edition). New York, NY:
McGraw-Hill Irwin