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Credit Analysis and Policy

Use the data in Example 3. Now suppose, however, that 10 percent of Cast Iron`s customers are slow payers, and that slow payers have a probability of 30 percent of defaulting on their bills. If it costs $5 to determine whether a customer has been a prompt or slow payer in the past, should Cast Iron undertake such a check? Hint: What is the expected savings from the credit check? It will depend on both the probability of uncovering a slow payer and the savings from denying these payers credit.

18. Credit Analysis. Look back at the previous problem, but now suppose that if a customer defaults on a payment, you can eventually collect about half the amount owed to you. Will you be more or less tempted to pay for a credit check once you account for the possibility of partial recovery of debts?

19. Credit Policy. 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. Velcro classifies customers on a scale of 1 to 4. During the past 5 years, the collection experience was as follows:

The average interest rate was 15 percent. What conclusions (if any) can you draw about Velcro`s credit policy? Should the firm deny credit to any of its customers? What other factors should be taken into account before changing this policy?

20. Credit Analysis. 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 number 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 8 years and, after considerable experimentation, has identified five variables that could form the basis of a new credit scoring system. On the evidence of the past 8 years, Galenic calculates that for every 10,000 accounts it would have experienced the following default rates:

By refusing credit to firms with a poor credit score (worse 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 decrease 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?

d. Suppose that one of the variables in the proposed new 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? Hint: Think about repeat sales.

1 To get the cash discount, you have to pay the bill within 10 days, that is, by May 11. With the 2 percent discount, the amount that needs to be paid by May 11 is $20,000 .98 = $19,600. If you forgo the cash discount, you do not have to pay your bill until May 21, but on that date, the amount due is $20,000.

2 The cash discount in this case is 5 percent and customers who choose not to take the discount receive an extra 50 Ј 10 = 40 days credit. So the effective annual interest is In this case the customer who does not take the discount is effectively borrowing money at an annual interest rate of 59.7 percent. This is higher than the rate in Example 21.1 because fewer days of credit are obtained by forfeiting the discount.

3 The present value of costs is still $1,000. Present value of revenues is now $1,100. The break-even probability is defined by

p 100 Ј (1 Ј p) 1,000 = 0

which implies that p = .909. The break-even probability is higher because the profit margin is now lower. The firm cannot afford as high a bad debt ratio as before since it is not making as much on its successful sales. We conclude that high-margin goods will be offered with more liberal credit terms.