Brealey−Meyers: Principles of Corporate Finance, 7th Edition - Chapter 32

Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and 32. Credit Management Short−Term Management © The McGraw−Hill Companies, 2003 C H A P T E R T H I R T Y - T W O C R E D I T M A N A G E M E N T 908 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and 32. Credit Management Short−Term Management © The McGraw−Hill Companies, 2003 WHEN COMPANIES SELLtheir products, they sometimes demand cash on or before delivery, but in most cases they allow some delay in payment. If you turn back to the balance sheet in Table 30.1, you can see that for the average manufacturing company, accounts receivable constitute about one-third of its current assets. Receivables include both trade credit and consumer credit. The former is by far the larger and will, therefore, be the main focus of this chapter. Companies that do not pay for their purchases immediately are effectively borrowing money from their suppliers. Such “debts” show up as accounts payable in the purchasing companies’ balance sheets. Table 30.1 shows that payables are the most important source of short-term finance, much larger than short-term loans from banks and other institutions. Management of trade credit requires answers to five sets of questions: 1. On what terms do you propose to sell your goods or services? How long are you going to give customers to pay their bills? Are you prepared to offer a cash discount for prompt payment? 2. What evidence do you need of indebtedness? Do you just ask the buyer to sign a receipt, or do you insist on some more formal commitment? 3. Which customers are likely to pay their bills? To find out, do you consult a credit agency or ask for a bank reference? Or do you analyze the customer’s financial statements? 4. How much credit are you prepared to extend to each customer? Do you play it safe by turning down any doubtful prospects? Or do you accept the risk of a few bad debts as part of the cost of building up a large regular clientele? 5. How do you collect the money when it becomes due? How do you keep track of payments? What do you do about reluctant payers or deadbeats? We will discuss each set of questions in turn. 32.1 TERMS OF SALE Not all sales involve credit. For example, if you are producing goods to the cus-tomer’s specification or incurring substantial delivery costs, then it may be sensi- ble to ask for cash before delivery (CBD). If you are supplying goods to a wide variety of irregular customers, you may prefer cash on delivery (COD).1 If your product is expensive and custom-designed, you may require progress payments as work is carried out. For example, a large, extended consulting contract might call for 30 percent payment after completion of field research, 30 percent more on submission of a draft report, and the remaining 40 percent when the project is fi-nally completed. When we look at transactions that do involve credit, we find that each industry seems to have its own particular usage with regard to payment terms.2 These norms have a rough logic. For example, firms selling consumer durables may al-low the buyer a month to pay, while those selling perishable goods, such as cheese or fresh fruit, typically demand payment in a week. Similarly, a seller will gener-ally allow more extended payment if its customers are in low-risk businesses, if 1Some goods can’t be sold on credit—a glass of beer, for example. 2Standard credit terms in different industries are reported in O. K. Ng, J. K. Smith, and R. L. Smith, “Ev-idence on the Determinants of Credit Terms Used in Interfirm Trade,” Journal of Finance 54 (June 1999), pp. 1109–1129. 909 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and 32. Credit Management Short−Term Management © The McGraw−Hill Companies, 2003 910 PART IX Financial Planning and Short-Term Management their accounts are large, if the customers need time to ascertain the quality of the goods, and if the goods are not quickly resold. To induce customers to pay before the final date, it is common to offer a cash dis-count for prompt settlement. For example, pharmaceutical manufacturers com-monly require payment within 30 days but may offer a 2 percent discount to cus-tomers who pay within 10 days. These terms are referred to as “2/10, net 30.” Cash discounts are often very large. For example, a customer who buys on terms of 2/10, net 30 may decide to forgo the cash discount and pay on the thirtieth day. This means that the customer obtains an extra 20 days’ credit but pays about 2 percent more for the goods. This is equivalent to borrowing money at a rate of 44.6 percent per annum.3 Of course, any firm that delays payment beyond the due date gains a cheaper loan but damages its reputation for creditworthiness. You can think of the terms of sale as fixing both the price for the cash buyer and the rate of interest charged for credit. For example, suppose that a firm reduces the cash discount from 2 to 1 percent. That would represent an increase in the price for the cash buyer of 1 percent but a reduction in the implicit rate of interest charged the credit buyer from just over 2 percent per 20 days to just over 1 percent per 20 days. For many items that are bought on a recurrent basis, it is inconvenient to require separate payment for each delivery. Acommon solution is to pretend that all sales during the month in fact occur at the end of the month (EOM). Thus goods may be sold on terms of 8/10, EOM, net 60. This arrangement allows the customer a cash discount of 8 percent if the bill is paid within 10 days of the end of the month; oth-erwise, the full payment is due within 60 days of the invoice date.4 When pur- chases are subject to seasonal fluctuations, manufacturers often encourage cus-tomers to take early delivery by allowing them to delay payment until the usual order season. This practice is known as “season dating.” 32.2 COMMERCIAL CREDIT INSTRUMENTS The terms of sale define when payment is due but not the nature of the contract. Repetitive sales to domestic customers are almost always made on open accountand involve only an implicit contract. There is simply a record in the seller’s books and a receipt signed by the buyer. If you want a clear commitment from the buyer, before you deliver the goods, you can arrange a commercial draft.5 This works as follows: You draw a draft ordering payment by the customer and send this draft to the customer’s bank together with the shipping documents. If immediate payment is required, the draft is termed a sight draft;otherwise, it is known as a time draft.Depending on whether it is a sight or a time 3The cash discount allows you to pay $98 rather than $100. If you do not take the discount, you get a 20-day loan, but you pay 2/98 2.04 percent more for your goods. The number of 20-day periods in a year is 365/20 18.25. A dollar invested for 18.25 periods at 2.04 percent per period grows to 11.0204218.25 $1.446, a 44.6 percent return on the original investment. If a customer is happy to borrow at this rate, it’s a good bet that he or she is desperate for cash (or can’t work out compound interest). For a discussion of this issue, see J. K. Smith, “Trade Credit and Information Asymmetry,” Journal of Fi-nance 42 (September 1987), pp. 863–872. 4Terms of 8/10, prox., net 60 would entitle the customer to a discount if the bill is paid within 10 days of the end of the following (or “proximo”) month. 5Commercial drafts are sometimes known by the more general term bills of exchange. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and 32. Credit Management Short−Term Management © The McGraw−Hill Companies, 2003 CHAPTER 32 Credit Management 911 draft, the customer either pays up or acknowledges the debt by adding the word ac- cepted and his or her signature. The bank then hands the shipping documents to the customer and forwards the money or the trade acceptanceto you, the seller.6 You may hold the trade acceptance to maturity or use it as security for a loan. If your customer’s credit is for any reason suspect, you may ask the customer to arrange for his or her bank to accept the time draft. In this case, the bank guarantees the customer’s debt. These bankers’ acceptances are often used in overseas trade; they have a higher standing and greater negotiability than trade acceptances. If you are selling goods overseas, you may ask the customer to arrange for an ir-revocable letter of credit. In this case the customer’s bank sends you a letter stating that it has established a credit in your favor at a bank in the United States. You then draw a draft on the customer’s bank and present it to your bank in the United States together with the letter of credit and the shipping documents. The bank in the United States arranges for this draft to be accepted or paid and forwards the documents to the customer’s bank. If you sell goods to a customer who proves unable to pay, you cannot get your goods back. You simply become a general creditor of the company, in common with other unfortunates. You can avoid this situation by making a conditional sale, whereby title to the goods remains with the seller until full payment is made. The conditional sale is common practice in Europe. In the United States it is used only for goods that are bought on an installment basis. In this case, if the customer fails to make the agreed number of payments, then the goods can be immediately re-possessed by the seller. 32.3 CREDIT ANALYSIS Firms are not allowed to discriminate between customers by charging them differ- ent prices. Neither may they discriminate by offering the same prices but different credit terms.7 You can offer different terms of sale to different classes of buyers. You can offer volume discounts, for example, or discounts to customers willing to ac-cept long-term purchase contracts. But as a rule, if you have a customer of doubt-ful standing, you should keep to your regular terms of sale and protect yourself by restricting the volume of goods that the customer may buy on credit. There are a number of ways to find out whether customers are likely to pay their debts. For example, you are likely to have more confidence in those existing cus-tomers that have paid promptly in the past. For new customers there are three broad sources of information about their creditworthiness. You can seek the views of a spe-cialist credit analyst, you can look at the information embedded in the firm’s security prices, or you can use the firm’s financial statements to make your own assessment. Specialist Credit Analysts The simplest way to assess a customer’s credit stand-ing is to seek the views of a specialist in credit assessment. For example, in Chap- ter 24 we described how bond rating agencies, such as Moody’s and Standard and Poor’s, provide a useful guide to the riskiness of the firm’s bonds. 6You often see the terms of sale defined as “SD-BL.” This means that the bank will hand over the bill of lading in return for payment on a sight draft. 7Price discrimination, and by implication credit discrimination, is prohibited by the Robinson-Patman Act. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and 32. Credit Management Short−Term Management © The McGraw−Hill Companies, 2003 912 PART IX Financial Planning and Short-Term Management Bond ratings are usually available only for relatively large firms. However, you can obtain information on many smaller companies from a credit agency. Dun and Bradstreet is by far the largest of these agencies and its database contains reports on more than 10 million companies. Credit agencies usually report the experience that other firms have had with your customer. Alternatively, you may be able to get this information by checking with a credit bureau or by contacting the firms directly. You can also ask your bank to un-dertake a credit check. It will contact the customer’s bank and ask for information on the customer’s average balance, access to bank credit, and general reputation. Security Prices In addition to checking with a credit agency or your bank, it may make sense to check what everybody else in the financial community thinks about your customer’s credit standing. Does that sound expensive? It isn’t if your cus-tomer is a public company. For example, you can learn what other investors think by comparing the yield on the firm’s bonds with the yields on those of other firms. (Of course, the comparison should be between bonds of similar maturity, coupon, etc.) You can also look at how the customer’s stock price has been behaving. A sharp fall in stock price doesn’t mean that the company is in trouble, but it does suggest that prospects are less bright than they were formerly. In Chapter 24 we saw how information on security prices can be used to put a figure on the chances of default. Companies have an incentive to exercise their option to default when the value of their assets is less than the amount of their debt. So, if you know how much the value of the firm’s assets may fluctuate, you can estimate the probability that the asset value will fall below the default point. In Chapter 24 we looked at an example of how one consulting firm, KMV, uses this market-based approach to estimate default probabilities. Financial Statements Security price data may not be available for many cus-tomers, and in these cases you will need to rely on the customers’ financial state- ments to make your own assessment of their credit standing. In Chapter 29 we saw how managers calculate a few key financial ratios to measure the firm’s financial strength. Firms that are highly leveraged, illiquid, and unprofitable generally don’t make dependable customers. If you have a large number of customers, it may be useful to combine different financial indicators into a single measure of which companies or individuals are most likely to default. For example, if you apply for a credit card or a bank loan, you will be asked various questions about your financial position. The information that you provide is then used to calculate an overall credit score. One widely used system, designed by the consultancy firm Fair Isaacs, takes account of five factors: (1) How promptly the applicant has paid in the past (35 percent of score); (2) how much debt of each type is outstanding (30 percent of score); (3) the length of the ap-plicant’s credit history (15 percent of score); (4) the number of credit cards and re-cently opened credit accounts that the applicant has (10 percent of score); and (5) the mix of regular credit cards, store cards, and margin accounts (10 percent of score). Applicants who fail to make the grade on the score are likely to be refused credit or subjected to more detailed analysis. Suppose you want to devise a scoring system that will help you to decide whether to extend credit to small businesses. You suspect that there is an above-average probability that firms with a low return on assets and a low current ratio ... - tailieumienphi.vn