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Chapter 22 - I

Providing and Obtaining Credit

2USE OF SECURITY IN SHORT-TERM FINANCING

• Roughly half of short-term bank loans to businesses are unsecured.

• Most common forms of collateral on secured loans: marketable securities, receivables, and inventories.

• Processing and bookkeeping costs cause the interest rate on secured loans to be higher than on unsecured loans.

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• Secured loans are also known as asset based financing.

• Recently, some firms have pledged receivables as collateral on long-term loans.

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Pledging

• Borrowing from a bank or finance company with receivables offered as collateral is called pledging.

The primary goal is to obtain the funds sooner than normal collection.

However …- lender will lend less than face value- bank will require detailed records- risk of default and cost of collection remains with company

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Pledging Problem

• Chico Corporation can borrow 80% of its receivables value at 2% above the prime rate, which is currently 6%. The bank also charges a fee for services, including credit checks, equal to 0.5% of the pledged amount. Receivables are based on a 30-day DSO and total $5 million. What is the nominal cost of borrowing?

6In-Class ExerciseProblem #1

• Ranger Enterprises can borrow against 75% of its $5 million in receivables (DSO=50 days) at an interest rate of 13.5%. In addition, the bank will charge a service fee equal to 1% of the pledged receivables. What is the nominal cost of this source of financing?

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Factoring

• When the receivables are sold to a bank or finance company, this is called factoring.

• If sold on nonrecourse basis:- the buyer of the receivables (called a factor) must suffer any bad debt losses.- creditworthiness of customer must first be approved by the factor.

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Advantages of factoring as a source of funds:– the company sheds the cost of a credit department.- the company sheds bad debt losses. (if on nonrecourse basis)- the factor can perform credit checks on the company’s customers at a lower cost than if done by the company.

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Disadvantages of factoring as a source of funds:- discount costs are high.- may lose sales if customer is unapproved by factor.- if on recourse basis, company still suffers bad debt losses.

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Factoring is most suitable for small companies with longer collection periods and who are less liquid.

Factoring also increases with geographically dispersed customers and fewer repeat sales. The factor is more efficient due to the high information and monitoring costs.

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Example of factoring - customers who pay with major credit cards.- credit card company charges fee for the credit check (around 3%).- risk is then transferred to credit card company.

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Factoring Problem

• The Zippo Corporation is considering factoring its receivables, which average $1 million (DSO=60 days). The factor charges a 2% commission and requires a 10% reserve for returns and allowances. It will advance funds at 4% over the prime, which is presently 10%. Credit dept. savings will be $2000 per month, and bad debt loss savings will be $6,000 per month.

13In-Class ExerciseProblem #2

• Designer Textiles can factor $2.5 mil in receivables (DSO=45 days) at an interest rate on advanced funds of 6%, plus a factor commission of 1.5% of receivables. The factor requires a 10% reserve for returns and allowances. The firm averages bad debt losses of $15,000 per month and credit dept. expenses of $14,000 per month. Nominal cost of funds?

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Inventory Financing

• Using inventory as collateral on loans is called inventory financing.

When inventories in general are pledged as loan collateral, without itemizing or specification, this is called a blanket lien.

The lender, however, only lends a small fraction of amount of inventory pledged.

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• When the borrower pledges expensive, serialized items as loan collateral, this is called trust receipt financing.

most suitable for low-turnover items like autos and other consumer durables, and industrial equipment.

because inventory remains on borrower’s premises for display purposes, also called floor planning.

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Trust receipt loans are made by banks, commercial finance companies, and captive finance companies (like GMAC).

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• When pledged inventories are policed by the lender, this is called warehousing.

Advances are issued against warehouse receipts.

A 3rd party is typically assigned to issue receipts and ensuring that pledged items are in the warehouse.

Although the pledged items are in legal possession of the lender, sometimes they may simply exist in a segregated area on borrower’s premises (called field warehousing).

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Problems with warehousing as a source of funds:- not flexible – items must be segregated and stored.- not feasible for small inventory items with high turnover.- public warehouses (also called terminal warehouses) carry high costs for security, warehouse rent, logistics, etc.

19CREDIT POLICY

• What are the tools of credit policy?Terms of credit (ex: 2/10, net 30)

- credit period (seasonal dating? Prox basis?)- discounts offered

Credit standards – which customers are offered trade credit (size of the credit limit)

Collection policy – how to deal with overdue accounts

20Other Factors Influencing Credit Policy

• Typically, credit sales are more profitable than cash sales if the firm charges interest (i.e., carrying charge) on the receivable.

Amortized loans on consumer durables often involve high interest rates.

• Different credit terms cannot be offered to different customers, unless the difference is cost-justified.

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• The final factor that should drive credit policy decisions is the expected effect on profit.

Note that with credit policy decisions, there are no noncash items (such as depreciation) to cause book profit to differ from cash flow.

22SETTING THE CREDIT PERIOD AND CREDIT STANDARDS

• Credit terms are usually dictated by the leading firm(s) in the industry, with other firms following suit.

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• Establishing credit standards:5 C’s of credit – character, capital,

capacity, conditions, and collateralCharacter – thought to be the most

important, refers to willingness to pay when times are bad.

Capital is measured by net worth (assets – liabilities).

Capacity – refers to the customer’s ability to generate cash flows.

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Key questions about conditions:- current stage of the business cycle?- how does the customer’s business track the business cycle (lead, lag)?- is there serious overcapacity in the customer’s industry, or is industry activity tapering off?- is the customer’s product line subject to booms or busts?

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Major question - what is the customer’s historic ability to weather recessions?

Collateral – considered the least important factor (although it is rare to hold collateral on trade credit)

What is the overall risk classification of the customer?

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Sources of credit information:- credit-reporting agencies (Dun & Bradstreet) - credit interchange bureaus – departments of local credit associations that provide info in reports (National Association of Credit Management)

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- trade associations – compile info from companies in the association (example – National Retail Merchants Association).- banks – company can ask bank to verify customer-supplied info from customer’s banks, as well as obtain loan payment info and average deposit balance histories.

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Credit-scoring models- multivariate models that help discriminate between good and bad credit risks.- tend to focus only on capacity and collateral.

Most companies base the scope of the credit investigation on the size of the potential sale.

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Best early warning system of a deterioration in customer’s ability to pay may be a sudden drop in customer’s stock or bond prices.

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• Primary considerations in establishing the credit limit:

If the customer is more dependent on the supplier’s products, that customer is more likely to pay.

A review of the customer’s payment history and current financial statements are used to estimate the customer’s ability to pay.

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Traditional approaches to setting the limit:- set the limit to customer need.- set the limit to 10% of customer capital.- set the limit to the highest credit reported by banks or other suppliers.- set credit limits for marginal customers at small dollar amounts for a short probationary period

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Some sellers believe the probability of repayment decreases with the amount of trade credit granted.

Roughly 1/4th of firms use agency ratings to set credit limits.

Only about 30% of companies inform their customers of the size of the limit

Roughly 80% of companies set credit limits for most of their customers

33SETTING THE COLLECTION POLICY

• Key issues:How long past due should the

company wait to initiate collection efforts?- normally contact customer within 10 days of delinquency.

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Method of contact?- usually customer is mailed a statement of account reflecting purchase order numbers and (maybe) a copy of unpaid invoices.- reminder letter may be followed with a phone call (especially with larger accounts).- seller’s sales force may ask for updates on buyer’s circumstances.

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Normal collection cycle:- lasts 2-to-3 months with 10-15 day intervals between successive collection efforts.- in final stages, a final letter may state that unless payment is immediately received, the account will be placed with a collection agency or attorney in 10 days.

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Advantage of referral to a collection agency?- collection agency frees up time and resources for the seller.

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Disadvantages of referral to a collection agency?- agency fee may be a small fixed amount plus percentage (15-50%) of funds recovered.- seller may also be required to pay portion of attorney fees up front.

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Average recovery rate in US is 11%.

Other strategies to get paid:- charge interest for late payments.- offer a cash discount.- work on a retainer (get some cash up front).- legalize your faxes (insert clause that “Fax is as original” so it can serve as a legal document).

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• Evidence on collection practices:Collection efforts are more

aggressive with larger amounts.Almost 90% of US firms involve

sales staff in collections.Credit insurance – indemnifies

seller against losses from nonpayment.

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• National Association of Credit Management – publishes the “Credit Manual of Commercial Laws” annually- also includes state and federal laws and regulations that govern extension of credit.