Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
CHAPTER THIRTY-TWO
908
C R E D I T
MANAGEMENT
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
WHEN COMPANIES SELL their 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.
909
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
1
Some goods can’t be sold on credit—a glass of beer, for example.
2
Standard 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.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
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. A common 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.”
910 PART IX
Financial Planning and Short-Term Management
3
The 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 percent more for your goods. The number of 20-day periods in
a year is . A dollar invested for 18.25 periods at 2.04 percent per period grows to
, 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.
4
Terms 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.
5

Commercial drafts are sometimes known by the more general term bills of exchange.
11.02042
18.25
ϭ $1.446
365/20 ϭ 18.25
2/98 ϭ 2.04
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 account and
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
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
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 acceptance to 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.
CHAPTER 32
Credit Management 911
6
You 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.
7
Price discrimination, and by implication credit discrimination, is prohibited by the Robinson-Patman Act.
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.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
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
912 PART IX
Financial Planning and Short-Term Management
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
will default on their debts.
8
To test this, you take a sample of past loans and con-
struct a scatter diagram showing for each borrower the return on assets and the
current ratio (see Figure 32.1). Those businesses that repaid their loans are shown
by a blue x; the ones that defaulted are shown in burgundy. Now try to draw a
straight dividing line between the two groups. You can’t completely separate them,

but the line in our diagram keeps the two groups as far apart as possible. (Note that
there are only three blue x’s below the line and three burgundy ϩ’s above it.) This
line tells us that if you wish to discriminate between the good and the bad risks, you
should give 10 times as much weight to the current ratio as you give to return on
assets. The index of creditworthiness is
You minimize the degree of misclassification if you predict that applicants with
Z scores over 15 will pay their debts and that those with Z scores below 15 will
not pay.
9
In practice you do not need to consider only two variables, nor do you need to
estimate the equation by eye. Multiple-discriminant analysis (MDA) is a straightfor-
ward statistical technique for calculating how much weight to put on each variable
to separate the creditworthy sheep from the impecunious goats.
10
Index of creditworthiness ϭ Z ϭ return on assets, percent ϩ 10 1current ratio2
CHAPTER 32 Credit Management 913
0
Return on
assets, percent
21
18
15
3
6
9
12
0.5 1.0 1.5
Current
ratio
x

x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
+
+
+
+
+
+
+
+
+
+
+
+
FIGURE 32.1
The black x’s represent a hypothetical
group of firms that subsequently

repaid their loans; the burgundy ϩ’s
represent those that defaulted. The
sloping line discriminates between the
two groups on the basis of return on
assets and current ratio. The line
represents the equation
Z ϭ return on assets
ϩ10(current ratio)
ϭ 15
Firms that plot above the line have
Z scores greater than 15.
8
The current ratio is the ratio of current assets to current liabilities. It is commonly used as a measure
of the company’s ability to lay its hands on cash. See Chapter 29.
9
The quantity 15 is an arbitrary constant. We could just as well have used 150, in which case the Z score is
10
MDA is not the only statistical technique that you can use for this purpose. Probit and logit are two
other potentially useful techniques. These estimate the probability of some event (e.g., default) as a
function of observable attributes.
Z ϭ 101return on assets, percent2 ϩ 1001current ratio2
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
Edward Altman has used discriminant analysis to come up with the following

index of creditworthiness:
11
Those companies with a Z-score of less than 1.20 were predicted to go bankrupt.
Companies with Z-scores between 1.20 and 2.90 were hovering in the grey area be-
tween decline and recovery.
Updated and refined versions of Altman’s Z-score model are regularly used by
banks and industrial companies. We wish we could show you one of these recent
versions, but they are all top secret. A company with a superior method for identi-
fying good and bad borrowers has a significant leg up on the competition.
12
Credit scoring systems should carry a health warning. When you construct a
risk index, it is tempting to experiment with many different combinations of vari-
ables until you find the equation that would have worked best in the past. Unfor-
tunately, if you “mine” the data in this way, you are likely to find that the system
works less well in the future than it did previously. If you are misled by the past
successes into placing too much faith in your model, you may refuse credit to a
number of potentially good customers. The profits that you lose by turning away
these customers could more than offset the gains that you make from avoiding a
few bad eggs. As a result, you could be worse off than if you had pretended that
you could not tell one customer from another and extended credit to all of them.
Does this mean that you should not use credit scoring systems? Not a bit. It sim-
ply implies that it is not sufficient to have a good credit scoring system; you also
need to know how much to rely on it. That is the topic of the next section.
ϩ.42
1shareholders’ equity2
total liabilities
ϩ 1.0
sales
total assets
Z ϭ .72

1net working capital2
total assets
ϩ .85
1retained earnings2
total assets
ϩ 3.1
1EBIT2
total assets
914 PART IX Financial Planning and Short-Term Management
11
EBIT is earnings before interest and taxes. Z-score models for predicting bankruptcy were originally
developed in E. I. Altman, “Financial Ratios, Discriminant Analysis and the Prediction of Corporate
Bankruptcy,” Journal of Finance 23 (September 1968), pp. 589–609. The equation cited here comes from
E. I. Altman, Corporate Financial Distress, John Wiley, New York, 1983.
12
When a British bank laid off a number of employees, one unhappy staff member decided that the best
way to retaliate was to leak details of the bank’s credit scoring system to the press. See V. Orvice,
“Would You Get a Loan?” Daily Mail, March 16, 1994, p. 29.
32.4 THE CREDIT DECISION
Let us suppose that you have taken the first three steps toward an effective credit
operation. In other words, you have fixed your terms of sale; you have decided on
the contract that customers must sign, and you have established a procedure for
estimating the probability that they will pay up. Your next step is to work out
which of your customers should be offered credit.
If there is no possibility of repeat orders, the decision is relatively simple.
Figure 32.2 summarizes your choice. On one hand, you can refuse credit. In this
case you make neither a profit nor a loss. The alternative is to offer credit. Sup-
pose that the probability that the customer will pay up is p. If the customer does
pay, you receive additional revenues (REV) and you incur additional costs; your
Brealey−Meyers:

Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
net gain is the present value of . Unfortunately, you can’t be certain
that the customer will pay; there is a probability of default. Default means
you receive nothing and incur the additional costs. The expected profit from each
course of action is therefore as follows:
11 Ϫ p2
REV Ϫ COST
CHAPTER 32
Credit Management 915
0
–COST
Refuse credit
Offer credit
Customer defaults (1 –
p
)
Customer pays (
p

)
REV–COST
FIGURE 32.2
If you refuse credit, you make neither profit nor
loss. If you offer credit, there is a probability p

that the customer will pay and you will make
REV Ϫ COST; there is a probability (1 Ϫ p) that the
customer will default and you will lose COST.
Expected Profit
Refuse credit 0
Grant credit pPV(REV Ϫ COST) Ϫ (1 Ϫ p)PV(COST)
You should grant credit if the expected profit from doing so is greater than the ex-
pected profit from refusing.
Consider, for example, the case of the Cast Iron Company. On each nondelin-
quent sale Cast Iron receives revenues with a present value of $1,200 and incurs
costs with a value of $1,000. Therefore the company’s expected profit if it offers
credit is
If the probability of collection is 5/6, Cast Iron can expect to break even:
Therefore Cast Iron’s policy should be to grant credit whenever the chances of col-
lection are better than 5 out of 6.
When to Stop Looking for Clues
We told you earlier where to start looking for clues about a customer’s creditwor-
thiness, but we never said anything about when to stop. Now we can work out how
your profits would be affected by more detailed credit analysis.
Suppose that Cast Iron Company’s credit department undertakes a study to de-
termine which customers are most likely to default. It appears that 95 percent of its
customers have been prompt payers and 5 percent have been slow payers. However,
Expected profit ϭ
5
6
ϫ 200 Ϫ a1 Ϫ
5
6
b ϫ 1, 000 ϭ 0
pPV1REV Ϫ COST2 Ϫ 11 Ϫ p2PV1COST2 ϭ p ϫ 200 Ϫ 11 Ϫ p2 ϫ 1,000

Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
customers with a record of slow payment are much more likely to default on the next
order than those with a record of prompt payment. On the average 20 percent of the
slow payers subsequently default, but only 2 percent of the prompt payers do so.
Suppose Cast Iron reviews a sample of 1,000 customers, none of whom has de-
faulted yet. Of these, 950 have a record of prompt payment, and 50 have a record
of slow payment. On the basis of past experience Cast Iron should expect 19 of the
prompt payers to default in the future and 10 of the slow payers to do so:
916 PART IX
Financial Planning and Short-Term Management
Number of Probability of Expected Number
Category Customers Default of Defaults
Prompt payers 950 .02 19
Slow payers 50 .20 10
All customers 1,000 .029 29
Now the credit manager must make a decision: Should the company refuse to give
any more credit to customers that have been slow payers in the past?
If you are aware that a customer has been a slow payer, the answer is clearly yes.
Every sale to a slow payer has only an 80 percent chance of payment . Sell-
ing to a slow payer, therefore, gives an expected loss of $40:
But suppose that it costs $10 to search through Cast Iron’s records to determine
whether a customer has been a prompt or slow payer. Is it worth doing so? The ex-
pected payoff to such a check is

In this case checking isn’t worth it. You are paying $10 to avoid a $40 loss 5 percent
of the time. But suppose that a customer orders 10 units at once. Then checking is
worthwhile because you are paying $10 to avoid a $400 loss 5 percent of the time:
The credit manager therefore decides to check customers’ past payment records
only on orders of more than five units. You can verify that a credit check on a five-
unit order just pays for itself.
Our illustration is simplistic, but you have probably grasped the message: You
don’t want to subject each order to the same credit analysis. You want to concen-
trate your efforts on the large and doubtful orders.
Credit Decisions with Repeat Orders
So far we have ignored the possibility of repeat orders. But one of the reasons for of-
fering credit today is that you may get yourself a good, regular customer by doing so.
Figure 32.3 illustrates the problem.
13
Cast Iron has been asked to extend credit
to a new customer. You can find little information on the firm, and you believe that
Expected payoff to credit check ϭ 1.05 ϫ 4002 Ϫ 10 ϭ $10
ϭ 1.05 ϫ 402 Ϫ 10 ϭϪ$8

Expected payoff
to credit check
ϭ
probability of identifying a slow payer
ϫ gain from not extending credit
Ϫ
cost of credit check
ϭ.812002 Ϫ .211,0002 ϭϪ$40
Expected profit ϭ pPV1REV Ϫ COST2 Ϫ 11 Ϫ p2PV1COST2
1p ϭ .82
(

)
13
Our example is adapted from H. Bierman, Jr., and W. H. Hausman, “The Credit Granting Decision,”
Management Science 16 (April 1970), pp. B519–B532.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
the probability of payment is no better than .8. If you grant credit, the expected
profit on this customer’s order is
You decide to refuse credit.
This is the correct decision if there is no chance of a repeat order. But look again
at the decision tree in Figure 32.3. If the customer does pay up, there will be a re-
order next year. Because the customer has paid once, you can be 95 percent sure
that he or she will pay again. For this reason any repeat order is very profitable.
Now you can reexamine today’s credit decision. If you grant credit today, you re-
ceive the expected profit on the initial order plus the possible opportunity to extend
credit next year:
ϭ Ϫ40 ϩ .80 ϫ PV11402
ϫ PV1next year’s expected profit on repeat order2
ϩ probability of payment and repeat order
Total expected profit ϭ expected profit on initial order
ϭ 1.95 ϫ 2002 Ϫ 1.05 ϫ 1,
0002ϭ $140
PV1 COST
2

2
Next year’s expected profit on repeat order ϭ p
2
PV1REV
2
Ϫ COST
2
2 Ϫ 11 Ϫ p
2
2
ϭ 1 .8 ϫ 2002 Ϫ 1.2 ϫ 1,0002 ϭϪ$40
Ϫ 11 Ϫ p
1
2 ϫ PV1COST2
Expected profit on initial order ϭ p
1
ϫ PV1REV Ϫ COST2
CHAPTER 32
Credit Management 917
Period 1 Period 2
0
–COST
1
Refuse credit
Refuse credit
Offer credit
Offer credit
Customer pays
p


2
= .95
Customer defaults
(1 -
p

2
) = .05
Customer defaults
(1 –
p

1
) = .2
Customer pays
p

1
= .8
0
–COST
2
REV
1
– COST
1
REV
2
–COST
2

FIGURE 32.3
In this example there is only a
.8 probability that your
customer will pay in period 1;
but if payment is made, there
will be another order in
period 2. The probability that
the customer will pay for the
second order is .95. The possi-
bility of this good repeat order
more than compensates for the
expected loss in period 1.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
At any reasonable discount rate, you ought to extend credit. For example, if the dis-
count rate is 20 percent,
In this example you should grant credit even though you expect to take a loss on
the order. The expected loss is more than outweighed by the possibility that you
will secure a reliable and regular customer.
Some General Principles
Sometimes the credit manager faces clear-cut choices. In such circumstances it may
be possible to estimate fairly precisely the consequences of a more liberal or a more
stringent credit policy. But real-life situations are generally far more complex than
our simple examples. Customers are not all good or all bad. Many of them pay con-

sistently late; you get your money, but it costs more to collect and you lose a few
months’ interest. Then there is the question of risk: You may be able to measure the
revenues and costs, but at what rate do you discount them?
Like almost all financial decisions, credit allocation involves a strong dose of
judgment. Our examples are intended as reminders of the issues involved rather
than as cookbook formulas. Here are the basic things to remember.
1. Maximize profit. As credit manager, you should not focus on minimizing the
number of bad accounts; your job is to maximize expected profit. You must
face up to the following facts: The best that can happen is that the customer
pays promptly; the worst is default. In the best case, the firm receives the
full additional revenues from the sale less the additional costs; in the worst,
it receives nothing and loses the costs. You must weigh the chances of these
alternative outcomes. If the margin of profit is high, you are justified in a
liberal credit policy; if it is low, you cannot afford many bad debts.
2. Concentrate on the dangerous accounts. You should not expend the same effort
on analyzing all credit applications. If an application is small or clear-cut,
your decision should be largely routine; if it is large or doubtful, you may
do better to move straight to a detailed credit appraisal. Most credit
managers don’t make credit decisions on an order-by-order basis. Instead,
they set a credit limit for each customer. The sales representative is required
to refer the order for approval only if the customer exceeds this limit.
3. Look beyond the immediate order. The credit decision is a dynamic problem.
You cannot look only at the present. Sometimes it may be worth accepting a
relatively poor risk as long as there is a likelihood that the customer will
become a regular and reliable buyer. New businesses must, therefore, be
prepared to incur more bad debts than established businesses. This is part
of the cost of building up a good customer list.
Total expected profit 1present value2 ϭϪ40 ϩ
.81 1402
1.2

ϭ $53.33
918 PART IX Financial Planning and Short-Term Management
32.5 COLLECTION POLICY
It would be nice if all customers paid their bills by the due date. But they don’t—
and since you may also occasionally “stretch” your payables, you can’t altogether
blame them.
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Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
The credit manager keeps a record of payment experiences with each customer.
Thus the manager knows that company Alpha always takes the discount and that.
Omega generally takes 90 days to pay. When a customer is in arrears, the usual pro-
cedure is to send a statement of account and to follow this at intervals with in-
creasingly insistent letters or telephone calls. If none of these has any effect, most
companies turn the debt over to a collection agency or an attorney. The fee for such
services is usually between 15 and 40 percent of the amount collected.
There is always a potential conflict of interest between the collection department
and the sales department. Sales representatives commonly complain that they no
sooner win new customers than the collection department frightens them off with
threatening letters. The collection manager, on the other hand, bemoans the fact
that the sales force is concerned only with winning orders and does not care
whether the goods are subsequently paid for.
There are also many instances of cooperation between sales managers and the
financial managers who worry about collections. For example, the specialty chem-
icals division of a major pharmaceutical company actually made a business loan to

an important customer that had been suddenly cut off by its bank. The pharma-
ceutical company bet that it knew its customer better than the customer’s bank did.
The bet paid off. The customer arranged alternative bank financing, paid back the
pharmaceutical company, and became an even more loyal customer. It was a nice
example of financial management supporting sales.
It is not common for suppliers to make business loans to customers in this way,
but they lend money indirectly whenever they allow a delay in payment. Trade
credit can be an important source of short-term funds for indigent customers that
cannot obtain a bank loan. But that raises an important question: If the bank is un-
willing to lend, does it make sense for you, the supplier, to continue to extend trade
credit? Here are two possible reasons why it may make sense: First, as in the case
of our pharmaceutical company, you may have more information than the bank
does about the customer’s business. Second, you need to look beyond the imme-
diate transaction and recognize that your firm may stand to lose some profitable
future sales if the customer goes out of business.
14
Factoring and Credit Insurance
A large firm has some advantages in managing its accounts receivable. There are
potential economies of scale in record keeping, billing, and so on. Also debt collec-
tion is a specialized business that calls for experience and judgment. The small firm
may not be able to hire or train a specialized credit manager. However, it may be
able to obtain some of these economies by farming out part of the job to a factor.
Factoring works as follows: The factor and the client agree on credit limits for
each customer and on the average collection period. The client then notifies each
customer that the factor has purchased the debt. Thereafter, for any sale, the client
sends a copy of the invoice to the factor, the customer makes payment directly to
the factor, and the factor pays the client on the basis of the agreed average collec-
tion period regardless of whether the customer has paid. There are, of course, costs
CHAPTER 32
Credit Management 919

14
Of course, banks also need to recognize future opportunities to make profitable loans to the firm.
The question therefore is whether suppliers have a greater stake in the continued prosperity of the
firm. For some evidence on the determinants of the supply and demand for trade credit, see M. A. Pe-
tersen and R. G. Rajan, “Trade Credit: Theories and Evidence,” Review of Financial Studies 10 (1997),
pp. 661–692.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
920 PART IX Financial Planning and Short-Term Management
to such an operation, and the factor typically charges a fee of 1 to 2 percent of the
value of the invoice.
15
This factoring arrangement, known as maturity factoring, provides assistance
with collection and insurance against bad debts. Generally, the factor is also will-
ing to advance 70 to 80 percent of the value of the accounts at an interest cost of 2
or 3 percent above the prime rate. Factoring that provides collection, insurance,
and finance is generally termed old-line factoring.
16
Factoring is most common in industries such as clothing and toys. These indus-
tries are characterized by many small producers and retailers that do not have long-
established relationships with each other. Because a factor may be employed by a
number of manufacturers, it sees a larger proportion of the transactions than any sin-
gle firm and therefore is better placed to judge the creditworthiness of each customer.
17

If you don’t want help with collection but do want protection against bad debts,
you can obtain credit insurance. The credit insurance company obviously wants to
be certain that you do not throw caution to the winds by extending boundless
credit to the most speculative accounts. It therefore generally imposes a maximum
amount that it will cover for accounts with a particular credit rating. Thus it may
agree to insure up to a total of $100,000 of sales to customers with the highest Dun
and Bradstreet rating, up to $50,000 to those with the next-highest rating, and so
on. You may claim not only if the customer actually becomes insolvent but also if
an account is overdue. Such a delinquent account is then turned over to the insur-
ance company, which makes vigorous efforts to collect.
Most governments have established agencies to insure export credits. In the
United States this insurance is provided by the Export–Import Bank (Ex–Im Bank) in
association with a group of insurance companies known as the Foreign Credit In-
surance Association (FCIA). Banks are much more willing to lend against export
credits that have been insured.
15
Many factors are subsidiaries of commercial banks. Their typical client is a relatively small manufac-
turing company selling on a repetitive basis to a large number of industrial or retail customers.
16
Under an arrangement known as with-recourse factoring, the company is liable for any delinquent ac-
counts. In this case the factor provides collection, but not insurance.
17
This point is made in S. L. Mian and C. W. Smith, Jr., “Accounts Receivable Management Policy: The-
ory and Evidence,” Journal of Finance 47 (March 1992), pp. 169–200.
SUMMARY
Credit management involves five steps. The first is to establish normal terms of
sale. This means that you must decide the length of the payment period and the
size of any cash discounts. In most industries these conditions are standardized.
The second step is to decide the form of the contract with your customer. Most
domestic sales are made on open account. In this case the only evidence that the

customer owes you money is the entry in your ledger and a receipt signed by the
customer. Particularly if the customer is located in a foreign country, you may re-
quire a more formal contract. We looked at two such devices—the trade acceptance
and the letter of credit.
The third step is to assess each customer’s creditworthiness. There are a variety of
sources of information—your own experience with the customer, the experience of
other creditors, the assessment of a credit agency, a check with the customer’s bank,
the market value of the customer’s securities, and an analysis of the customer’s fi-
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32. Credit Management
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Companies, 2003
CHAPTER 32 Credit Management 921
nancial statements. Firms that handle a large volume of credit information often use
a formal system for combining the data from various sources into an overall credit
score. Such numerical scoring systems help separate the borderline cases from the
obvious sheep or goats. We showed how you can use statistical techniques such as
multiple-discriminant analysis to give an efficient measure of default risk.
When you have made an assessment of the customer’s credit standing, you can
move to the fourth step in credit management, which is to establish sensible credit lim-
its. The job of the credit manager is not to minimize the number of bad debts; it is to
maximize profits. This means that you should increase the customer’s credit limit as
long as the probability of payment times the expected profit is greater than the prob-
ability of default times the cost of the goods. Remember not to be too shortsighted in
reckoning the expected profit. It is often worth accepting the marginal applicant if

there is a chance that the applicant may become a regular and reliable customer.
The fifth, and final, step is to collect. Doing so requires tact and judgment. You
want to be firm with the truly delinquent customer, but you don’t want to offend
the good one by writing demanding letters just because a check has been delayed
in the mail. You will find it easier to spot troublesome accounts if you keep a care-
ful record of the aging of receivables.
These five steps are interrelated. For example, you can afford more liberal terms
of sale if you are very careful about whom you grant credit to. You can accept
higher-risk customers if you are very active in pursuing any late payers. A good
credit policy is one that adds up to a sensible whole.
FURTHER
READING
A standard text on the practice and institutional background of credit management is:
R. H. Cole and L. Mishler: Consumer and Business Credit Management, 11th ed., McGraw-Hill,
New York, 1998.
For a more analytical discussion of credit policy, see:
S. Mian and C. W. Smith: “Extending Trade Credit and Financing,” Journal of Applied Corpo-
rate Finance, 7:75–84 (Spring 1994).
M. A. Peterson and R. G. Rajan: “Trade Credit: Theories and Evidence,” Review of Financial
Studies, 10:661–692 (1997).
Altman’s paper is the classic on numerical credit scoring:
E. I. Altman: “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bank-
ruptcy,” Journal of Finance, 23:589–609 (September 1968).
Altman also provides a review of credit scoring models in:
E. I. Altman: Corporate Financial Distress and Bankruptcy, 2nd ed., John Wiley, New York, 1993.
QUIZ
1. Company X sells on a 1/30, net 60 basis. Customer Y buys goods invoiced at $1,000.
a. How much can Y deduct from the bill if Y pays on day 30?
b. What is the effective annual rate of interest if Y pays on the due date rather than on
day 30?

c. How would you expect payment terms to change if
i. The goods are perishable.
ii. The goods are not rapidly resold.
iii. The goods are sold to high-risk firms.
2. The lag between the purchase date and the date on which payment is due is known as
the terms lag. The lag between the due date and the date on which the buyer actually
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IX. Financial Planning and
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32. Credit Management
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Companies, 2003
922 PART IX Financial Planning and Short-Term Management
pays is the due lag, and the lag between the purchase and actual payment dates is the
pay lag. Thus,
State how you would expect the following events to affect each type of lag:
a. The company imposes a service charge on late payers.
b. A recession causes customers to be short of cash.
c. The company changes its terms from net 10 to net 20.
3. Complete the passage below by selecting the appropriate terms for each blank from the
following list (some terms may be used more than once): acceptance, open, commercial,
trade, the United States, his or her own, draft, account, bank, the customer’s, letter of credit,
shipping documents.
Most goods are sold on ______ ______. In this case the only evidence of the debt is
a record in the seller’s books and a signed receipt. If you wish to ensure that its buyer
will pay, you can arrange a(n) ______ ______ , ordering payment by the customer. In or-
der to obtain the ______ ______, the customer must acknowledge this order and sign

the document. The signed acknowledgment is known as a(n) ______ ______. Sometimes
the seller may ask ______ ______ bank to sign the document. In this case it is known as
a(n) ______ ______. The fourth form of contract is used principally in overseas trade.
The customer’s bank sends the exporter a(n) ______ ______ ______ stating that it has es-
tablished a credit in his or her favor at a bank in the United States. The exporter then
draws a draft on ______ bank and presents it to ______ ______ bank together with the
______ ______ and ______ ______. The bank then arranges for this draft to be accepted
and forwards the ______ ______ to the customer’s bank.
4. The Branding Iron Company sells its irons for $50 apiece wholesale. Production cost is
$40 per iron. There is a 25 percent chance that wholesaler Q will go bankrupt within the
next year. Q orders 1,000 irons and asks for six months’ credit. Should you accept the
order? Assume that the discount rate is 10 percent per year, there is no chance of a re-
peat order, and Q will pay either in full or not at all.
5. Look back at Section 32.4. Cast Iron’s costs have increased from $1,000 to $1,050. As-
suming there is no possibility of repeat orders, answer the following:
a. When should Cast Iron grant or refuse credit?
b. If it costs $12 to determine whether a customer has been a prompt or slow payer in
the past, when should Cast Iron undertake such a check?
6. Look back at the discussion in Section 32.4 of credit decisions with repeat orders. If ,
what is the minimum level of at which Cast Iron is justified in extending credit?
7. True or False?
a. Exporters who require greater certainty of payment arrange for the customers to
sign a bill of lading in exchange for a sight draft.
b. Multiple-discriminant analysis is often used to construct an index of
creditworthiness. This index is generally called a Z score.
c. It makes sense to monitor the credit manager’s performance by looking at the
proportion of bad debts.
d. If a customer refuses to pay despite repeated reminders, the company will usually
turn the debt over to a factor or an attorney.
e. The Foreign Credit Insurance Association insures export credits.

p
2
p
1
ϭ .8
Pay lag ϭ terms lag ϩ due lag
PRACTICE
QUESTIONS
1. Listed below are some common terms of sale. Can you explain what each means?
a. 2/30, net 60.
b. net 10.
c. 2/5, EOM, net 30.
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CHAPTER 32 Credit Management 923
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2. Some of the items in question 1 involve a cash discount. For each of these, calculate the rate
of interest paid by customers who pay on the due date instead of taking the cash discount.
3. Phoenix Lambert currently sells its goods cash on delivery. However, the financial man-
ager believes that by offering credit terms of 2/10 net 30 the company can increase sales
by 4 percent, without significant additional costs. If the interest rate is 6 percent and the
profit margin is 5 percent, would you recommend offering credit? Assume first that all
customers take the cash discount. Then assume that they all pay on day 30.

4. As treasurer of the Universal Bed Corporation, Aristotle Procrustes is worried about his
bad debt ratio, which is currently running at 6 percent. He believes that imposing a
more stringent credit policy might reduce sales by 5 percent and reduce the bad debt
ratio to 4 percent. If the cost of goods sold is 80 percent of the selling price, should
Mr. Procrustes adopt the more stringent policy?
5. Jim Khana, the credit manager of Velcro Saddles, is reappraising the company’s credit
policy. Velcro sells on terms of net 30. Cost of goods sold is 85 percent of sales, and fixed
costs are a further 5 percent of sales. Velcro classifies customers on a scale of 1 to 4. Dur-
ing the past five years, the collection experience was as follows:
Defaults as Percent Average Collection Period in Days
Classification of Sales for Nondefaulting Accounts
1.0 45
2 2.0 42
3 10.0 40
4 20.0 80
The average interest rate was 15 percent.
What conclusions (if any) can you draw about Velcro’s credit policy? What other
factors should be taken into account before changing this policy?
6. Look again at question 5. Suppose (a) that it costs $95 to classify each new credit applicant
and ( b) that an almost equal proportion of new applicants falls into each of the four cate-
gories. In what circumstances should Mr. Khana not bother to undertake a credit check?
7. Until recently, Augean Cleaning Products sold its products on terms of net 60, with an
average collection period of 75 days. In an attempt to induce customers to pay more
promptly, it has changed its terms to 2/10, EOM, net 60. The initial effect of the changed
terms is as follows:
Average Collection Periods, Days
Percent of Sales with Cash Discount Cash Discount Net
60 30* 80
*Some customers deduct the cash discount even though they pay after the specified date.
Calculate the effect of the changed terms. Assume

• Sales volume is unchanged.
• The interest rate is 12 percent.
•
There are no defaults.
• Cost of goods sold is 80 percent of sales.
8. Look back at question 7. Assume that the change in credit terms results in a 2 percent
increase in sales. Recalculate the effect of the changed credit terms.
9. Financial ratios were described in Chapter 29. If you were a credit manager, to which
financial ratios would you pay most attention? Which do you think would be the least
informative?
EXCEL
EXCEL
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
924 PART IX Financial Planning and Short-Term Management
10. Discuss the problems with developing a numerical credit scoring system for evaluating
personal loans. You can only test your system using data for applicants who have in the
past been granted credit. Is this a potential problem?
11. Discuss ways in which real-life decisions are more complex than the decision illustrated
in Figure 32.3. How do you think these differences ought to affect the credit decision?
12. How should your willingness to grant credit be affected by differences in (a) the profit
margin, (b) the interest rate, (c) the probability of repeat orders? In each case illustrate
your answer with a simple example.
13. Select two companies from the Market Insight database (www

.mhhe.com/
edumarketinsight). Use their latest financial statements to calculate some financial
ratios that throw light on their relative creditworthiness. Calculate a Z-score for each,
using the formula shown in Section 32.3. Now look at other indicators of creditwor-
thiness, such as the company’s bond rating or the return on its stock. Are the differ-
ent indicators providing consistent messages?
14. Use the Market Insight database (www
.mhhe.com/edumarketinsight) to compare the
average collection periods (see Section 29.3) for different companies. Can you explain
why some companies grant more credit than others?
CHALLENGE
QUESTIONS
1. Why do firms grant “free” credit? Would it be more efficient if all sales were for cash
and late payers were charged interest?
2. Sometimes a firm sells its receivables at a discount to a wholly owned captive finance
company. This captive finance company is partly financed by the parent, but it also is-
sues substantial amounts of debt. What are the possible advantages of such an
arrangement?
3. Reliant Umbrellas has been approached by Plumpton Variety Stores of Nevada. Plump-
ton has expressed interest in an initial purchase of 5,000 umbrellas at $10 each on Reliant’s
standard terms of 2/30, net 60. Plumpton estimates that if the umbrellas prove popular
with customers, its purchases could be in the region of 30,000 umbrellas a year. After de-
ductions for variable costs, this account would add $47,000 per year to Reliant’s profits.
Reliant has been anxious for some time to break into the lucrative Nevada market,
but its credit manager has some doubts about Plumpton. In the past five years, Plump-
ton had embarked on an aggressive program of store openings. In 2001, however, it
went into reverse. The recession, combined with aggressive price competition, caused
a cash shortage. Plumpton laid off employees, closed one store, and deferred store
openings. The company’s Dun and Bradstreet rating is only fair, and a check with
Plumpton’s other suppliers reveals that, although Plumpton traditionally took cash

discounts, it has recently been paying 30 days slow. A check through Reliant’s bank in-
dicates that Plumpton has unused credit lines of $350,000 but has entered into discus-
sions with the banks for a renewal of a $1,500,000 term loan due at the end of the year.
Table 32.1 summarizes Plumpton’s latest financial statements.
As credit manager of Reliant, how do you feel about extending credit to Plumpton?
4. Galenic, Inc., is a wholesaler for a range of pharmaceutical products. Before deducting
any losses from bad debts, Galenic operates on a profit margin of 5 percent. For a long
time the firm has employed a numerical credit scoring system based on a small num-
ber of key ratios. This has resulted in a bad debt ratio of 1 percent.
Galenic has recently commissioned a detailed statistical study of the payment
record of its customers over the past eight years and, after considerable experimenta-
tion, has identified five variables that could form the basis of a new credit scoring sys-
tem. On the evidence of the past eight years, Galenic calculates that for every 10,000 ac-
counts it would have experienced the following default rates:
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By refusing credit to firms with a low credit score (less than 80), Galenic calculates that
it would reduce its bad debt ratio to 60/9,160, or just under .7 percent. While this may
not seem like a big deal, Galenic’s credit manager reasons that this is equivalent to a de-
crease of one-third in the bad debt ratio and would result in a significant improvement
in the profit margin.

a. What is Galenic’s current profit margin, allowing for bad debts?
b. Assuming that the firm’s estimates of default rates are right, how would the new
credit scoring system affect profits?
c. Why might you suspect that Galenic’s estimates of default rates will not be
realized in practice? What are the likely consequences of overestimating the
accuracy of such a credit scoring scheme?
d. Suppose that one of the variables in the proposed scoring system is whether the
customer has an existing account with Galenic (new customers are more likely to
default). How would this affect your assessment of the proposal?
Credit Score under
Number of Accounts
Proposed System Defaulting Paying Total
Greater than 80 60 9,100 9,160
Less than 80 40 800 840
Total 100 9,900 10,000
2001 2000 2001 2000
Cash $ 1.0 $ 1.2 Payables $ 2.3 $ 2.5
Receivables 1.5 1.6 Short-term loans 3.9 1.9
Inventory 10.9 11.6 Long-term debt 1.8 2.6
Fixed assets 5.1 4.3 Equity 10.5 11.7
Total assets $18.5 $18.7 Total liabilities $18.5 $18.7
2001 2000
Sales $55.0 $59.0
Cost of goods sold 32.6 35.9
Selling, general, and administrative expenses 20.8 20.2
Interest .5 .3
Tax .5 1.3
Net income $ .6 $ 1.3
TABLE 32.1
Plumpton Variety

Stores: summary
financial statements
(figures in millions).
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
32. Credit Management
© The McGraw−Hill
Companies, 2003
RELATED WEBSITES
For an introductory guide to understanding
financial statements see:
www
.ibm.com/investor/financialguide
For easy access to annual reports see:
www
.reportgallery.com
www
.prars.com
Downloadable software for short- and long-
term financial planning is available on:
www
.decisioneering.com
Journals with articles on short-term financial
management include:
www
.americanbanker.com
www

.intltreasurer.com
www
.treasuryandrisk.com
The Federal Reserve Bank sites are good general
sources of reference for short-term interest rates
and material on payment systems. See, for
example:
www
.federalreserve.gov
www.ny.frb.org
www.stls.frb.org
Sites on short-term debt markets include:
www.afponline.org (money market and
interest rate data)
www
.gecfosolutions.com
(GE Capital’s
website contains information on sources and
costs of short-term finance)
www
.ny.frb.org/pihome/addpub/credit.
pdf (a guide to sources of credit)
The websites of most major banks provide
material on cash management services. See, for
example:
www
.bankone.com
www
.bankofamerica.com
Other sites dealing with cash management

include:
www
.nacha.org
(material on electronic
payment)
www
.phoenixhecht.com (a comprehensive
website on cash management with useful links)
Some sites that are concerned with credit
management:
www
.creditworthy.com
(credit management)
www
.dnb.com
(examples of Dun and
Bradstreet credit reports, articles on credit
management, and an introductory guide to
understanding financial statements)
www
.ftc.gov/bcp/conline/pubs/credit/
scoring.htm (a guide to credit scoring)
www.nacm.org (contains links to sites on
credit-related issues)
PART NINE
RELATED
WEBSITES